Bank Regulation and Securitization: How the Law Improved Transmission Lines between Real Estate and Banking Crises

Erik F. Gerding is a Professor at the University of Colorado Law School. This post is based on his recent article.

Economists and economic historians have explored how financial crises become particularly severe when they involve either the banking industry, real estate, or both. The recent global financial crisis represented a confluence of crises in both sectors. In an article published in the Georgia Law Review, I explore how securitization formed a coupling rod that joined together real estate and banking crises and how changes in banking law improved this transmission line. Thanks to these legal changes, securitization became a new pathway for financial contagion.

Beginning in the 1980s and accelerating in the 1990s, these legislative and regulatory changes incrementally expanded bank participation in the markets for mortgage-backed securities, as well as in asset-backed securities more generally. Certain changes facilitated bank investments in mortgage-backed securities. These included the Secondary Mortgage Market Enhancement Act of 1984 and a series of regulations issued by the Office of the Comptroller of the Currency (“OCC”). Other shifts in legal rules, including interpretations by the OCC and Federal Reserve, enabled and encouraged banks to securitize mortgage assets on their balance sheets or to act as dealers for the resulting securities. In the decade before the global financial crisis, other agency interpretations allowed banks to extend credit to, and purchase assets from, non-bank affiliates involved in mortgage lending. In the aftermath of Glass-Steagall’s demise, scholars feared that financial conglomerates would use these interpretations to exploit the explicit subsidies afforded to depository banks to gamble with taxpayer money. Lastly, capital requirements gave preferential treatment to bank investments in mortgage-backed securities and formed part of a raft of legal changes that turbocharged the growth of the shadow banking system. Together, these changes significantly enlarged the exceptions to U.S. legal restrictions on bank investments both in real estate and securities. Curiously, many of these changes did not generate much debate, nor did they receive sufficient scholarly attention.

Part of this neglect may be explained by the fact that securitization offered to address three of the historical concerns underlying bank restrictions on real estate investments: the credit, liquidity, and interest rate risk associated with real property investments. The legal changes rested on a series of assumptions regarding the ability of securitization to mitigate the risks to banks inherent in mortgage lending and real estate investment, either when banks securitized mortgages that they originated or when they purchased mortgage-backed securities. These assumptions proved ill-founded, as highly correlated losses on exotic mortgages during the crisis erased the value and liquidity of mortgage-backed securities.

Changes in bank regulation not only permitted banks to take on these risks and fueled the growth of mortgage-backed securities; they also helped create a national market for real estate mortgages. By fostering the growth of securitization and permitting massive financial industry consolidation, banking law contributed to the development of a nationwide (or countrywide, if you prefer) market for mortgages. In the period surrounding the turn of the twenty-first century, exotic and subprime mortgages came to enjoy a larger share of this newly national market. [1] Banking law changes thus sowed the seeds for a nationwide real estate decline. These regulatory changes thus undermined a core assumption upon which they were premised, namely that such a widespread national decline in residential real estate prices was extremely unlikely. Regulatory changes exposed banks to an often overlooked danger of real estate investments, the cyclicality of real estate losses, and blunted the ability of geographic diversification to mitigate this risk. This created the potential for feedback mechanisms between real estate cycles and bank leverage cycles.

In the article, I provide 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 article concludes by discussing the political dynamics that will shape and constrain any of these policy approaches.

The complete article is available for download here.


1See Souphala Chomsisengphet & Anthony Pennington-Cross, The Evolution of the Subprime Mortgage Market, Fed. Res. Bank of St. Louis Rev., Jan.–Feb. 2006, at 36–40, (commenting on the market share growth of subprime mortgages from 1995–2003).(go back)

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