georgetown university law center business, economics and...

Electronic copy available at: http://ssrn.com/abstract=1462895

Georgetown University Law Center Business, Economics and Regulatory Policy Working Paper Series

Research Paper No. 1462895

Institute for Law & Economics University of Pennsylvania Law School

Research Paper No. 09-31

SECURITIZATION: CAUSE OR REMEDY OF THE FINANCIAL CRISIS?

Adam J. Levitin Georgetown University Law Center

Andrey D. Pavlov

Simon Fraser University

Susan M. Wachter

University of Pennsylvania

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Electronic copy available at: http://ssrn.com/abstract=1462895Electronic copy available at: http://ssrn.com/abstract=1462895

8/27/09]

©2009,AdamJ.Levitin,AndreyD.Pavlov,&SusanM.Wachter

SECURITIZATION:CAUSEORREMEDYOFTHEFINANCIALCRISIS

ADAMJ.LEVITIN*ANDREYD.PAVLOV†SUSANM.WACHTER

‡

ABSTRACT

This article describes the causes of the boomand bust inthe U.S. housing market, which brought down not just the U.S.financialsystembuttheglobaleconomy.Howdidthisviciouscyclebegin?Howdidhomepricesappreciate so farand so fast?Whydid rational investors not recognize and stop mispricing andinvesting in these loans onWall Street? We offer a supply‐sideexplanationofthemortgagecrisis.Attherootofthecrisiswasanew class of specialized mortgage lenders and securitizersunrestricted by regulations governing traditional lending andsecuritization. Eager to take profits in an originate‐to‐distributelendingmodel, aggressive lenders piled in by offering loanswithlow upfront costs, attracting first‐time home buyers previouslyunable toaffordhouses, repeatbuyersbuyingpricierhomesandsecondhomes,aswellasspeculators.ThesepracticesdrovepricesparticularlyhighinArizona,California,Florida,andNevada,whichhad significant land‐use regulations and environmental controlsthat reduced supply elasticity, leading increases in demand totriggermostlyhigherpricesinsteadofagreatersupplyofhousing.

*Adam J. Levitin ([email protected]) isAssociateProfessor

of Law at the Georgetown University Law Center. A version of this paperappearedin16WHARTONREALESTATEREV.(2009).

†AndreyD.Pavlov([email protected])isAssociateProfessorofBusinessatSimonFraserUniversity.

‡ Susan M. Wachter ([email protected]) is Richard B.Worley Professor of FinancialManagement and Professor of Real Estate andFinanceatTheWhartonSchool.

Electronic copy available at: http://ssrn.com/abstract=1462895Electronic copy available at: http://ssrn.com/abstract=1462895

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SECURITIZATION:CAUSEORREMEDYOFTHEFINANCIALCRISIS

ADAMJ.LEVITINANDREYD.PAVLOVSUSANM.WACHTER

I.THENEWSECURITIZATION .......................................................................................... 3II.NONTRADITIONAL(NONPRIME)MORTGAGES ............................................................... 6III.ADEBT‐DRIVENPHENOMENON ................................................................................ 9IV.NON‐RECOURSELENDING ....................................................................................... 12V.MISALIGNEDINCENTIVES .........................................................................................13VI.THENEWNEWSECURITIZATION.............................................................................. 15

Inthisfinancialcrisis,realestatehasbeenhithardand,in

turn, real estate has hit individual homeowners, the financialsector,andtheoveralleconomy. In fact, the losses inresidentialmortgage‐backed securities (MBS) were the proximate cause ofthemeltdownofthefinancialsysteminthefallof2008.Precedingthis,thebubbleinrealestateassetsanddebtlaidthegroundworkfor the eventual crash. Despite extraordinary countercyclicalmonetary and fiscal policy, as of the third quarter, housingcontinues to be a negative force. As of mid‐year 2009, homepriceshavefallenapproximately30percent fromtheirpeakandthe stock market has plummeted twice as much.1 Because thefinancial sector is exposed to commercial and residentialmortgages, banking and the economydepend fundamentally onthestabilityofrealestate.

