The Future of Securitization

Wharton real estate professor Susan M. Wachter points out that many recent -- and historic -- international financial problems originated in real estate. The nature of real estate finance and incentive structures is more to blame than securitization this time around. "The most recent crisis is coming through the securitization market, but this isn't the only real estate crisis," Wachter notes, adding that the fundamental problem in real estate finance is that there is no way to bet against the industry. Real estate is essentially priced by optimists, and rising prices themselves justify even higher values as assets are marked to market, creating new incentives for investors to overpay.

Wachter points to real estate investment trusts (REITS), publicly traded bundles of real estate assets, as an example of how securitization can help provide liquidity, but also a chance for short-sellers to correct against overly optimistic pricing. Research indicates that REIT prices may not have increased as much as other sectors of real estate finance because the industry has at least 200 analysts looking at the underlying assets in each REIT with the ability to point out faulty pricing to investors. "REITS have performed fluidly relative to the overall market, and that is a good thing," says Wachter. Fee-driven Lending

Another problem was that much of the subprime lending was fee-driven, giving banks incentives to write loans to earn the fees because they could then pass the risky assets along to securitized bondholders. And even bank shareholders had no way to limit their real estate exposure because banks invest in various kinds of economic activity and not just in real estate. Biased pricing and bubbles also arise because the supply of real estate is not elastic. By the time the market recognizes supply has outstripped demand, construction has already begun on many more projects that will continue to be built out; this tends to exacerbate oversupply and create downward pressure on prices for years.

In a research paper titled, "Incentives for Mortgage Lending in Asia," Wachter and her co-authors write: "With [the] forbearance of regulatory authorities and the intervention of governments, banks may be bailed out, mitigating the consequences for shareholders. Nonetheless, the fundamental factor which explains why episodes of bank under-pricing of risk are likely to occur is the inability of banking shareholders to identify these episodes promptly and incentivize correct pricing."

Wharton real estate professor Joseph Gyourko notes that significant differences exist in the performance of commercial and residential real estate securities. "Securitized commercial property debt will come back once the market calms down," he says, adding that there has been very little default in commercial real estate finance. "You'll be able to pool mortgages and securitize them, but almost certainly won't be able to leverage them as much as you did in the past."

The residential side, where there is significant default, is more problematic. Gyourko believes the residential market will go back to what it was in the mid-1990s and most borrowers will have to put down at least 10% of the sales price. "We will get rid of the exotic, highly leveraged loans," he says. "That will lead to lower homeownership, but it should. We put a lot of people into homeownership that we shouldn't have."

Wharton emeritus finance professor Jack Guttentag, who runs a Web site called mtgprofessor.com, says the short-term future for residential real estate is "bleak."

"Secured bondholders have been badly burned. They discovered to their dismay that all kinds of problems are connected to mortgage-backed securities, which they hadn't anticipated." Guttentag also points to the failure of ratings agencies, which are already being revamped. The methodologies used to determine ratings were flawed, he says. "They used historic performance over a period that simply wasn't representative."

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