Securitization and How Law Improved the Transmission Line between Real Estate & Banking Crises

Feliz Ano Nuevo!

In service of my resolution to blog more regularly (and to take a break from grading)…

I recently posted on ssrn a symposium piece I wrote for the Georgia Law Review that examines how securitization formed a coupling rod that joined together real estate and banking crises. Moreover, changes in banking law improved this transmission line.

Here is the abstract:

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.

This symposium piece continues a line of research that examines securitization in light of the financial crisis. I’ve looked at how:

¶ regulators outsourced responsibility for regulating markets and financial products to risk models (including models that price securitizations);

¶ securitization creates a channel for failures of consumer financial protection to generate systemic risk;

¶ how securitization provides an example of how contract “patterns” (think “boilerplate” but more conceptual) can modularize contract language and turn contracts into complex transactions and ultimately into new markets for financial instruments; and

¶ asset-backed securities represent an example of “safe assets” constructed by law (see this article, this symposium piece, and this book chapter, all co-written with Anna Gelpern).

A half-dozen or so more pieces and I can write a book: “13 ways of looking at securitization.”  Or I can go meta – writing about derivatives and being derivative.