People tend to attribute the outbreak of the 2008 financial crisis to deregulation. In my paper ‘From the Great Depression to the Great Recession: On the Failure of Regulation in the Mortgage Market’, I challenge this view and present a unique perspective of the crisis as in fact rooted in the way the residential mortgage market is regulated.

Focusing on non-recourse mortgage legislation, which is a unique feature of the US mortgage market dating back to the period following the Great Depression, I analyze the contribution of this legislation to the onset of the Great Recession. My paper illustrates how regulation that was enacted as a reaction to a severe economic crisis (the Great Depression) not only failed to prevent a large-scale future crisis (the Great Recession), but also laid the groundwork for the emergence of the latter.

States that have adopted non-recourse mortgage legislation, such as California and Arizona, were at the center of the outbreak of the mortgage meltdown. Non-recourse laws prevent lenders from seeking a deficiency judgment after foreclosure and impose no personal liability on borrowers in the event of default. Even if the foreclosure sale price returns only a portion of the unpaid debt, the lender is not able to recover the outstanding balance from the borrower’s non-collateralized assets or future income. In effect, non-recourse mortgages give borrowers a put option, allowing them to terminate the remainder of the debt in exchange for transferring the mortgaged property to the lenders.

The effect of non-recourse mortgages, in conjunction with the elimination of down payment requirements in the years leading up to the mortgage meltdown, was a distortion of risk allocation in the mortgage market. When borrowers are not required to invest anything upfront in order to get a mortgage and bear no personal liability for repayment in the event of default, they are not deterred from taking out loans beyond their means. Quite the contrary: this only incentivized excessive borrowing, increased the demand for real estate assets, and led to the housing bubble.

When the real estate market crashed, however, this bubble burst and the value of the collateralized assets plummeted to below the value of the balance of the mortgages. Since equity in an asset is defined as the surplus of value over debt, this created a negative equity situation (‘underwater’). When the negative equity was significant, rational borrowers preferred to stop repaying their loans, walk away from their homes, and be freed of their debt. This was possible because the loans were non-recourse mortgages. Known as strategic default, this phenomenon characterized the US real estate market during the mortgage meltdown. The massive abandonment of property had a snowball effect, leading to rapidly deteriorating prices in the market and further escalating the meltdown.

The analysis in my paper has important implications for current reforms in leading foreclosure states, such as California and Nevada, where regulators recently expanded the scope of the existing mandatory non-recourse legislation. The borrower-friendly state legislation enacted in the wake of the mortgage meltdown failed to give proper weight to the negative long-term implications of this regulation, such as distorted incentives for excessive borrowing. Regulators should take heed of the insights from my paper, and beware of overestimating the short-term benefits of the regulation and of underestimating its long-term costs.

Dov Solomon is an Assistant Professor at the College of Law and Business, Ramat Gan Law School.