How the Housing Credit Bubble got started
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The mortgage business was traditionally fairly conservative with a local savings and loan lending to a resident of their community. Bankers typically knew their markets from personal experience and often knew the borrowers personally (see the film It’s a Wonderful Life for the Hollywood version).
The major factor that transformed the housing boom into a credit bubble was disintermediation in the credit markets. Former Fed Reserve Chairman Alan Greenspan has argued (see his article in the Financial Times blog here) that there were real estate bubbles in over 20 countries in the first half of this decade (from 2001 to 2005); the common factor seems to be that long-term interest rates declined in all major countries at the same time. Greenspan argues that the housing price bubble in the U.S. was not different from the housing bubble in the other countries. What was different in the U.S. was the credit bubble
, from the securitization of subprime loans.
In this essay I will describe how the mortgage market works, the development of securitization and then how things went wrong.
While the first savings institutions in the U.S. date back to the early 19th century, the savings and loan industry was greatly expanded by the Federal Home Loan Back Act of 1932 (see here for the text of the Act). In the 1950s and 1960s, a borrower would get a mortgage at a savings and loan or a commercial bank, which would then hold the mortgage on its books.
Here is a table derived from the Federal Reserve Flow of Funds (from Table F218) that shows the amount of home mortgages made in selected years and the amount of the change in home mortgage assets of the banking system.
|Year||Home Mortgages||From Banks|
Billions of Dollars; Banks include commercial banks, savings institutions and credit unions.
In the table you can see that from 1955 to 1975, the largest source of mortgage finance was the banking system. Other holders of mortgages included the household sector (often mortgages provided by the seller of the property), life insurance companies, finance companies and the government sponsored entities (GSEs).
By the 1980s a greater fraction of loans were held outside the banking system, as more mortgages were sold to Fannie Mae and other GSEs. In 1985 Agency and GSE-backed mortgage pools accounted for $77.6 Billion of the $178.6 Billion home mortgages, compared to $52.7 Billion for banks.
- GSEs such as Fannie Mae (the Federal National Mortgage Association or FNMA) purchase mortgages from mortgage issuers and then resell them in the form of Mortgage Backed Securities (MBS) that are packaged in ways attractive to institutional investors. There is a limit to the size of the mortgages that they can purchase from mortgage issuers; until recently the maximum mortgage was $417,000 but this has been recently increased to $729,000. While Fannie Mae was established by the government, it is a private company; but investors seem to believe that if Fannie Mae had real trouble they would get some help from the government. There are other GSEs that perform similar functions including GNMA and Freddie Mac.
In recent years the ABS (Asset Backed Securities) issuers became a more important source for home mortgages. In 2005 $507.4 Billion mortgages were acquired by ABS pools compared to $167.6 by Agency and GSE-backed mortgage pools and $324.0 Billion that were held by banks.
- Asset Backed Securities (ABS) are pools of securities whose credit rating often exceeds that of the underlying securities. Obligations such as home loans, auto loans or credit card receivables may have a high degree of risk, but can be “packaged” to produce a security with fairly low risk. This is usually done by providing a credit enhancement or dividing a pool of risky debt into various tranches. An example of credit enhancement would be overcollateralization and yield spread, for example issuing a $100 security with a 6% yield backed by $120 of risky debt with a yield of 10%. An example using tranches might be using sequential pay: $500 of mortgages could fund 5 bond issues; holders of bonds 2 through 5 would receive nothing until bond 1 was fully paid off.
With all that in mind, here is what happened in the peak years of the housing boom. Interest rates were low; financial institutions were hunting for high quality securities that would yield a bit more than Treasury securities. ABS or more specifically MBS (mortgage backed securities) seemed to be the answer to the problem. The typical transaction was something like this (and see here for an example with more details):
- Mortgage broker makes a somewhat risky home loan.
- Mortgage broker sells the home loan immediately to a SIV (Structured Investment Vehicle) that packages the mortgages.
- The SIV then creates new securities that represent claims on the mortgages. Some of these securities get AAA ratings since they are overcollateralized and have a positive yield spread.
These new securities were incredibly popular among institutional investors. As Chairman Greenspan notes in his essay
, judging from the demand, the mortgage securities appeared to be underpriced. Buyers asked the SIVs for more securities, so the SIVs asked the mortgage brokers for more mortgages. Mortgage brokers faced little risk if they could sell any mortgage immediately. Why carefully examine the loan application if there was a line of buyers waiting to buy the security as soon as the deal was signed? And so the bubble expanded, until it could not and everything fell apart.
Housing prices stopped rising, borrowers \started to default on their mortgages, investors stopped buying mortgage products from SIVs and SIVs stopped buying mortgages from mortgage brokers and people with poor credit got fewer mortgages.
The question to ask today is why these securities seemed so cheap at the time.
- One serious question is how many securities were real and how many were fraudulent. In a boom period there are always some illegal/unethical participants in the market who create a product that looks like the real thing but is deficient in some way. See here for some mortgage brokers who are going to prison.
- A related question is how many mortgage brokers made mortgage loans without sufficient attention to details. Undoubtedly the pressure on mortgage brokers (lots of money if they could process mortgages quickly) led some to overlook missing information and ignore possibly disqualifying circumstances.
- Another question is how many of the SIVs misrepresented exactly what they were selling or the likely returns.
Certainly the low interest rate environment and the hot housing market were necessary underlying conditions. The major risk for someone who buys a mortgage is that the borrower will stop paying. But if home prices are rising, then even if the borrower has a financial problem (loss of a job, poor health) and cannot pay his mortgage the problem is not so serious. As we will see in the essay on “What happens if borrowers do not pay their mortgages?”, banks usually expect to lose about half the value of a defaulted mortgage. But if home prices have risen sufficiently, the borrower may be able to sell the home and pay off the mortgage preventing any loss for the owner of the mortgage.