The root of the crisis: homeownerswho could notmakepayments falling into foreclosure and the lenders putting thesehomes up for sale at fire sale prices, resulted in an increase insupply. This pushed down real estate values, which left manyother homeowners with negative equity—their homes wereworth less than they owed on their mortgages. Paying amortgageonapropertywithnegativeequityiseconomicrenting,andwithcheaperrentalratesmanyhomeownerswhootherwise

1S&P/Case‐ShillerHomePriceIndex.

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would continue making payments despite financial reversalssimply stopped making their mortgage payments and walkedawayfromtheirproperties,feedingmoreforeclosures(Figure1).2More fuelwas thrownon this fireas theeconomydeclined. Asunemployment rose more mortgages became unaffordable,resulting inmoreforeclosures,andfurtherpricedeclines leadingtomorenegativeequity.

Figure1.GrowthinForeclosures3

How did this vicious cycle begin? How did home pricesappreciate so far and so fast? Why did rational investors notrecognizeandstopmispricingandinvestingintheseloansonWallStreet?Thisarticledescribesthecausesoftheboomandbustinthe U.S. housing market that brought down not just the U.S.financialsystembuttheglobaleconomy.

2 See, e.g., CONG. OVERSIGHT PANEL, THE FORECLOSURE CRISIS: WORKING

TOWARDASOLUTIONpin(2009)3MortgageBankersAssociationNationalDelinquencySurveys.

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I.THENEWSECURITIZATION

The economic circumstances that contributed to therecenthousingmarketboomandbustarenotunique inhistory.RealestateboomsandsubsequentbankingcrasheshaveoccurredintheU.S.andelsewhere,intheearly1980sinJapan,inthelate1980s in the savings and loan crisis and as recently as the late1990s in theAsianFinancialCrisis.Moreover, thehousingboomthat preceded this crisis was global. Nonetheless, this time theasset and credit bubble blowout and subsequent crash wereMade in the USA. Downturns in the mortgage and housingmarketshavecausedeconomicproblemsbefore,butthecurrentsituation is the first of its kind and severity, underscoringprofoundchangesinthesemarkets.

At the root of themortgage problemwas a new class ofspecialized mortgage lenders and securitizers unrestricted byregulations governing traditional lending and securitization.Historically, themortgagemarketwasdominatedbysavingsandloans and commercial banks. Both of these types of entitieseither held mortgages in portfolio or securitized them throughgovernment‐sponsoredentities(GSEs):FannieMae,FreddieMac,andGinnieMae.BecausetheGSEsguaranteethetimelypaymentof principal and interest on their MBS, they are permitted tosecuritize only “investment‐grade” mortgages. This meant thatlenders who made non‐investment grade loans were forced tokeep the mortgages—and the credit risk—on their books. Notsurprisingly,lendershadlittleappetiteformakingriskierloans.

The balance of the mortgage market began to change,however, in themid‐1990s and a rapid transformation occurredafter 2000. Lenders discovered that rather than securitizingmortgagesthroughtheGSEs, theycouldsecuritizethemthroughunregulated, private conduits managed by investment banks.These “private‐label”MBS did not carry the GSE’s guarantee oftimely payment of principal and interest; instead, investorsassumed the credit risk on these MBS, which meant on theunderlyingmortgages.Theseoriginationdemandoftheseprivate

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conduits were feed heavily by thinly regulated mortgage banksandmortgagebrokers.

Because private label MBS do not have the paymentguarantee (with implicit or explicit government backing) of theGSEs, they were designed with other forms of creditenhancement,mostnotablythedivisionofthesecuritiesbackedby a pool ofmortgages into a cashflowwaterfall that allocateddefault risk on themortgages by a hierarchy of “tranches.” Theresult was the creation of AAA securities from risky underlyingmortgages.Theriskiesttranchesreceivedthelowestratingsfromthe credit rating agencies and therefore paid the highest yields,and theywere the first to lose value if borrowers fell behind inpayments.On topof this, financial firms leveraged private labelMBSbyusingtheseascollateralforadditionaldebt,intheformofcollateralizeddebtobligations(CDOs).FirmsoftenmadeCDOs2bypooling and tranching CDOs themselves. Leverage on top ofleverageleftthesystemvulnerabletoeventheslightestdeclineinpricesorincreaseinloandefaults.

