The two main factors that led to the housing bubble were:
1. Cheap credit: Large capital inflows from abroad plus the Fed’s lax interest rate policy lead to a low interest rate environment in the United States, making mortgages less expensive for borrowers.
2. Decline in lending standards: The originate-to-distribute model allowed banks to offload risk to investors, which led to falling lending standards because banks had less incentive to exercise care when approving and monitoring loans.
The related liquidity squeeze and the mortgage crisis was caused by two major banking industry trends:
The originate-to-distribute model and asset-liability maturity mismatches.
The originate-to-distribute model refers to the process through which banks create securities based on an underlying pool of mortgages, bonds, or other loans and then sell the securities to investors. By originating and selling the securitized assets, the banks transfer the default risk of borrowers to the investors.
Banks, via structured investment vehicles (SIVs), used commercial paper and repurchase agreements (repos) to roll over short-term financing for investing in long-term assets. The banks’ mismatches in asset-liability maturities exposed the banks to funding liquidity risk.
The financial crisis that stemmed from rising mortgage delinquencies and falling housing prices led to a worldwide liquidity crisis because institutions had
(1) taken on too much leverage,
(2) generated large maturity mismatches between assets and liabilities, and
(3) become too interconnected.
Funding Liquidity and Market Liquidity
Funding liquidity refers to the ability of an institution to settle its obligations when they are due.
- Margin/haircut funding risk: A risk that arises when a decline in the collateral value of an asset results in an increase in margin requirement, requiring additional equity capital.
- Rollover risk: The risk that investors may not be able to roll over short-term debt to finance the purchase of an asset. The breakdown of short-term commercial paper and repo markets for financing long-term investments was a trigger that transformed the mortgage crisis into a global financial crisis. Short-term debt markets dried up, and SIVs and hedge funds, heavily invested in MBSs and other asset-backed securities, were unable to continue to use these securities as collateral for rolling over debt.
- Redemption risk: The risk that depositors will withdraw funds from banks, or that investors will redeem their shares (e.g., from mutual funds). A decline in a source of funding has the same effect as an increase in margin requirements.
Market liquidity refers to the ease with which an asset can be sold without having to lower the price to attract a buyer.
- Bid-ask spread can be thought of as the loss that would be sustained by a trader who sells an asset and then immediately buys it back. The higher the spread, the lower the market liquidity, and vice versa.
- Market depth refers to the number of units of an asset a trader can buy or sell at the current market quote (bid and ask prices). The greater the market depth, the higher the market liquidity.
- Market resiliency describes the length of time it will take an asset to regain its price after the price has fallen temporarily.
Loss Spiral and Margin Spiral
Loss spiral refers to the forced sale of an asset by a leveraged investor to maintain margin or leverage ratio requirements. A margin spiral refers to the forced sale of an asset as a result of an increase in margins or, equivalently speaking, a decline in the leverage ratio.
Network Risk
Network risk arises as a result of an increase in counterparty credit risk, which forces contracting parties to seek additional protection and liquidity enhancement. In the absence of a clearinghouse that could facilitate multilateral netting arrangements, an increase in counterparty credit risk can produce systemic effects, as evidenced by the recent global financial crisis.
