Smith
Faculty Opinion Article
The 30
Seconds Outlook
May 1, 2009
|
“... [D]eregulation and feeble enforcement enabled and
drove the demand for new types of risky mortgages ... financed by the
private-label securitization market ...”
|
|
— P. A. McCoy, A. D. Pavlov,
and S. M. Wachter, Working
paper, February 9, 2009. |
In the
prior Outlook, it was stated
that regulation of financial markets
and institutions should favor
transparency more so than
regulation, unless proved wrong.
However, the current financial
crisis was accompanied by failures
of both, including too much
deregulation, failures of
enforcement, political pressures on
supervision, poor risk management of
financial institutions, and lack of
effective transparency in financial
institutions and markets. As a
result, the way to prevent another
financial crisis must focus on
effective regulation, rather than
any hope that real and complete
transparency alone would be
sufficient.
The need for effective regulation
has been demonstrated by failures in
financial legislation across the
board. In what was arguably the
primary failure, Congress
deregulated (1990s and 2000) the
large secondary markets for mortgage
instruments and thus ignited demand
for new types of private-label
mortgages. These mortgages were
bundled into "collateralized debt
obligations" (CDOs) and sold on the
private-label market. “Jumbo”
mortgages had heterogeneous terms,
which made trading difficult and
illiquid. Issuers of CDOs did not
bear the credit risk and these
securities were not market priced
for risk. Risk was assessed by
credit rating agencies, but they
assumed incorrectly, for example,
that senior CDO tranches (“slices”)
had virtually no risk.
Development of the private-label
market for subprime mortgages was
facilitated by automated
underwriting that incorrectly
determined that the risk of loans to
subprime borrowers was limited.
The private-label market greatly
increased demand for housing and
housing prices responded. But, once
the credit easing of subprime
mortgages reached its limits,
housing prices began their “big
fall” in late 2006. As loan defaults
became systemic, investors fled the
private-label markets and the
sub-prime mortgage market collapsed.
This market failure spread worldwide
and gave impetus to the “credit
squeeze” that engendered the current
financial crisis and depression.
Issuance of CDOs and their rapid
growth without regulation was
unsustainable and ultimately became
the systemic risk that brought the
financial markets and the economy to
crisis. It is amazing, but sad, what
the lack of regulation and resultant
lack of real transparency and
pricing of risk in well-functioning
markets has done to so many citizens
and their futures.
John A. Haslem
