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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.
Posted by James Hamilton at April 25, 2010 01:14 PM
Presumably a steady sequence of federal reserve rate overnight rate hikes increased the cost of speculative borrowing and fits with this notion that the ultimate lenders started to wise up. Another interpretation of events is that ultimate lenders saw the yield curve flatten and turn negative, and then decided to rebalance portfolios in light of an anticipated recession.
This is like staring at the road map to a horrendous automobile crash. Strikes me that the credit-fueled boom started to fizzle in summer 2007 but didn't really crash until late summer 2008. Gets one thinking about monetary policy lags. Two years, even more, is not extreme.
Posted by: GNP at April 25, 2010 03:00 PM
What happened in '05-'07 was that the cumulative differential rate of growth of wages and M2/bank loans/debt from the late 1960s and early 1970s (US oil production peak and onset of the "limits to growth") reached the critical order of exponential magnitude, i.e., the "Jubilee threshold", requiring debt-money growth to be faster than exponential to keep debt service and so-called "growth" going.
Of course, once the Jubilee threshold is reached, diminishing returns to debt expansions results in the inability of firms and labor to sustain investment, production, and debt service sufficient to sustain the existing debt, let alone service still more debt at compounding interest.
The Jubilee threshold has been forgotten (never learned or not taught) by post-modernists ("end of history" bunch) neo-Keynesians and the economics profession; however, it was well established by the ancients from the Sumerians, Babylonians, Persians, and Hebrews, to name just a few. Growth of debt and its service cannot exceed labor product or production longer than the extent to which the debt becomes unservicable at a given term.
For example, $1 lent for a perpetual term of, say, 30 years must include a subsequent growth of debt of more than ~2.6%/yr. over production or labor perpetually just to ensure the existing debt can be serviced. Grow debt (credit-money "inflation") at a faster sustained rate over labor and production, and the Jubilee threshold is reached before the 30-year term.
And it is not a coincidence that we achieved the Jubilee debt burden threshold at virtually precisely the point at which global oil production (extraction of finite reserves) occurred in '05-'08.
Now we have gov't taking over where the private banking system cannot continue to lend, having reached the Jubilee threshold. But neither can gov't grow debt at a differential rate in excess of output before the public debt Jubilee is reached. Since '00, US nominal GDP has averaged just 3.96%, which is less than the 60% of the long-term trend of ~7%. However, gov't is growing borrowing and spending at more than twice the rate of GDP, implying that the public debt Jubilee threshold date is awaiting us in '16-'18 at the given trend of gov't spending and GDP.
Not coincidentally, '16-'18 is when China's oil consumption will converge with US oil imports, with the projected date for US and China oil consumption parity in the early '20s. At that point, in addition to approaching US and EU fiscal insolvency, we will be in direct competition with the Middle Kingdom for dwindling global oil reserves, with OPEC exports falling and China running a persistent trade deficit for oil and food.
In fact, Japan has de facto reached the Jubilee threshold for public debt after reaching the same point for private debt in '97-'98. Japan is the canary in the proverbial mine shaft for the US and EU WRT debt/GDP. What happens to Japan will very likely occur for the US and EU 7-10 years hence (and sooner for Greece, Portugal, Ireland, Italy, easter Europe, and the UK).
Nemesis
Posted by: Nemsis at April 25, 2010 03:24 PM
Ya, James mon. Sounds like it. We had the "wholesale bank run" that ended it. (Repos dryed up) It was low interest rates and the "search for yield" that got us "other people" to put our money there, like we had a choice. If you wanted to "stay on the sidelines", the banks, and brokerages did it for you. No choice again.
And the system is still trying to force the same thing with ZIRP and QE. When will they finally acknowledge that economics as they know it is broken?
Posted by: Cedric Regula at April 25, 2010 06:43 PM
Great post. Especially this: "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."
Right. I don't think there was a "panic", but a massive repricing which was entirely consistent with what reasonable people thought the "true" market value of the assets really was. In Gorton's piece, which you cite, the prices dipped almost 50%, which sounds about right since everyone knew the underlying collateral was suspect.
Of course, Bernanke still clings to the idea that these are just "unloved" assets that will eventually bounce back. But what else can he say: "We're going to mark these turkeys down to their real value and shove the banking system off a cliff?"
He's just doing his job, which is fine, but cooler heads need to demand that the shadow banks are strictly regulated from here-on-out so we don't end up in the same pickle two years from now.
Posted by: Raskolnikov at April 25, 2010 07:30 PM
Keep following the money!
Where did all the money from Money Market/Repo/Shadow banking come from, and where did it go?
I would say that the rapid expansion of 1st world productivity to 3rd world labor caused productivity to rise faster than wages globally, creating the supply of capital. Government risk (mis)regulation directed that supply into securitized debt markets, creating the housing bubble (Stocks could not be securitized into AAA rated securities). It went into government bonds, forcing the fed/treasury to regurgitate it back into the housing market/bailouts.
Posted by: TDM at April 25, 2010 07:48 PM
WRT 'other people's money' -- Money market mutual funds filled this role by buying much of the short term debt. Once the short term market became illiquid they broke the buck. With no short term source of funds, the entire MBS business model collapsed. Bernanke and Paulson warned the government that we were on the verge of a global meltdown and the big investment banks accepted the government cramdown.
The investment banking business model collapsed and Lehman 'was allowed' to fail while the others morphed into commercial banks.
Fast forward to today. The FED has replaced money market mututal funds as the source of shrot term funds in the MBS game, now controlled by Fannnie and Freddie, (with government support). Fannie and Freddie have expanded in scope and continue to operate using a broken business model.
Posted by: tj at April 25, 2010 07:49 PM
"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."
It should be pointed out that this investment is very dubious on its face. In essence, you're competing against a subsidized competitor without the subsidy. Why is there a subsidy? Why are there GSEs? To loan money to people who private lenders wouldn't lend to. So, in the end, you had lenders lending to people who the private sector wouldn't lend, that needed a subsidy to incentivize lending to them, without the subsidy.
As well, you had lenders lending to people who had the most problems paying their loans at the top of a market. Nothing makes either of these moves prudent. How risky they are is a matter of opinion, or used to be rather.
Posted by: Don the libertarian Democrat at April 25, 2010 09:47 PM
I have trouble believing it was all due to what was a $700B trade deficit in the peak years being re-cycled back into a $15 trillion US economy.
I think one of the flaws in the analysis is the focus on "flows", and ignoring "stock" of the $60 trillion the US has in personal savings to invest. I think that is what the banks have their eye on.
Posted by: Cedric Regula at April 25, 2010 11:03 PM
On following the money
Were the credits making the deposits? Money multiplier at work isn it ? http://research.stlouisfed.org/fred2/series/GSAVE savings deposits http://research.stlouisfed.org/fred2/series/PSAVERT Bank credit of all commercial banks (see vintage MAX http://alfred.stlouisfed.org/series?seid=TOTBKCR&cid=101) Assets at Banks whose ALLL exceeds their Nonperforming Loans http://research.stlouisfed.org/fred2/series/LLRNPT?cid=93
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