Bank Regulation and Securitization: How the Law Improved Transmission Lines between Real Estate and Banking Crises
42 Pages Posted: 27 Dec 2016
Date Written: December 4, 2015
This essay examines how securitization served as a new coupling rod joining cycles in real estate and banking markets and created a new pathway for financial contagion in the “subprime” financial crisis. Legal changes promoted the growth of securitization and improved this crisis transmission line. The essay examines the history of legislative and regulatory changes that facilitated bank participation in the markets for mortgage-backed securities. The essay then explains how securitization failed to mitigate the credit, liquidity, and interest rate risk associated with real estate when losses in residential markets became correlated nationwide. It then discusses how regulation contributed to this, as the spread of securitization and financial industry consolidation created a nationwide market for mortgages.
The essay telescopes out from securitization to discuss an often overlooked danger of bank investments in real estate: the cyclicality of real estate losses. The essay analyzes the evidence that real estate prices exhibit positive serial correlation. It also summarizes historical evidence of the correlation between banking and real estate crises. The essay then looks at feedback mechanisms between banking and real estate markets, including research on bank leverage cycles.
The essay next provides a very high level outline of various approaches to decoupling bank and real estate crises and the advantages and drawbacks of various approaches. These approaches include curbing bank investments in real estate and mortgage-backed securities, using bank regulations as a more surgical tool to fix problems with securitization, and developing countercyclical approaches to regulations of mortgage markets and bank investments in them. The essay then concludes by discussing the political dynamics that will shape and constrain any of these policy approaches.
Keywords: securitization, bank regulation, mortgage-backed securities, real estate crises, bank crises, subprime
JEL Classification: K22, G21, G28
Suggested Citation: Suggested Citation