Systemic Risk and Market Institutions

Abstract

With private-label mortgage-backed securities (MBS), investors bore default risk; while this risk should have been priced, as systemic risk grew, the pricing of risk did not increase. This paper attempts to explain why this happened. We point to market institutions’ incentive misalignments that cause asset prices to rise above fundamentals, producing systemic risk. The model attributes the asset price inflation to the provision of underpriced credit as lending institutions misprice risk to gain market share. The resulting asset price inflation itself then generates further expansion of underpriced credit.

Keywords: Real estate, mortgages, housing, mortgage-backed securities, pricing of risks, default risk, incentive misalignments, underpriced credit, asset price inflation, market bubbles

JEL Classification: G21, K22