Explaining The U.S. Housing Bubble: Are CDOs To Blame?

Thomas Bernardin

Saint Olaf College

March 1, 2016

Abstract:

I argue that a credit supply shift, originating in the CDO market in 2004, was a significant causal factor in the unsustainability of the credit driven housing boom of the early 2000’s. This paper sheds light on when credit booms become bubbles and why. Not all credit driven asset price growth need be problematic, and not all unsustainable credit expansions need affect asset prices. My results suggest that the credit fueled housing price growth prior to 2004 may have been the result of sustainable innovations in meeting the needs of credit constrained borrowers. I argue that the CDO market was the critical link along the credit chain both in terms of its unsustainability as well as the causal role it played in effecting home price appreciation. The central implication for regulatory policy is that credit chains with appreciable assets as collateral are potentially greater sources of instability, and may need to be regulated differently than other types of credit chains.

Explaining The U.S. Housing Bubble: Are CDOs To Blame? – Introduction

What caused the credit supply shock which precipitated the bursting of the housing bubble and subsequent financial crisis of 2008 in U.S.? The answer is key to understanding the relationship between credit booms and asset prices. While it is now fairly well established that an exogenous credit supply shock played a significant role in the U.S. housing boom of the late 90s and earl 2000s. Less well understood is the nature of the credit boom and how and why it resulted in unsustainable asset price growth. This paper investigates the complex nature of the credit supply as it evolved prior to the bursting of the housing bubble.

Two types of securitizations were at the core of mortgage market credit expansion. Mortgages were first securitized in the asset backed securities (ABS) market. In this market, individual mortgages were pooled and securities of varying credit ratings were issued using those mortgages as collateral. Beginning in the early 2000s, in a process analogous to the original securitization, a significant number of these mortgage backed securities were “re-securitized” in the collateralized debt obligation (CDO) market. Losses in the CDO market bore the brunt of all housing related losses, and the uncertainty surrounding the CDO holdings of banks was perhaps the most significant precipitor of what ultimately beacme a run on the entire securitized banking system.

CDOs have received prominent attention in both popular and academic accounts of the crisis. Popular accounts emphasize both that CDOs were engines of expansion in the mortgage and housing markets, as well as inherently flawed securitization vehicles. (See for example: Angelides and Thomas (2011); Davies (2010); and Lo (2012) among others). Academic accounts on the other hand, emphasize almost exclusively the flawed nature of CDOs as risk repositories. For example: Coval, Jurek, and Stafford (2009) show that ratings agencies mispriced AAA rated tranches of individual CDOs relative to systemic risk; Benmelech and Dlugosz (2010) show that CDO ratings models were exploited by securitizers in order to package the riskiest possible collateral with the highest possible rating; Griffin and Tang (2011) show that ratings were often adjusted upwards of what the rating agencies’ own models suggested.

Despite these flaws, Haughwout, Peach, and Tracy (2008) argue that the majority of losses in securitized lending markets, were a function of declining home prices and not flaws in the underwriting process per se. Figure 1 depicts monthly U.S. housing prices, mortgage related ABS issuance, and CDO issuance from 1990 through 2012. Mortgage related ABS issuance grows robustly over the entire period of home price appreciation. On the other hand, the growth of the CDO market does not appear to accelerate until 2004. The figure also shows that housing prices have stabilized to approximately their 2004 levels, suggesting that the period of growth in housing markets prior to the emergence of the CDO market may have been sustainable.

My goal in this paper is to examine the relationship between the CDO boom and the unsustainable portion of the housing boom. If the CDO market effected an unsustainable rise in housing prices, the impact of the CDO market’s expansion on housing prices may have been a more significant contributor to CDO market losses than the mispricing of CDO risk. The question turns on the degree to which the CDO market expansion was housing demand led, or whether the CDO market itself was leading a credit supply shift. If the credit expansion were demand driven, this would suggest that CDOs inefficiently soaked up risk, and in this capacity provided fuel for the housing bubble fire. On the other hand, if the CDO market was the origin of a credit supply shift that caused housing prices to grow unsustainably, the role played by CDOs was more significant.

CDOs

In order to examine the direction of causality between the CDO and housing markets, I develop a stylized map of the securitization process which highlights the differences between mortgage and non-mortgage related credit chains, as well as ABS and CDO securitization vehicles. I then examine whether credit expansion was driven by the ABS or CDO markets. Finally, I consider whether the timing of credit supply shifts in these markets is consistent with a CDO led unsustainable rise in housing prices.

CDOs

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