The rating agencies, did not carefully analyze theunderlyingcollateralofthesecuritiestoidentifytheprobabilityofdefault or price fluctuation. Instead, they assumed home priceswould not decline by much, if at all. Since the U.S. had neverexperiencedaneconomy‐widedecrease inhomepricesofmorethan 1 percent, the agencies considered this to be a reasonableassumption, and the firms issuing the securities assumed theirdiversificationhadremovedanyriskofconsiderablelosses.

This “private‐label” securitization permitted thesecuritizationofnon‐investmentgrademortgages,andtherewasa market appetite for private‐label MBS because of the higheryields they offered relative toGSEMBS. The development of amarket for non‐investment grade mortgages led to a boom intheir production. From the mid‐1990s to 2006, nontraditional(nonprime) mortgages grew from virtually zero to nearly 50percentoforiginations.Manyofthenewloanswereweremadeto borrowers who could not qualify for traditional mortgages

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because of poor credit or low incomes. Many were alsooriginated bymortgage banks ormortgage brokerswhodid notholdloansinportfolio,andwhosebusinesswassolelygeneratingmortgageproductforprivate‐labelsecuritizationpipelines.

Lendingqualityforprivate‐labelsecuritizationwasdifficulttomonitoranddeclinedovertime.Becausethesesecuritieswerenotbackedby standardizedassets, theygenerallydidnot trade.Private‐label securities (PLS), as opposed to those issued by theGSEs,werenot traded because theywerenon‐standardizedandtherefore illiquid. PLSwere thereforemarked tomodel, not tomarket. Evidence of misallocated investment and growing riskwasmaskedbythefactthatthelooserstandardsbuoyedhousingpricesintheshortterm.

TableI.DeteriorationofLendingStandards,2002‐2006

MortgageInformation AllLoans

YearofOrigination 1999 2003 2006

NumberofLoans(AllLoans) 596,710 1,840,040 3,251,355

SubprimeLoans 512,476 1,426,503 2,376,949

AltALoans 84,233 413,494 872,208

LowDocLoans 120,682 678,810 1,635,176

InterestOnlyLoans 1,169 95,870 725,317

SecondLoans 86,482 192,337 708,343

ARMTeaserLoans 172579 361811 1639509

MARGIN(AdjustableRate) 6 6 5

Source:LoanPerformance,AnthonyPennington‐Cross,etal.,WRECWRC

Moreover the erosion of lending standards was nearlyimpossibleto identify inreal timebecausemortgageswerenon‐standardizedandheterogeneous.Giventhisheterogeneity,itwasnotpossibletotrackthechange inthecompositionofmortgageproduct or the layering of risk. And because these were nottraded, there was no ability to signal this credit erosion to themarket.Theprice bubble fueledbypoorunderwriting increased

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the risk exposure of the entire mortgage system given theinevitablecollapseof inflatedprices.Homepricesplummetedsosharply that by the spring of 2009, some have estimated thateveryfifthborrowerowedmorethanhisorherhomewasworthand defaults rose to postwar records: almost one out of everytwenty‐fiveborrowersisinforeclosure.Financialinstitutionswithmajormortgagemarketexposurehavefailedorrequiredextremegovernment assistance, and even AAA‐rated MBS tranches aretrading for a fraction of face because of market uncertaintyregardingfuturedefaults.Thisisthesystemicriskengenderedbysecuritizationwithoutregulation.

II.NONTRADITIONAL(NONPRIME)MORTGAGES

In an era of deregulation and optimism, private‐labelsecuritizationdrovethedemandfornewtypesofriskymortgages.For the past half‐century, the classic U.S. mortgage charged afixedinterestratethatstayedthesamefortheloan’s30‐yearlife.Once the mortgage papers were signed, the homeowner’smonthly payments never changed,making payments easier andeasier to shoulder as the borrower’s income rosewith inflation.Generally,homevalueswentupaswell,sotheborrowerscouldexpecttosellatvirtuallyanytimeformorethantheyowed.

