Adam J. Levitin

Explaining the Housing Bubble

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.

The Commercial Real Estate Bubble

Two parallel real estate bubbles emerged in the United States between 2004 and 2008, one in residential real estate, the other in commercial real estate. The residential real estate bubble has received a great deal of popular, scholarly, and policy attention. The commercial real estate bubble, in contrast, has largely been ignored.This Article shows that the commercial real estate price bubble was accompanied by a change in the source of commercial real estate financing. Starting around 1998, securitization became an increasingly significant part of commercial real estate financing. The commercial mortgage securitization market underwent a major shift in 2004, however, as the traditional buyers of subordinated commercial real estate debt were outbid by collateralized debt obligations (CDOs). Savvy, sophisticated, experienced commercial mortgage securitization investors were replaced by investors who merely wanted “product” to securitize. The result was a decline in underwriting standards in commercial mortgage backed securities (CMBS).The commercial real estate bubble holds important lessons for understanding the residential real estate bubble. Unlike the residential market, there is almost no government involvement in commercial real estate. The existence of the parallel commercial real estate bubble presents a strong challenge to explanations of the residential bubble that focus on government affordable housing policy, the Community Reinvestment Act, and the role of Fannie Mae and Freddie Mac.

Skin-in-the-Game: Risk Retention Lessons from Credit Card Securitization

The Dodd-Frank Act’s “skin-in-the-game” credit risk retention require- ment is the major reform of the securitization market following the housing bubble. Skin-in-the-game mandates that securitizers retain a 5% interest in their securitizations. The premise behind skin-in-the-game is that it will lessen the moral hazard problem endemic to securitization, in which loan originators and securitizers do not bear the risk on the ultimate performance of the loans. Contractual skin-in-the-game requirements have long existed in credit card securitizations. Their impact, however, has not been previously examined.This Article argues that credit card securitization solves the moral hazard problem not through the limited risk retention of formal skin-in-the-game re- quirements, but through implicit recourse to the issuer’s balance sheet. Absent this implicit recourse, skin-in-the-game actually creates an incentive misalign- ment between card issuers and investors because card issuers have lopsided upside and downside exposure on their securitized card receivables. For- mally, the card issuers bear a small fraction of the downside exposure, but retain 100% of the upside, should the card balance generate more income than is necessary to pay the investors. The risk/reward imbalance should create a distinct problem because the card issuer retains control over the terms of the credit card accounts. Prior to the Credit CARD Act of 2009, the issuer could increase a portfolio’s volatility through rate-jacking: when interest rates and fees are increased, some accounts will pay more and some will default. Per the Black-Scholes option-pricing model, the increased volatility benefits the issuer because of the risk-reward imbalance.Despite the problems posed by the formal risk/reward imbalance, credit card securitization avoided the excesses of mortgage securitization. The ex- planation for this is that credit card securitization features complete implicit recourse. Implicit recourse exists because credit card securitization is not about risk transfer, but instead is about regulatory capital arbitrage and creat- ing a funding and liquidity source for the issuer. The implication is that for- mal skin-in-the-game requirements alone may be insufficient to ensure against moral hazard problems in securitization. Skin-in-the-game’s effectiveness will instead depend on its interaction with other deal features.

Bankruptcy Law and the Cost of Credit: The Impact of Cramdown on Mortgage Interest Rates

AbstractRecent proposals to address housing market troubles through principal modification could increase the cost of credit in the mortgage market. We explore this possibility using historical variation in federal judicial rulings regarding whether Chapter 13 bankruptcy filers could reduce the principal owed on a home loan to the home’s market value. The practice, known as cramdown, was definitively prohibited by the Supreme Court in 1993. We find that home loans closed during the time when cramdown was allowed had interest rates 12–16 basis points higher than loans closed in the same state when cramdown was not allowed, which translates to a roughly 1 percent increase in monthly payments. Consistent with the theory that lenders are pricing in the risk of principal modification, interest rate increases are higher for the riskiest borrowers and zero for the least risky and higher in states where Chapter 13 filing is more common.

Information Failure and the U.S. Mortgage Crisis

This paper argues that during the housing bubble, housing finance markets failed to price risk correctly because of information failure caused by the complexity and heterogeneity of private-label mortgage-backed securities and structured finance products. Addressing the informational problems with mortgage securitization is critical not just for avoiding future housing bubbles but for rebuilding American housing finance. The continued availability of the long-term fixed-rate mortgage, which has been the bedrock of American homeownership since the Depression, depends on the continued viability of securitization. The paper proposes that mortgage securitization and origination be standardized as a way of reducing complexity and heterogeneity in order to rebuild a sustainable, stable housing finance market based around the long-term fixed-rate mortgage.

The Dodd-Frank Act and Housing Finance: Can It Restore Private Risk Capital to the Securitization Market?

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.

