Systemic Risk and Market Institutions

Abstract

With private-label mortgage-backed securities (MBS), investors bore default risk. This risk should have been priced. As systemic risk grew, why didn't the pricing of risk increase? 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.