This picture changed dramatically in the run‐up to thehousingbubbleasthedemandforsecuritizedmortgagesfedthedemandforrecklesslyunderwritten loans. Initially,MBS involvedonly “prime” mortgages issued to low‐risk borrowers, but thenprivate label securitizers entered themarket to poolmortgagesbacked by increasingly risky loans that the GSEs were notpermitted to securitize.Prior to 2003,nontraditional (nonprime)mortgages never held more than 16 percent of the market; by2006,theyhadreachedastaggering46percent(Figure2).Nearlytwo‐thirdsofallhomeloansissuedsince2003were“aggressive,”entailing risks not found in conventional loans. In addition tosubprime loans, this includednon‐amortizing, interest‐only loanswhere the borrowermade no principal payments; “low doc” or“no doc” loans that required little or no down payment,

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documentation, or proof of income; and pay option adjustable‐rate mortgages (ARMs) that allowed borrowers to choose themonthly payment level, including making interest only ornegativelyamortizingpayments.

Figure2.MortgageOriginationsbyProduct

At the same time, the subprime market developed newproducts whose features had never faced a market test. Thisincluded “hybridARMs”, often known as 2/28 and 3/27 loans—30‐yearloanswithafixedrateteaserperiodoftwoorthreeyearsandannuallyadjustedratesthereafter.Theycarriedprepaymentpenalties making it prohibitively expensive for borrowers torefinance when their payments got too high, such as at theexpiration of the teaser period. Buyers qualified based on theinitial low “teaser” rate, even though theymight not be able toshoulder the higher payments that could come if the rateadjustedupward.

The race for market share fueled the extension ofincreasingly risky loans to borrowers without the capacity torepay. The expansion of these aggressive loans beyond theirsuitable use is the real concern. Alt‐A loans, for example, are

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riskier thanprimebut less riskythan subprime,.Asa result theyare niche productswell‐targeted to self‐employed homeowners.Similarly, option ARMs were originally designed for individualswithirregularincome(suchascommissions,seasonalearnings,oryear‐endbonuses),notasageneralmarketproduct.

Aggressive lenders piled in by offering loans with lowupfrontcosts,attractingfirst‐timehomebuyerspreviouslyunabletoaffordhouses,repeatbuyersbuyingpricierhomesandsecondhomes, as well as speculators. Aggressive lending drove pricesparticularlyhighinArizona,California,Florida,andNevada,whichhad significant land‐use regulations and environmental controlsthat reduced supply elasticity, leading increases in demand totriggermostlyhigherpricesinsteadofagreatersupplyofhousing.

By 2007, it was clear that neighborhoods and cities thathadhighconcentrationsofaggressivelendingsufferedthelargesthome‐price declines after the market cooled. For each one‐percent higher share of subprime origination in 2005, pricesdeclined increased by 1.5 percent for that neighborhood. 4Thiswas especially ominous for both inner‐city and far‐out “drive toqualify”neighborhoodswhereaggressiveloanswereprevalent.

Foratime,capitalmarketshadanappetiteforalmostanykindofrisk,aslongasparticipantsreceivedfeesfortheproductsthey were manufacturing and selling. There was littleunderstandingofthedefaultriskinthenew,fast‐growingmarket,andfirmsdidnothaveastrongincentivetofocusondefaultrisk.Thebulkofnewproductswere“originate‐to‐distribute,” so theywere soldoff insteadofheld in firms’portfolios.The issuer, thesecuritizerandtheraterwereonlyinterestedinthefeesthattheybookedforeachsale,whichofcourselentitselftoahighvolumeof short‐term profits instead of calibration of default risk andlong‐termloanperformance.

4SeePavlovandWachter(2009b).

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III.ADEBT‐DRIVENPHENOMENON

There are three common explanations for Wall Street’sdrivetowardMBSandtheincredibleappreciationofhomeprices(Figure3).Thefirstisastoryofeasymoneylookingfortrouble.5Itargues that the low interest rates set by theGreenspan FederalReserve made borrowing so cheap that consumers rationallybought houses in droves. This explains part, but not all, of thebubble. Low interest rates allowed people to borrow more,bidding up home prices. Because home prices soared,homeownerswhoranintofinancialtroublecouldeasilyselltheirhomes for more than they owed, avoiding default andforeclosure.

Figure3.HomePriceIndex(Case‐Shiller)

Interest rates do not tell the whole story, though. Evenwhile the Fedwas lowering interest rates, the rest of theworldwas experiencing the same cheap credit. By 2003, U.S. interestrates began to rise, and home price appreciation slowedthroughout the world—except in the U.S., where home pricescontinuedtoacceleratedespiterisinginterestrates.Cheapcredit

5 Adam J. Levitin, Foreword, The Crisis without a Face: Emerging

Narratives of the Financial Crisis, 64MIAMI L. REV. (2009). See, e.g., RICHARDPOSNER, FAILURE OF CAPITALISM: THE CRISIS OF '08 AND THE DESCENT INTO DEPRESSION(2009).

