The Market Structure of Securitisation and the US Housing Bubble

Abstract

Housing finance and, specifically, the subprime private label securitisation market in the US, was at the epicentre of the global financial crisis. Excessive debt expansion in the run-up to the crisis resulted in credit risk, under-identified and mispriced ex ante, and in systemic risk. This paper considers the role of financial innovation in debt markets and the changing market structure of securitisation in the evolution of the US housing price bubble. New financing vehicles contributed to growing risk, but the more salient factor was the change in the structure of securitisation, which led to unsustainable levels of debt. AbstractHousing finance, and, specifically, the subprime private label securitisation market in the US, was at the epicentre of the global financial crisis. Excessive debt expansion in the run-up to the crisis resulted in credit risk, under-identified and mispriced ex ante, and in systemic risk. This paper considers the role of financial innovation in debt markets and the changing market structure of securitisation in the evolution of the US housing price bubble. New financing vehicles contributed to growing risk, but the more salient factor was the change in the structure of securitisation, which led to unsustainable levels of debt.

Real Estate and the Great Crisis: Lessons for Macroprudential Policy

“…These can be thought of as “real estate financial accelerators,” akin to the more business‐oriented financial accelerator of Bernanke, Gertler, and Gilchrist (). And each of these give rise to negative externality effects that lenders do not internalize when making loan decisions, giving rise to more lending than is socially optimal (Herring and Wachter ; Turner ; Wachter ) . A financial decelerator effect arises from the overhang of mortgage debt accumulated during housing booms that not only impairs housing activity, but also consumption (Mian and Sufi , ).…”

“…More generally, unless new econometric techniques are employed (Duca, Muellbauer, and Murphy , being an exception), it is difficult to track how much the liquidity of housing wealth has been affected by new regulatory actions, thereby limiting the impact of house prices on consumer spending. Nor is it possible going forward to identify risks deriving from easing of lending conditions through shadow market activity (Wachter , 2015). Other correlated risks concern how problems in one market can cascade into others, particularly if there are complex interactions and exposures.…”

Representations and Warranties: Why They Did Not Stop the Crisis

“…Starting in the late 1990s and accelerating between 2003 to 2007, regulatory shifts (McCoy et al 2009) and changes to the structure of the mortgage chain led to the onset of a secondary mortgage lending regime dominated by private-label securitization and mediated by Wall Street investment banks Wachter, 2014). A substantial expansion of credit followed.…”

“…Loan fraud also became more prevalent during this period, with private-label securitized mortgages and low-documentation mortgages experiencing particularly high levels of fraud (Mian and Sufi 2015). Loan origination volume shifted to lenders who used private-label securitization with lower and less well enforced underwriting standards, although there is evidence that there was somewhat of a decline in the GSE underwriting standards as well (Wachter 2014;Wachter 2016). Under pressure to maintain market share, other lenders cast aside their reputational concerns and lowered their lending standards in response (Engel and McCoy 2011, 38-40).…”

“…The result will be higher prices as loans are made that otherwise would not be made and the higher prices will mask the poor underwriting. The representations and warranties may stop some but if more aggressive lenders operate in this way, there is an "externality" (Wachter 2014) that results as the quality of the aggregate mortgage book of business deteriorates and risk increases even for more careful lenders. Moreover those lenders who are willing to undermine standards will set the bar lower for other lenders who unless they similarly lower the bar will not be able to attract the marginal borrower (Pavlov and Wachter 2006).…”