Abstract
In the last chapter I explained why the decisions made during the housing boom can be understood as ecologically rational. In this chapter, I shall attempt to explain in detail how those ecologically rational decisions generated an unsustainable boom. To quote Adam Ferguson, the housing boom was “the result of human action, but not the execution of any human design.”3
Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments.
—Ben Bernanke1
Securitization was meant to disperse credit risk to those who were better able to bear it. In practice, securitization appears to have concentrated the risks in the financial intermediary sector itself.
—Hyun Song Shin2
We sit in the mud … and reach for the stars.
—Ivan Turgenev
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Notes
For a general theory of the concurrence of asset price booms driven by a low cost of capital, see Ricardo J. Caballero, Emmanuel Farhi, and Mohamad L Hammour, “Speculative Growth: Hints from the US Economy,” American Economic Review, Vol. 96, Number 4 (2006): 1159–1192. The authors cite instances where capital costs are lowered by an increase in the supply of credit, due to capital flow bonanzas or procyclical fiscal surpluses, or to a reduction in the demand for credit resultant from improvements in the productivity of capital, and those same forces drive up asset prices. In my review of monetary policy during the housing boom in chapter 8, I shall reflect one theme from this paper; that it is not always a good idea to prick an asset price bubble, even one that might crash later on.
There were assets called collateralized debt obligations (CDO), which were comprised of investments in various subprime ABS. CDO were themselves leveraged, so they magnified the leverage of the underlying ABS. By order of magnitude, there were around $1.8 trillion of subprime ABS and $640 CDO issued during the US housing boom. CDO filled a similar, but riskier, investment niche as ABS. In the text, for notational convenience, I refer to both assets as ABS, unless there is a reason to distinguish between them. For data on ABS issuance, see Viral V. Acharya, Phillipp Schnable, and Gustavo Suarez, “Securitization without Risk Transfer,” Journal of Financial Economics, Vol. 107 (2013): 515–536. For data on CDO issuance, see Cordell et al., “Collateral Damage: Sizing and Assessing the Subprime CDO Crisis.”
While there is no conclusive evidence showing the disposition of spending out of home equity proceeds, one survey supports the assertion in the text. See Glenn Canner, Karen Dynan, and Wayne Passmore, “Mortgage Refinancing in 2001 and Early 2002,” Federal Reserve Bulletin 88, no. 12, 2002, pp. 469–481.
Christpher D. Carroll, Misuzu Otsuka, and Jirka Slacalek, “How Large Is the Housing Wealth Effect? A New Approach,” National Bureau of Economic Research Working Paper No. 12746, 2006.
See Jian Hu, “Assessing the Credit Risk of CDO’s Backed by Structured Finance Securities: Rating Analysts’ Challenges and Solutions,” Journal of structured Finance (Fall 2007): 43–59.
Ben S. Bernanke, “The Subprime Mortgage Market,” Speech at the Federal Reserve Bank of Chicago, May 17, 2007; emphasis added.
George R. Carter, III, “Housing Units With Negative Equity, 1997 to 2009,” Cityscape: A Journal of Policy Development and Research, Vol. 14, Number 1 (2015); and Core Logic Q3 2009 Media Alert, available at http://www.recharts.com/reports/FACLNERQ32009/FACLNERQ32009.pdf.
John Geanakoplos, “Leverage, Default, and Forgiveness: Lessons from the American and European Crises,” Journal of Macroeconomics, Vol. 39 (2014): 313–333, 319.
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© 2016 Daniel Aronoff
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Aronoff, D. (2016). The Capital Flow Bonanza and the Housing Boom. In: The Financial Crisis Reconsidered. Palgrave Macmillan, New York. https://doi.org/10.1007/978-1-137-54789-7_7
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