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helps explain the beginning of the boom, but themagnitude ofthebubble‐and‐burstcyclerequiresafullerexplanation.

Thesecondexplanation,advocatedbyEdGlaeser,JosephGyourko,andAlbertSaiz,arguesthatsupplyhasbecomeinelasticintheUnitedStates,soincreaseddemandbidpricesthroughtheroof instead of increasing the quantity supplied.6 While this iscertainlytrue(as indicated inthediscussionoftheeffectof landuseregulations),thishousingfocusignorestheroleofthesupplyofcapital,alinkwhichwewilladdressshortly.Arelatedrationalehas been put forth by Robert Shiller that “irrationalexuberance”—or“animalspirits,”tousethetermheandGeorgeAkerlof borrowed from John Maynard Keynes—blindedconsumers to the bubble, so they bid prices higher and higher,thinkingtheywouldneverfall.7

The third explanation pins the blame on the affordablehousing policies of the GSEs and the Community ReinvestmentAct. This argument holds that government encouragement ofhomeownership incentivizedfinancial institutionstomakeriskierloans, with disastrous results.8 It is important to remember,however, that regulation prevented the GSEs from issuingMBSbasedonsubprimemortgages.Infact,theGSEsdidnotarriveonthe subprime scene until 2005—well after the bubble hadbegun—and then only by buying so‐called “AAA” and Alt‐Atranches of subprime CDOs for their portfolio. In this regard,shareholdersandCongressdeservetheblameforpressuringtheGSEs in thisdirection,and their safetyand soundness regulator,the Office of Federal Housing Enterprise Oversight (OFHEO)

6 Edward L. Glaeser et al., Housing Supply and Housing Bubbles, at

http://www.economics.harvard.edu/faculty/glaeser/files/bubbles10‐jgedits‐NBER%20version‐July%2016,%202008.pdf(July16,2008draft).

7 Robert Shiller, THE SUBPRIME SOLUTION: HOW TODAY'S GLOBAL FINANCIALCRISISHAPPENED,ANDWHATTODOABOUTIT(2008).

8See,e.g.,StanLeibowitz,AnatomyofaTrainWreck: Causesof theMortgage Meltdown, Oct. 3, 2008, athttp://www.independent.org/publications/policy_reports/detail.asp?type=full&id=30.

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deserves the blame for not stopping them (though, in fairness,Congress gave OFHEO very little power to do so). The GSEsthereforeaddedalotoffueltoanalreadyragingfire,byaddingtothe demand for subprime MBS, but bear less responsibility forstartingthecrisis.

Two of us—Andrey Pavlov and Susan Wachter—haveoffered a fourth explanation: because the price of risk(represented by the yield rates of MBS) fell during the housingbubble,wecannotconcludethatitwassimplyarightwardshiftinthe demand curve for housing, as the first two explanationssuggest,orelse increaseddemandwouldhavegeneratedhigherrates for MBS.9 Instead, it must be the case that supply ofmortgage capital increased more than demand, which isconsistent with the observed lower cost of capital according tostandard economic theory. Specifically, Wall Street firms musthavebeensupplyingMBSatsuchahighpacethatitexceededthehigh demand for houses. In other words, the demand formortgages,whichdrovehighhomeprices,wasledbyWallStreet,whichneededthemtocreateandsellMBS.Why,then,wasWallStreetsoeagertoproduceMBS?

Short‐term incentives—such as origination‐focusedcompensationpackagesand traderbonusesgeared towardend‐of‐year revenues instead of any long run measure ofperformance—encouraged financial firmstosellMBSforaquickprofitatarapidpaceandhighvolume.Thecreditboomcreatedby the Fed, as earlier suggested, played an important role ininitiatingthepriceappreciation,butWallStreet’shungerformoremortgages ratified it. The mortgage crisis was born of both ademand‐side and a supply‐side boom that led to a real‐timeerosioninlendingstandards.

9 See Pavlov, Poznar, and Wachter (2008); Pavlov and Wachter

(2009b);andPavlovandWachter(2009c).

