A Tale of Two Markets: Regulation and Innovation in Post-Crisis Mortgage and Structured Finance Markets

Adam J. Levitin is the Agnes N. Williams Research Professor at Georgetown University Law Center and William W. Bratton is Nicholas F. Gallicchio Professor of Law and Co-Director, Institute for Law & Economics at the University of Pennsylvania Law School. This post is based on their recent paper.

Our paper, A Tale of Two Markets: Regulation and Innovation in Post-Crisis Mortgage and Structured Finance Markets, takes the occasion of the tenth anniversary of the financial crisis to review recent developments in the structured products market, connecting the emergent pattern to post-crisis regulation.

The financial crisis stemmed from excessive risk-taking and shabby practices in the “subprime” segment of the home mortgage market, a market that got its financing from an array of “toxic” products and investment vehicles created in the structured credit market—private-label mortgage-backed securities (PLS), collateralized debt obligations (CDOs), collateralized debt obligations squared (CDO2s), synthetic securitizations, and structured investment vehicles (SIVs). These products provided the funding for the mortgage lending that enabled housing prices to be bid up in an unsustainable bubble.

Ten years later, both the home mortgage market and the structured credit market look different in many respects.  Subprime mortgages, CDOs, CDO2s, and SIVs have entirely disappeared, and the PLS market looks very different, implying fundamental change.  But there are also places where the markets before and after differ only by degree—some risky consumer borrowers still find mortgage lenders, the private structured credit market remains in place and still collateralizes certain debt obligations, and synthetic securitizations still appear.

How much of this change is the result of post-crisis regulatory prohibition and how much results from changes in investors’ appetite for risk?  To the extent that regulation, rather than appetite for risk, has caused the changes, which of the new constraints have proven salient and for what reason? Where does the regulation leave open loopholes and regulatory arbitrage by intermediaries and investors with voracious appetites for risk?

To answer these questions, our article takes a deep dive into today’s credit markets to ascertain and trace the transactional pattern ten years later. We take a close look at risky mortgage lending and complex securitization structures and map the market activity against the new regulatory background.  Our inspection leads to a pair of important observations about post-crisis regulation.

First, we identify a distinction in the post-crisis regulatory approach between consumer markets (the subprime mortgage loans themselves) and the capital markets (the toxic structured products that funded voluminous subprime lending). The post-crisis regulatory approach, we argue, is a tale of two markets that mismatches the immediate government response to the crisis itself even as it reflects the political economy of financial regulation.

The immediate federal response to the financial crisis was a series of market interventions—bailouts—of both individual financial institutions and capital markets more generally. In contrast, consumers received much less in the way of succor from the federal government directly, even though consumer mortgage defaults were the root of the crisis. One would expect, then, that the post-crisis regulatory response would focus on the institutions and markets that received bailouts in order to confirm the politicians’ oft-repeated pledge of “no more bailouts.” Yet that is the opposite of what emerged. The post-crisis regulatory response has been much more muscular in consumer markets than in capital markets.

On the consumer side, there are new constraints on mortgage lending that apply to all lenders. The provisions impose exacting standards of underwriting and documentation that combine to impose a conservative attitude toward risk. They effectively prevent the return of a large subprime loan market.  Post-crisis enforcement initiatives by federal and state prosecutors and agencies reinforced this regulatory shift. They focused mostly on problems in the pre-crisis mortgage market and with post-crisis mortgage servicing, casting a prospective chill over the origination and management of risky mortgages.

On the capital markets side, things are different. Financial regulators did not respond to the crisis by imposing thorough-going underwriting standards or defining and prohibiting categories of dangerous structured transactions. Nor did they impose a tax or regulatory constraint on financial innovation. Instead, they tightened two existing legal regimes: (1) the disclosure rules applied to new public issues of securities, and (2) the rules regulating risk assumption by institutions intertwined with the public interest, banks most prominently. Nothing in post-crisis regulatory reform stops a private actor from packaging or purchasing a CDO or CDO2, although there are additional regulatory burdens:  the packager will have to satisfy stepped up disclosure requirements if it sells to the public (rather than in a private placement), and it will in many cases have to retain some credit risk. Additionally, banks (defined in regulation as insured depository institutions) are now discouraged from securitizing assets by rules that move securitized debt onto their balance sheets and discouraged from investing in securitized assets by rules that require substantial equity capital support. The new constraints dampen innovation indirectly by making securitization more expensive and reducing demand for structured products. Even so, marketplace intermediaries remain free to create structured products keyed to the risk appetites of the legions of institutional investors that are not regulated as banks.

Overall, regulation has been tightened much more significantly in consumer markets than in capital markets. Post-crisis enforcement actions have followed the same pattern, focused primarily on residential mortgage origination and securitization rather than on broader issues related to structured products.

The contrast between the heavier regulatory touch in consumer markets (and for banks) as opposed to the limited interventions in capital markets speaks to the political economy of financial regulation.  Interventions in consumer markets are likely to be more politically salient to consumer-voters because they address products that consumers use directly. In contrast, reforms in capital markets, other than perhaps trading markets open to retail investors, are, if anything, more technically complex and lack a direct connection to the interests of consumers. As a result, there is likely more political pressure (and political upside for regulators) to focus reform on consumer markets. One expects less in the way of regulatory intervention in capital markets, where political pressure is less acute. And this is precisely what we see.

Our second observation about post-crisis regulation concerns unintended effects. The intensification of regulation of banks has resulted in a hydraulic market shifts. Banks, more heavily-regulated and more than a little gun-shy in the wake of post-crisis litigation initiatives by prosecutors and regulators, have walked away from the riskier end of the residential mortgage market. Less-regulated, nonbank lenders, almost wiped out by the financial crisis, have since reemerged to fill the void in the riskier part of the mortgage market. Nonbanks also loom larger in today’s structured product markets, where they have taken the lead in innovative packaging and sale. The question is not whether innovation is being choked off, but whether the seeds of the next crisis are being sown by innovation in lightly regulated sectors.

The complete paper is available for download here.

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