In the post from Thursday, I argued that the current recession is the result of classic over investment, in this case in housing. This brings up the very important question of why we had an over investment in housing. (I’m posting a new poll on this subject, but first, you read.)
The potential suspects I’m going to consider are: the GSEs, the Fed’s low interest rate policy in 2002-2003, and the rise of structured finance, especially CDOs.
First, one suspect I’m immediately tossing out. Lack of government regulation on lending. There is a perfectly legitimate argument that regulation was too lax. But I’d rather investigate why banks were so willing to underwrite so many sketchy mortgages. Because if there was some perverse incentive to lend money recklessly, then no regulatory scheme would have prevented it. Had mortgage regulations been more stringent, the lending would have flowed someplace else anyway.
Blaming the GSEs is complicated, because the GSEs have been around a very long time. It is undeniably true that without the GSEs there wouldn’t have been as much supply of available funds for loans. But in my opinion, the GSEs incremental impact on loanable funds didn’t wildly change from 2001-2007. In fact, the evidence is that the GSE’s market share declined during this period, as other types of securitization gained in popularity. More on that later.
1% Fed Funds in 2003
This is a popular argument, that ultra low rates lead to ultra easy liquidity. Plus ultra low government bond yields lead investors to aggressively seek out higher yielding investments.
There is something to this, but to me it doesn’t explain why availability of mortgage capital actually accelerated in 2004-2006 as interest rates were rising.
I argued, over a year ago, that CDOs were the primary culprit in causing the sub-prime problem. Consider: why were mortgage brokers willing to underwrite every loan they saw? Because they knew they could sell the loan. Who was the buyer? Structured finance.
On the lower end of the credit spectrum, structured finance created the leverage. On the top end of the credit spectrum, banks levered their positions through SIVs. All that liquidity flowed right into mortgages, and thus into houses.
Now, you could argue that 1% Fed Funds helped to create demand for structured finance. Sure. There is plenty of inter-related issues here. But in my opinion, without CDOs, the Fed’s interest rate policies wouldn’t have caused the housing bubble we’re seeing now. I’d also argue that low volatility, not low interest rates, were the primary reason why structured finance flourished. The Fed can’t really be blamed for creating a low volatility environment, after all, that’s their job.
If readers have other potential suspects, go ahead and post a comment.