The tidal wave of cash coming from the emerging world and from nervous central bankers overwhelmed the financial system. Wall Street’s preferred channel for funneling all this liquidity—the securitization market—had worked in the pre-boom era, but couldn’t scale up easily to handle the flood.
Securitization involves combining lots of loans and using the principal and interest payments to back bonds, which are then sold to investors. The first security backed by residential mortgage loans was issued in 1970 by Ginnie Mae, a federal government creation. In its infancy, securitization had been a straightforward business, handling only high-quality loans or those guaranteed by the federal government. Principal and interest payments were passed directly through to investors. There were no frills and few moving parts.
The benefit of securitization is similarly straightforward; it lets capital flow where it’s needed. For borrowers this means cheaper loans because more institutions are providing them; for investors it means the ability to diversify their portfolios. And regulators liked the idea of letting financial institutions offload some risk to other investors.
Yet as we learned, securitization has its problems. Because financial institutions that originated loans could sell them off quickly to Wall Street, they suffered little if the loans went bad and therefore had less incentive to be sure they were sound. This problem became evident in the late 1990s, in the market for securitized mobile-home loans. Banks made hundreds of thousands of such loans to lower-income households who were ill-prepared to repay them. The resulting defaults sank the manufactured housing market.
Securitization also turned out to be susceptible to a kind of bank run, similar to those that had ravaged the economy in the early 1930s. In those years, when depositors thought a bank was in trouble, they would rush to withdraw funds all at once, causing the failure they feared. Investors in securitized loans could panic as well, it turned out, causing cash to stop flowing suddenly. The credit-card securitization market was hit by this kind of panic briefly during the Asian crisis in the late 1990s.
But the lessons of the mobile-home and credit-card securitization markets were quickly forgotten in the boom of the mid-2000s. Wall Street bundled trillions in residential mortgage loans and sold them to global investors in structures that grew increasingly complex and opaque (see Figure 1.4). The proceeds flowed back into housing in a flood of new mortgages offered to increasingly risky borrowers. At the peak of the lending frenzy in 2006, approximately one-half of all new mortgages required no down payments, little documentation of employment or income, and only a cursory building appraisal.
Figure 1.4. Issuance of securitized instruments, bil $.
Source: Moody’s Investor Service