The Crash of the Housing Bubble

Explosion of Residential Mortgage Debt

According to the Case-Shiller housing index, residential housing prices peaked in July of 2006. Housing prices were still in decline at the time this chapter was written (summer of 2011). Credit for the bubble can be attributable to policy objectives as well as easy credit. Policy during both the Clinton and Bush administrations was clearly focused on increasing home ownership. This motive was not new; GSEs were established to expand the secondary market in mortgages by purchasing and securitizing conforming loans and creating mortgage-backed securities (MBS), transferring ownership (and risk) of cash flows to investors. MBSs were essentially plain vanilla pass-through securities with no credit enhancement and stable credit risk.

GSEs essentially enjoyed a carry trade in MBS due to their low borrowing costs; they were backed by the government and therefore had the highest credit quality. Some pertinent facts:

• Twenty percent of the mortgage debt was funded by MBS in 2003 (up from 5 percent in 1992).
• Forty-seven percent of all mortgage debt was held by GSEs in the form of MBS and whole loans by 2003.

Government's Role

As mentioned earlier, there has been a clear policy mandate aimed at increasing home ownership in the United States, for financial reasons (home equity was considered a form of savings) as well as for less tangible purposes. For example, home ownership is part of the American dream. HUD specified in 1996 that 42 percent of GSE purchases be mortgages to borrowers below median income and 12 percent below 60 percent of the median. These shares rose to 50 percent (20 percent) in 2000 and 52 percent (22 percent) in 2005.

GSEs reached these targets by lowering credit standards and raising LTVs. Home ownership rose significantly but many of these loans were either subprime (risky, high LTV, lower credit scores), Alt-A (good credit rating but low or no documentation), or nonamortizing (option ARM recasts, which pay less than monthly accrued interest for the trial period). In 2003, 60 percent of all mortgages were conforming, 10 percent were junk, and the rest were jumbos. In 2005 and 2006, one-third of all originations were conforming and one-third were junk. Credit expansion had clearly laid the groundwork for an unstable bubble in housing prices.

Household Leverage and the Housing Meltdown

Rising housing values and expectations that the trend would continue incentivized homeowners to take on second mortgages and tax-deductible home equity lines of credit (2 percent of mortgages in 2002 involved a second lien while 30 percent did so by 2006).

The tax deductibility of mortgage interest also provides more incentives for renters to transition to home ownership. Moreover, home owners greatly underestimated the risk of losing their homes to default.

By 2001, 45 percent of the $215 billion of subprime and Alt-A mortgages were placed into private label ABS. By 2005 and 2006, this had risen to 80 percent of $2 trillion. Because private label securitization fell outside the mandates of GSEs (these were nonconforming loans), their contribution to the credit risk of securitized pools of mortgages went undetected. Originators used SPVs (for example, Bank of America, Countrywide, WAMU, GMAC Mortgage LLC), which held title to these pools off their balance sheets and out of sight of regulators.

What contributed to the explosion in below-investment-grade tranches was in some part due to the carry trade—BASEL accords established capital requirements of zero on government bonds, 8 percent on commercial loans, 4 percent on residential mortgages and 1.6 percent on GSE pass-throughs. Since SPVs could attain a AAA rating on over 80 percent of an ABS issue, then banks accelerated their holdings of MBS.

Hedge funds and special investment vehicles like Citigroup, Lehman, and Bear Stearns levered up, increasing their debt-to-equity ratios to 30:1 and held the below-investment-grade tranches because they felt there was no downside risk since housing prices were thought to have only upside volatility. These investments went from $500 billion in 2000 to about $2 trillion in 2008. At the same time, SIVs started issuing commercial paper to buy junk. They also had lines of credit with commercial banks in case holders of commercial paper would not roll their debt. Thus, the commercial banks were exposed to all of the risk on the SIV investments.

The acceleration in housing value, which tripled over the 10 years from 1998 to 2007, sparked a construction boom. The supply of housing eventually overwhelmed demand by July 2006, and housing values thereafter began to decline. As they did, defaults on subprime and Alt-As spiked and the credit quality of the CDOs and MBS fell.

As market prices on these securities declined, spreads over Treasuries blew out, erasing balance sheets on SIVs and SPVs (recall that they retained the junior tranches for themselves) and eventually the GSEs themselves. The market for commercial paper virtually went away (picked up by the Fed) and credit markets collapsed. Without access to cash, funds could not meet their margin requirements, assets were liquidated at a fraction of their booked values and what ensued was a string of investment bank and thrift failures.