Lenders drove the boom and the bust

In the years leading up to the 2008 financial crisis, trillions of new dollars flooded into housing.  Why?

Was it coaxed into the housing market by borrowers who convinced bankers they could pay back the loans?

No. It gushed into the housing market from financiers with piles of money they needed to invest.

In other words, the housing boom was driven by lenders, not by borrowers, say several economists.

Economist  Zoltan Pozsar writes about the piles of money in his recent “A Macro View of Shadow Banking,”  which expands on his 2011 study “Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System.”  While these cash pools have been discussed before, most notably by National Public Radio, Pozsar fills in important understandings.

These pools, largely developed since 2000, fueled the housing boom a decade ago, caused the bust that followed in 2008 and threaten further destabilization today, writes Pozsar who is calling for a better understanding of the pools.

Examples are pension plans, corporate treasuries, money market funds, endowments, mutual funds, insurance separate accounts, foundations, hedge funds, central bank and government holdings, mortgage real estate investment trusts (mREITs), and securities lenders.

Each pool controls enormous piles of money that it must invest. In his analysis, Pozsar includes pools that have at least $10 billion each. Altogether they controlled $5.6 trillion in 2013, Pozsar estimates. That was up from $5.4 trillion in 2007 and $2.8 trillion in 2000. 

How much is $5.6 trillion? Spending at $1 a second, it would take 31,710 years to spend $1 trillion.

Although investment pools existed long before the 21st century, they have grown much larger since the millennium, and their hunger for safe, high-yielding investments — like AAA-rated mortgage-backed securities – is a new, little-understood force in the financial markets, Pozsar claims.

Shadow banking grew up to supply the safe, high-yielding investments that the pools demand. Stabilizing this new financial market will be a key challenge for regulators, writes Pozsar, a recognized expert on shadow banking.

His insight is amplified by other recent reports.

In a New York Fed report by economists Alejandro Justiniano, Giorgio E. Primiceri and Andrea Tambalotti, “Credit Supply and the Housing Boom,” the authors argue that the housing boom wasn’t caused by looser borrowing standards. It was caused by looser lending standards. It was caused by “a significant expansion in the supply of mortgage credit,” which drove up the cost of housing and enabled more lending, they claim.

An unprecedented boom and bust in house prices and household debt have been among the defining features of the U.S. macroeconomic landscape since the turn of the millennium. Common accounts of this credit cycle, in the economics literature and beyond, have pointed to changes in the tightness of borrowing constraints, and to the consequent shifts in credit demand, as its key driver. In this paper, we argued that the focus of this discussion should shift from constraints on borrowing to obstacles to lending, when it comes to understanding the boom phase of the cycle.

And …

The housing boom that preceded the Great Recession was the result of an increase in credit supply driven by looser lending constraints in the mortgage market. This view on the fundamental drivers of the boom is consistent with four empirical observations: the unprecedented rise in home prices, the surge in household debt, the stability of debt relative to home values, and the fall in mortgage rates. These facts are difficult to reconcile with the popular view that attributes the housing boom to looser borrowing constraints associated with lower collateral requirements.

From “The continuing investigation into the U.S. housing bubble” by Nick Bunker of The Washington Center for Equitable Growth, writing about “Household Debt and Defaults From 2000 to 2010: Facts from Credit Bureau Data” by Atif Mian of Princeton University and Amir Sufi of the University of Chicago:

There’s a disagreement about whether the increase in debt was the result of a loosening of a borrowing constraints, in which lenders let borrowers take out loans with less collateral, or of a lending constraint, in which lenders give out more loans. One way to test these competing hypotheses is to see if the debt-to-income ratio moves more than the ratio of debt to the value of housing.

Mian and Sufi find that debt-to-income ratios rose steeply for most households and mostly at the bottom of the credit-score distribution while debt-to-home value ratios actually declined for all groups above the bottom 20 percent of the distribution. This is a pretty good sign that lending constraints were loosened, perhaps by “advances” in lending technology such as securitization, which enabled mortgage lenders to sell their mortgages to institutional investors and then originate more mortgages to sell into the securitization machine.

A rise in lending can be seen at work today in such areas as student loans , car loans and online lending, and it’s developing in other areas such as solar panels.

(Editor’s 7-10-15 update: The increase in the availability of student loans 2001-2012 led to a rise in tuition costs and student debt, especially at expensive private four-year institutions, according to a July 2015 staff report from the New York Fed.)

In the solar panel example, a rush to install solar panels before the federal Investment Tax Credit falls from 30% to 10% at the end of 2016 has spurred a search for funding. Because securitization of solar panel loans has the potential to supply an endless river of money from investors, some consider it the holy grail of solar panel financing. Investors are attracted to securities backed by solar panel loans in part because the interest rates are high and they have a save-the-planet quality that endears them to Americans, just as Americans uncritically embraced homeownership a decade ago.  Some solar panel securitizations are already underway.

Investment pools and shadow banking

Around 2000, events led to the growth of investment pools and their embrace of shadow banking. Among these events, according to the economists:

— Government and corporate treasuries grew: The founding of the World Trade Organization in 1995, the steady entry of former Soviet Union countries followed in 2001 by China, and Congress’s enactment of normal trade relations with China in 2000 led to increased international trade, to growth in central bank and government holdings and to increases in corporate treasuries as companies benefited financially from moving jobs to lower-wage countries. 

