Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure
Patricia A. McCoy
Boston College Law School
Andrey D. Pavlov
Simon Fraser University (SFU) - Finance Area
Susan M. Wachter
University of Pennsylvania - Wharton School, Department of Real Estate
February 9, 2009
Connecticut Law Review, Vol. 41, p. 493, May 2009
Without regulation, securitization allowed mortgage industry actors to gain fees and to put off risks. During the housing boom, the ability to pass off risk allowed lenders and securitizers to compete for market share by lowering their lending standards, which activated more borrowing. Lenders who did not join in the easing of lending standards were crowded out of the market. Artificially low risk premia caused the asset price of houses to go up, leading to an asset bubble and breeding fraud. The consequences of lax lending were thereby covered up.
The market might have corrected this problem if investors had been able to express their negative views by short selling mortgage-backed securities, thereby allowing fundamental market value to be achieved. However, the one instrument that could have been used to short sell mortgage-backed securities - the credit default swap - was also infected with underpricing due to lack of minimum capital requirements and regulation to facilitate transparent pricing. As a result, there was no opportunity for short selling in the private-label securitization market. The authors propose countercyclical regulation to prevent a race to the bottom at the height of the business cycle.
Number of Pages in PDF File: 49
Keywords: Securitization, credit default swap, subprime, mortgage, asset bubble
JEL Classification: D21, D43, G12, G18, G21, G28, K20, L13, L51
Date posted: March 26, 2009 ; Last revised: May 16, 2012