Bubbles, Incentives, Booms, Busts

REIT Financing Choices: Preparation Matters
(with Andrey D. Pavlov and Eva Steiner)
Real Estate Economics, forthcoming.

Why are Aggressive Mortgage Products Bad for the Housing Market? (with Andrew Davidson, Alex Levin, and Andrey D. Pavlov)
Journal of Economics and Business, March 2016, 148-161.

Second Liens and the Leverage Option (with Adam J. Levitin)
Vanderbilt Law Review, Vol. 68, October 2015, 1243-1294.

Housing and Credit Bubbles in the US and Europe: A Comparison
Journal of Money, Credit and Banking, Vol. 47, Issue S1, March/April 2015, 37-42.

The Market Structure of Securitisation and the US Housing Bubble
National Institute Economic Review, No. 230, November 2014, 34-44.

Borrowing Constraints During the Housing Bubble (with Irina Barakova and Paul Calem)
Journal of Housing Economics, Vol. 24, June 2014, 4-20.

Macroeconomic Risk Factors and the Role of Mispriced Credit in the Returns from International Real Estate Securities (with Andrey D. Pavlov and Eva M. Steiner)
Real Estate Economics, Vol. 43, Issue 1, Spring 2015, 241-270.

Will Private Risk-Capital Return? The Dodd-Frank Act and the Housing Market (with Adam J. Levitin and Andrey D. Pavlov)   Abstract  
Yale Journal on Regulations, Vol. 29,No.1, Winter 2012, p.155-180

Private risk capital has virtually disappeared from the U.S. housing finance market since the market’s collapse in 2008. This Article argues that private risk capital is unlikely to return on any scale until the informational problems in housing finance are resolved so that investors can accurately gauge and price the risks they assume. The Dodd-Frank Act represents a first step in reforming the U.S. housing finance. It takes a multi-layered approach, regulating both loan origination and securitization. Dodd-Frank’s reforms, however, fail to adequately address the opacity of credit risk information in mortgage markets and thus are insufficient for the restoration of private risk capital. The Article argues that Dodd-Frank reforms like “skin-in-the-game” credit risk retention fail to solve the informational problems in the housing finance market, as they merely replace one informational opacity with another. Instead, the Article argues, it is necessary to institute structural changes in the housing finance market, particularly the standardization of mortgage securitization, that force the production of information necessary for accurate risk-pricing.

Explaining the Housing Bubble (with Adam. J Levitin)   Abstract  
Georgetown Law Journal, Vol. 100, No.4, April 2012, p. 1177-1258)

There is little consensus as to the cause of the housing bubble that precipitated the financial crisis of 2008. Numerous explanations exist: misguided monetary policy; a global savings surplus; government policies encouraging affordable homeownership; irrational consumer expectations of rising housing prices; inelastic housing supply. None of these explanations, however, is capable of fully explaining the housing bubble. This Article posits a new explanation for the housing bubble. First, it demonstrates that the bubble was a supply-side phenomenon attributable to an excess of mispriced mortgage finance: mortgage-finance spreads declined and volume increased, even as risk increased — a confluence attributable only to an oversupply of mortgage finance. Second, it explains the mortgage-finance supply glut as resulting from the failure of markets to price risk correctly due to the complexity, opacity, and heterogeneity of the unregulated private-label mortgage-backed securities (PLS) that began to dominate the market in 2004. The rise of PLS exacerbated informational asymmetries between the financial institutions that intermediate mortgage finance and PLS investors. These intermediation agents exploited informational asymmetries to encourage overinvestment in PLS that boosted the financial intermediaries’ volume-based profits and enabled borrowers to bid up housing prices. This Article proposes the standardization of PLS as an information-forcing device. Reducing the complexity and heterogeneity of PLS would facilitate accurate risk pricing, which is necessary to rebuild a sustainable, stable housing-finance market.

Subprime Lending and Real Estate Prices (with Andrey Pavlov)   Abstract  
Real Estate Economics, Vol. 38, No. 1, Spring 2011, p.1-17

This article establishes a theoretical and empirical link between the use of aggressive mortgage lending instruments, such as interest-only, negative-amortization or subprime mortgages, and the underlying house prices. Such instruments, which come into existence through innovation or financial deregulation, allow more borrowing than otherwise would occur in previously affordability-constrained markets. Within the context of a model with an endogenous rent-buy decision, we demonstrate that the supply of aggressive lending instruments temporarily increases the asset prices in the underlying market because agents find it more attractive to own or because their borrowing constraint is relaxed, or both. This result implies that the availability of aggressive mortgage lending instruments magnifies the real estate cycle and the effects of fundamental demand shocks. We empirically confirm the predictions of the model using recent subprime origination experience. In particular, we find that regions that receive a high concentration of aggressive lending instruments experience larger price increases and subsequent declines than areas with low concentration of such instruments. This result holds in the presence of various controls and instrumental variables.

