What happened to housing and financial markets over the last decade? To find out, follow the money.
According to Yale Professor Robert Shiller’s data, the run-up and collapse of U.S. home prices over the last decade were without precedent over the previous century. Where did U.S. households get the money they needed to bid up house prices so high?
The answer is, they borrowed it, with household mortgage debt growing more than twice as fast as GDP between 1999 and 2006.
And where did the money come from that the institutions lent to U.S. households? The loan originators, who provided the initial mortgage loans, quickly sold them off to loan aggregators. In the 1980s these loan aggregators were primarily the government-sponsored enterprises Fannie Mae and Freddie Mac. But by the final days of the housing boom, the loan aggregators were more often private institutions who bundled the mortgages into asset-backed securities.
OK, so where did the loan aggregators get the money with which they bought the mortgages from the loan originators? The GSEs took the majority of loans they purchased and collected them into securitized pools that were sold off to banks, pension funds, mutual funds, state and local governments, and buyers all around the world. What made these attractive to the buyers was the fact that the GSEs guaranteed the securities. Although Fannie and Freddie did not themselves remotely have sufficient capital to make such guarantees credible, investors thought– correctly, as events turned out– that if Fannie and Freddie ran out of cash, the federal government would step in to honor the guarantees.
Another good chunk of the loans that the GSEs purchased they ended up holding themselves. And where did the money for that come from? Again, it was borrowed. Investors willingly lent trillions of dollars to the GSEs at rates only slightly above that on U.S. Treasuries because lenders again believed that Uncle Sam would ensure that the GSE debt was repaid.
But most of the later egregious NINJA loans (no income, no job, no assets) were made by private loan aggregators. And where did they get the money? Again, much of it seems to have been borrowed. If you buy a mortgage-backed security (or collateralized debt obligation constructed from assorted MBS), you could then issue commercial paper against it to get most of your money back, essentially making the purchase self-financing. This was the idea behind the notorious off-balance sheet structured investment vehicles or conduits, which basically used money borrowed on the commercial paper market to buy various pieces of the mortgage securities created by the loan aggregators. The dollar value of outstanding asset-backed commercial paper nearly doubled between 2004 and 2007.
Yale Professor Gary Gorton has also emphasized the importance of repo operations involving mortgage-related securities. If I buy a security, I can then pledge it as collateral to obtain a repo loan, again getting most of my money back and allowing the purchase to be mostly self-financing as long as I keep rolling over repos. Although I have not been able to find numbers on the volume of such transactions, it appears to have been quite substantial.
The question of how the house price run-up was funded thus has a pretty clear answer: Other People’s Money. Because of so much money pouring into house purchases, the price was driven up. And because house prices continued to go up, the shaky quality of many of the underlying loans for a while did not come back to bite anybody. If the buyer makes a capital gain on the home purchase, there is every opportunity to refinance the loan and repay the original lender, no matter how poor the borrower’s initial financial condition. But after house prices began declining in 2006, the jig was up. The freeze of assets by BNP Paribas in August 2007 was followed by a sharp increase in the spread between the rate on asset-backed commercial paper and nonfinancial commercial paper.
The haircut on structured-debt repo– the amount by which the value of collateral delivered must exceed the money lent against it– started to climb dramatically after August 2007, forcing repo positions to be unwound.
To the extent that purchases of mortgages were being ultimately being funded by short-term borrowing through commercial paper or repos, the institution borrowing in this manner was essentially fulfilling the function of a bank– borrowing short and lending long. If, as happened starting in 2007, those providing the short-run funds choose not to renew the loans, the institution would be forced to liquidate its long positions in a market where the underlying securities could only be sold at a deep loss. In other words, there would be a run on the shadow banking system.
Now, there are two aspects of the situation that began in August 2007 that one might choose to emphasize. The first perspective supposes that self-fulfilling fear itself is the key dynamic that propagates the crisis, as fire-sale prices create ever-spreading losses. When calm and rational valuation return, all will be well. The key problem, according to this perspective, is that would-be short-term lenders were hit in August 2007 with a sudden irrational lack of exuberance that ended up persisting over a year and bringing much of the world economy down with it.
The other perspective of what happened beginning in 2007 is that those Other People– the ones who ultimately provided the Money that drove all this– finally started to wise up.