Bankrupt Politics and the Politics of Bankruptcy

The most recent round of state budget crises has resulted in calls to permit states to file for bankruptcy in order to restructure and reduce their financial obligations. This Article argues that these proposals are misguided because states’ financial distress is primarily a political problem created by fiscal federalism - the financial relationship between the federal government and the states - and exacerbated by political agency problems. Accordingly, state bankruptcy proposals need to be evaluated in political, rather than financial terms. Bankruptcy can no more remake fiscal federalism than it can fix a firm with an untenable business model. While bankruptcy might provide a tool for mitigating political agency problems, it is more likely to be used to provide judicial cover for partisan agendas. Attempts to use bankruptcy to solve political problems invite a reevaluation of the “creditors’ bargain,” the dominant theory of bankruptcy law, which argues that bankruptcy law tries to replicate the bargain that creditors would have made themselves. This Article argues that contractarian approaches to bankruptcy are necessarily incomplete because they do not account for the politics of bankruptcy. Instead, this Article sketches out a new theory of bankruptcy law as the dynamic “armistice line” between competing interest groups. Bankruptcy is fundamentally a distributional exercise and the shape of bankruptcy law is an expression of distributional norms and interest group politics rather than an exercise in economic efficiency. A proper theoretical understanding of bankruptcy must therefore commence from a political rather than economic perspective.

Mortgage Market Regulation: North America

The financial crisis of the Great Depression prompted the U.S. government to modify its laissez faire approach to the American mortgage market. Under President Roosevelt, the New Deal government implemented a series of measures to combat the mortgage crisis, namely the network of Federal Home Loan Banks that assisted in offering liquidity to mortgage providers, the Federal Home Loan Bank Board that increased oversight of the housing sector, and the Home Owners’ Loan Corporation that addressed the plague of defaulted loans through short refinancing of troubled mortgages. The next few decades yielded continued measures to stabilize and regulate the mortgage system. These measures relied predominantly on long-term, fixed-rate mortgages. In the late 1960s, the government sponsored several enterprises in an effort to ensure stability and maintain affordability of housing. The implicit government guarantee worked in ensuring financing of mortgages and allowing the development of a second market. However, later regulations also led to the development of non-standard loans and widespread malpractices, creating challenges for the mortgage industry while masking potential problems for the housing industry. This dichotomy persisted in practice and policy, aggravating and ultimately triggering the financial crisis of 2008.

Mortgage Market, Character and Trends: United States

The United States housing finance system has undergone multiple evolutions accompanying its dynamic mortgage history. The early days of homeownership funding before and during the Great Depression were characterised by instability and risk. Over the next several decades, reform gradually led housing finance to its heyday as a stable foundation for the ‘American dream’. However, this stability proved misleading as US financial companies pursued increasingly risky practices, partly reverting back to the fragile structure in place before the New Deal. Ultimately, the pursuit of risky products and cheap credit provoked unsustainable growth in housing prices that culminated in the financial crisis of 2008, severely disrupting both domestic and global financial systems. Now on the process to recovery, the US mortgage market is undergoing a possible structural transformation that embraces securitisation, without abandoning the initial spirit of the New Deal. The effectiveness of this transformation is yet to be determined. Only by reinstating transparency, securitisation, and defence mechanisms against the procyclicality of leverage can the United States restore stability to the foundation that supports millions of American lives and homes.

Pandora's Digital Box: The Promise and Perils of Digital Wallets

Digital wallets, such as ApplePay and Android Pay, are “smart�? payment devices that can integrate payments with two-way, real-time communications of any type of data. Integration of payments with real-time communications holds out tremendous promise for consumers and merchants alike: the combination, in a single, convenient platform, of search functions, advertising, payment, shipping, customer service, and loyalty programs. Such an integrated retail platform offers consumers a faster and easier way to transact, and offers brick-and-mortar retailers an ecommerce-type ability to identify, attract, and retain customers. At the same time, however, digital wallets present materially different risks for both consumers and merchants than traditional plastic card payments precisely because of their “smart�? nature. For consumers, digital wallets can trigger an unfavorable shift in the applicable legal regime governing the transactions, increase fraud risk, create confusion regarding error resolution, expose consumers to non-FDIC-insured accounts, and substantially erode transactional privacy. These risks are often not salient to consumers, who cannot distinguish them by digital wallet. Consumers’ inability to protect against these risks points to a need for regulatory intervention by the Consumer Financial Protection Bureau to ensure minimum standards for digital wallets. For merchants, digital wallets can deprive them of valuable customer information used for anti-fraud, advertising, loyalty, and customer service purposes. Digital wallets can also facilitate poaching of customers by competitors, impair merchants’ customer relationship management, deprive merchants of influence over consumers’ payment choice and routing, increase fraud risk, subject merchants to patent infringement liability, and ultimately increase the costs of accepting payments. Merchants are constrained in their ability to refuse or condition payments from digital wallets based on the risks presented because of merchant rules promulgated by credit card networks. These rules raise antitrust concerns because they foreclose entry to those digital wallets that offer merchants the most attractive valuation proposition, namely those wallets that do not use the credit card networks for payments.