(Editor’s 7-10-15 update: U.S. non-financial corporate cash holdings reached a record $1.82 trillion in 2014, according to Standard & Poor’s Ratings Services.)

— International money chose the U.S.: Following the Asian crisis in the late 1990’s,  global savings fled to safety in the U.S.

— Low interest rates triggered a search for yield: The stock market crashed in 2000-2002 and terrorists attacked the World Trade Center in September 2001. The Federal Reserve slashed interest rates, making it hard for investors to get the yields they wanted.

— Underfunded pensions searched for yield: Pension pools that had ballooned during the go-go 1990s were hurt by the stock market crash and the fall in interest rates.  The largest public retirement systems fell from being fully funded in 2001 to only 73 percent funded in 2012, Pozsar reports.

—  Hedge funds grew: The steady performance of some hedge funds through the dot-com crash and 9/11 attack in 2000-2002 helped lead to an explosion in hedge fund holdings, from $500 billion in 2000 to $1.9 trillion in 2007.

— Money market funds grew: Cash held by money market funds grew dramatically after the turn of the century, from $1.8 trillion in 2000 to $3 trillion in 2007, in part because they promised instant access like a bank checking account but a higher return.

After the 2000-2001 scares, the managers of cash pools were looking for investments that were safe, high-yielding and not volatile, which Pozsar describes as “equity-like returns with bond-like volatility.”

Shadow banking to the rescue

The financial markets responded to the investment needs of these giant pools of money by offering shadow banking. What follows is the typical shadow banking structure they created. At its heart is the repurchase “repo” market where the cash pools buy and sell securities with each other, as a way to invest or get cash, and the seller promises to reverse the deal soon – or “repurchase” the securities – often tomorrow.

* In the middle is a broker-dealer like Lehman Brothers that has a hedge fund as a client. The hedge fund accepts $100 million from a pension fund client and uses it to buy stocks and bonds. Then, to increase its yield, the hedge fund repos some of the securities to the broker-dealer in exchange for cash and uses the cash to buy more stocks and bonds. 

* The broker-dealer,  in turn,  repos the hedge fund’s securities to a money market fund that needs a safe place to invest $100 million. The broker-dealer gets cash from the money market fund, which it repos to the hedge fund in exchange for more stocks and bonds. To a money market fund, repos feel safe because the securities are collateral and because the fund can choose to reverse the deal the next day, though usually it renews. 

The purpose of the broker-dealer in this structure is to arrange and manage the financing between (1) the pools like hedge funds that seek higher yields with some safety and (2) the pools like money market funds that seek safety with some higher yields.

Once this structure was in place, the pools needed securities to use as collateral for the transactions. That set in motion the securitization pipelines that poured money into housing by selling mortgage-backed securities to the pools and using that money to make more home loans and more mortgage securities to sell to the pools.

Even more money flowed into those pipelines after Congress rewrote the bankruptcy laws in 2005 and gave mortgage securities a special status. The new law said repo lenders could immediately sell mortgage collateral if their borrower went bankrupt. That meant repo lenders could avoid the costs and delays of becoming a creditor in bankruptcy court if their repo collateral was mortgage securities.

But when the pools of money began losing faith in the mortgage securities in 2007, and when the government let Lehman fail in 2008, the pools stopped renewing the repo deals they’d made. That was the financial crisis.

Lenders tried to sell the collateral into a market panic, accepting lower and lower prices  just to get out. That drove down the values of the securities, not just for themselves but for everyone in the market. The spiral threatened the solvency of the cash pools that could no longer finance themselves on the repurchase market.

That’s what Federal Reserve Chairman Ben Bernanke was talking about when he told the Financial Crisis Inquiry Commission:

As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression. If you look at the firms that came under pressure in that period. . . only one . . . was not at serious risk of failure. So out of maybe the 13 — 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.

Today the pools are growing and looking for new collateral to secure their transactions.

Some observations about shadow banking:

* Shadow banking operates parallel to traditional banking. Often the same financial institutions do both traditional banking and shadow banking. For example, a financial conglomerate like J.P. Morgan may own a commercial bank, a pension fund, a broker-dealer, a hedge fund, a money market fund and more.

* Shadow banking does not serve the financial needs of citizens, consumers, governments or businesses. It’s not banking that finances the engines of the economy. Instead, shadow banking conducts “financial economy transactions,” writes Pozsar. It serves the financial goals of the pools and their investors. Pozsar believes this may be one sign of structural problems in the U.S. economy, that managers of large pools of cash choose to invest in financial instruments instead of commerce.

That said, when investment pools buy securities from companies that make consumer loans, those companies can use that new money to make more loans. When pools distribute profits to their investors, the investors may spend some of that money in the real economy. And some pools have indeed begun lending directly to businesses – but that is prompting some concern.

* Pozsar posits that the pools’ relentless demand for securities is keeping interest rates unusually low, by driving the price of securities up and the yields down.

* Pozsar worries about the paucity of shadow banking data and about the potential for runs on banking that is not protected by FDIC  insurance.

 The antidote for runs, he says, is for central banks to keep cash flowing into the markets, either  by serving as a lender of last resort as the Bank of England does or by providing the market with plenty of Treasuries or other safe securities as the U.S. is considering.

He prefers the lender-of-last-resort solution.