Systemic Risk and Market Institutions (with Andrey Pavlov)   Abstract  
Yale Journal on Regulations, Vol.26, No.1, Winter 2009, p. 445-455

With private-label mortgage-backed securities (MBS), investors bore default risk; while this risk should have been priced, as systemic risk grew, the pricing of risk did not increase. This paper attempts to explain why this happened. We point to market institutions’ incentive misalignments that cause asset prices to rise above fundamentals, producing systemic risk. The model attributes the asset price inflation to the provision of underpriced credit as lending institutions misprice risk to gain market share. The resulting asset price inflation itself then generates further expansion of underpriced credit.

Systemic Risk Through Securitization: The Result of Deregulatory and Regulatory Failure (with Patricia McCoy and Andrey Pavlov)   Abstract  
Connecticut Law Review, Vol. 41, May 2009, p. 1327-1375

Without regulation, securitization allowed mortgage industry actors to gain fees and to put off risks. During the housing boom, the ability to pass off risk allowed lenders and securitizers to compete for market share by lowering their lending standards, which activated more borrowing. Lenders who did not join in the easing of lending standards were crowded out of the market. Artificially low risk premia caused the asset price of houses to go up, leading to an asset bubble and breeding fraud. The consequences of lax lending were thereby covered up. The market might have corrected this problem if investors had been able to express their negative views by short selling mortgage-backed securities, thereby allowing fundamental market value to be achieved. However, the one instrument that could have been used to short sell mortgage-backed securities – the credit default swap – was also infected with underpricing due to lack of minimum capital requirements and regulation to facilitate transparent pricing. As a result, there was no opportunity for short selling in the private-label securitization market. The authors propose countercyclical regulation to prevent a race to the bottom at the height of the business cycle.

Mortgage Put Options and Real Estate Markets (with Andrey Pavlov)   Abstract  
Journal of Real Estate Finance and Economics, Vol. 36, No.2, Summer 2008, 231-239

In this paper we offer direct evidence that financial intermediation does impact underlying asset markets. We develop a specific observable symptom of a banking system that underprices the put option imbedded in non-recourse asset-backed lending. Using a dataset for 19 countries and over 500 real estate investment trusts, we find that, following a negative demand shock, the “underpricing” economies experience far deeper asset market crashes than economies in which the put option is correctly priced.

The Inevitability of Market-Wide Underpriced Risk (with Andrey Pavlov)   Abstract  
Real Estate Economics, Vol. 34, No.4, Winter 2006, 479-496

Lenders are frequently accused of mispricing the put option imbedded in non-recourse lending (Herring and Wachter, 1999 and 2003). Prior research (Pavlov and Wachter, 2004) shows one lender’s incentives to underprice. Here we identify the conditions for a market-wide underpricing equilibrium. We demonstrate that in a market with many players, given sufficient time, a race to the bottom and market-wide mispricing are inevitable. Underpricing occurs because bank managers and shareholders exploit mis-priced deposit insurance. We show that the probability of the underpricing equilibrium increases with time since the previous market crash and that the more volatile the underlying asset market, the more likely it is subject to underpricing

Bank Lending and Real Estate in Asia: Market Optimization and Asset Bubbles (with Winston T. H. Koh et.al)   Abstract  
Journal of Asian Economics, Vol. 15.6, November-December, 2004

This paper investigates the Asian real estate price run-up and collapse in the 1990s. We identify financial intermediaries’ underpricing of the put option imbedded in non-recourse mortgage loans as a potential cause for the observed price behavior. This underpricing is due to behavioral causes (lender optimism and disaster myopia) and/or rational response of lenders to market incentives (agency conflicts, deposit insurance, or limited liability of bank shareholders). The empirical evidence suggests that underpricing occurred in Thailand, Malaysia, and Indonesia. Consequently, these countries experienced a more severe market crash than Hong Kong and Singapore, where underpricing was kept under control by strong government intervention and/or more appropriate incentive mechanisms.

Robbing the Bank: Non-recourse Lending and Asset Prices (with Andrey Pavlov)   Abstract  
Journal of Real Estate Finance and Economics, Vol. 29, No. 4, December 2004, 393-410

We investigate the market prices of assets in fixed supply whose purchase is typically financed through non-recourse loans. The largest and most common asset in this category is real estate. We demonstrate two features of such markets: Lenders’ underpricing of the put option contained in non-recourse loans leads to inflated asset prices within efficient markets, and lenders with short-term horizons have incentives to underprice the put option. These results hold when participants in both equity and debt markets are rational. The model also allows for management compensation that is aligned with maximizing bank shareholders’ value. Using real estate transaction data we find empirical evidence consistent with the predictions of the model.