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IV.NON‐RECOURSELENDING

Because most American mortgages are effectively non‐recourse,10 a borrower who defaults stands to lose only thecollateral—thatis,thehouse—andanyequitytheyhaveputintothehouse(which isasunkcostanyway).Theborrower, inotherwords, isnotpersonally liable for the full amountof the loan indefault.Anotherwaytolookatthisstructure isthroughthelensof a put option. When a bank makes a non‐recourse loan, itimplicitly provides a put option on the underlying asset. If thevalueoftheassetdeclines,theborrowerhastheright,butnottheobligation,to“put”theassetbacktothebank(thatis,walkawayfrom the property). In otherwords, the borrower can “sell” theassettothebankfortheoutstandingloanbalance.This“righttosell”limitsthelossesoftheborrowerandisaputoption,writtenby the bank, with a strike price equal to the outstanding loanbalance.

Iftheputoptionispricedcorrectly,anditspriceispassedontotheborrowerintermsofahigherinterestrate,lendinghasno impact on asset prices, that is, property values. If the putoption imbedded ina loan isunderpriced, that is, if the interestratechargedistoolowrelativetothedepositrate,theninvestorsincorporatethismistakeintheirdemandpricefortheasset.Thuslendingwithoutproperlypricingtheputoptionresultsininflatedprice of the asset even within efficient equity markets. Oncelenders began to issue mortgages with loan‐to‐value ratiosgreater than one, mortgages were almost “in‐the‐money” putoptionsimmediatelyatthepointoforigination.

Managers’ inability to correctly value the put optionresults in underpricing, but managers who underprice the putoption are discovered only in case of financial crisis whenhomeownersarelikelytoexercisetheoption.Absentsuchcrisis,

10 Andra C. Ghent & Maryanna Kudlyak, Recourse and Residential

MortgageDefault: TheoryandEvidencefromtheUnitedStates,Fed.ReserveBankofRichmondWP‐09‐10(2009).

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managershaveanincentivetounderpricetheputoptioninordertoincreasetheprofitsingoodstates.Long‐termmanagershavealottoloseiftheyunderpriceandarediscovered.Thus,long‐termmanagerswouldnotunderprice.Short‐termmanagers,however,haverelativelylittletoloseiftheirunderpricingisdiscovered.Forthem,thebenefitofincreasedprofitsintheshortrunissufficienttounderprice.Infact,aswehavepreviouslyshown,thepresenceof short‐termmanagers puts sufficient competitive pressure onthe industry that all managers underprice the put option,regardless of their time horizon.11 This result holds even ifmanagers act in the best interest of shareholders, absent anyagencyconflicts.

Theabsenceofshortsellinginrealestateandtheabilityofoptimists to drive prices up can, for example, produce pricebubbles even in the absence of underpricing, but mortgagefunding is necessary to sustain real estate price bubbles. Thewillingness and ability of the banking sector to provideunderpricedfundingratifiesandexacerbatestheseinefficiencies.

V.MISALIGNEDINCENTIVES

Thekeylinkinthechain,asdescribedabove,istheshort‐termperspectiveofmanagers. Ifmanagershad reason toworryabout the franchise value of the firm, they would not risk afinancialcrisisbyunderpricingMBS.Severalfactorscontributedtothisperspective.

First,thecompensationstructureatmostWallStreetfirmsfocusedonyear‐endbonusesbasedonannualprofits.ManagersneededtoproduceahighvolumeofprofitsbeforeDecember31,and had no incentive to consider the systemic risk thatunderpricingMBSmightleadtoanunsustainablehousingbubble.

Second,therewasnowayto“keepthemarkethonest.”Incompletemarkets, traders can recognize underpricing and short

11 See Pavlov andWachter (2006), Pavlov andWachter (2009a), and

PavlovandWachter(2009c).

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sell the firms and assets to profit from the long‐termdefault ofthe system. Real estate, however, is famously difficult, if notimpossible, to short. Because financial firms kept MBS in theirportfolios, they were not actively traded. Without a tradingmarketforMBSs,shortsellingcannotoccur.Withoutshortselling,themarketcannotindicateorcorrectunderpricing.

Also, firmsattemptedtohedgetheirriskbybuyingcreditdefault swaps (CDS) from insurance firms like AIG and someinvestment banks like Lehman Brothers. CDS insured the buyeragainstdefaultonaparticularunrelatedtransaction—inthiscase,the mortgages underlying MBS held in the banks’ portfolios. ACDSbuyerpaysafeeforCDSprotection,andifthereisadefault,theCDS selleressentiallypurchases thedefaulteddebt from theprotection buyer at a previously agreed price. Because the CDSbuyersfeltthattheyhadhedgedtheirdownsiderisk,theyhadanincentivetocontinuetounderpriceMBS.

Unfortunately, the firms underwriting CDS alsounderpricedrisk.Oneofaninsurer’sprimarydutiesistoanalyzetheircounterpartyrisktodetermineasufficientpremiumtocoverany eventual payments; for CDS, thatmeans understanding theriskprofileofthetransactionsbeing insured.Why,then,didCDSsellers likeAIG andCDS buyers like Lehman fail in their primaryduty?

ManagersatCDSfirms,likemanagersatMBSissuers,hada compensation structure that rewarded short‐term revenuesinsteadof long‐termperformance.SellingCDSnowandworryingabout risk later was a profitable strategy. Buying CDS now andworrying about counterparty risk later was also a profitablestrategy.Furthermore,CDSbuyersmayhaveconsideredmostoftheir counterparties “too big to fail,” and so therewas amoralhazard in the system that encouragedCDS sellers to issuemoreinsurancethantheycouldcover inthebelief thatanyremaininglosseswouldbesocialized.

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The system was essentially insolvent. Firms hadunderpricedMBSandcouldnotsustainthelossesofaneconomy‐wide housing crash. They had bought and sold CDS that did notreallyhedge their risk, as thebuyerswould be stuckwith lossesthey could not pay, and the sellers would be forced to insuredefaultsthattheydidnothavesufficientcollateral tocover.Theresult was a run on the bank in reverse: Managers had anincentive to “get it while you can.” It was the classic lootingbehaviordescribedbyGeorgeAkerlofandPaulRomer.12

VI.THENEWNEWSECURITIZATION

While it is clear that systemic risk derives from the pro‐cyclical erosion of lending standards, there is no consensus onhow to avoid this. While no system is perfect, fixed‐rate long‐term mortgages with robust, standardized securitizationhistorically has been consistent with financial stability.Standardization promotes liquidity, ensures suitability, andenhances system stability. A market and a formal tradingexchange for standardizing and, if necessary, short selling realestate securities could be helpful in bringing increased liquidity,decreasedheterogeneity,andtheabilitytorecognizeandpreventcreditmispricing.Butmoreisnecessary.

The central question is how to prevent excesses thatinevitablyleadtoliquiditycrises.BenBernankeandMarkGertlerargued in1999thatassetbubblesarenotdestructiveenoughtosystemic stability to warrant monetary intervention.13 Theirmodel,however,didnotaccountforthepossibilitythatcreditwilldry up bringing about the historical banking system panicscenario.

12 George A. Akerlof & Paul M. Romer, Looting: The Economic

Underworld of Bankruptcy for Profit, 24 BROOKINGS PAPERS ON ECON. ACTIVITY 1(1992).

13 Ben Bernanke & Mark Gertler,Monetary Policy and Asset PriceVolatility, 1999 FED. RESERVE BANK OF K.C. ECON. REV. 17 (1999) athttp://www.kc.frb.org/publicat/sympos/1999/4q99bern.pdf.

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Asset bubbles that affect the payment mechanism haverepeatedlyledtoliquiditycrises.Realestateisespeciallypronetoassetbubblesbecauseofthedifficulty inshortingtheunderlyingasset. Real estate bubbles are a matter of particular concernbecausefinancialintermediarieslikebanksareheavilyexposedtoresidentialandcommercialmortgagesmakingtheentirefinancialsystemsusceptible to realestateboomsandbusts.Relyingonamacro‐prudential risk regulator may not be sufficient.Securitization has become an essential component of consumerfinance and of housing finance in particular. But to makesecuritizationwork,clearrulesofthegameareneededthathelpachieve transparency, assure against counterparty risk and dataprovisionto informtrading.Marketscanpriceandexposerisk,ifwegivethemtothetoolstodoso.

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