Before the consequences of the housing market's collapse are explained, it is important to clarify why a slump in housing had such a profound effect on the broader economy of the United States, and subsequently, the world economy. A process called securitization played a key role in creating critical linkages between the housing and financial sectors of the economy. Securitization is the practice of packaging different types of loans - mortgages in this case - into a variety of tradable securities. The major parties involved in this relatively new system were homeowners, lenders, investment banks, and outside investors.
First, an eager homeowner would take out a mortgage loan with his or her lending institution. In this new structure, the lender would no longer hold onto that particular mortgage loan for 15 to 30 years and wait for gradual repayment. Instead, the lender would package this mortgage with a number of other similar loans into a larger basket of mortgages known as a mortgage-backed security. A mortgage-backed security is a type of derivative. A derivative is any financial asset that is priced according to the price of another, underlying asset. In the case of the mortgage-backed security, those underlying assets were mortgages made out to homeowners across the U.S.
Mortgage-backed securities, along with other types of derivatives tied to assets like car loans, student loans, and credit card debt were sold to investment banks. These were sold at a slight premium so the original lender could secure a profit in the short-term. In turn, investment banks would securitize these derivatives into larger assets. Known as collateralized debt obligations, these new instruments were also a type of derivative, and were even larger and more diversified than mortgage-backed securities. As can probably be guessed, investment banks packaged and sold collateralized debt obligations - at a slight premium - to outside investors. These investors consisted of hedge funds, mutual funds, employee pension funds, and other banks.
This chart shows the securitization chain as the interactions between borrowers, lenders, investment banks, and outside investors. The italicized term represents what each party is selling (or paying in the case of homeowners).
Throughout the history of the housing market, the financial consequences of a mortgage loan stayed between the homeowner and their lending institution. By the dawn of the 21st century, however, a greater number of parties had interests in a homeowner's mortgage. In the years leading up to crisis, this securitization chain, of reselling loans as new derivatives onto other parties, became the dominant force in mortgage lending, and was an extremely profitable business model. In 2006, the value of U.S. mortgage-backed securities reached about $8.5 trillion, while U.S. collateralized debt obligations were valued at $2 trillion. Altogether, the approximate market value of these two derivative industries totaled almost the entire gross domestic product of the United States that year.
This bar graph compares the market value of the entire gross domestic product of the United States in 2006, with the market value of the two largest mortgage derivative industries in that same year.
Aside from the borrower, all parties involved in the securitization chain experienced healthy profits because they were able to sell each derivative at a slight premium, multiplied over a high volume of transactions each year. Profitable transactions were accomplished because of two main factors that most investors took for granted during the early 2000s: continually increasing home prices and low rates of mortgage delinquency. If either of these elements failed, any derivative tied to the affected mortgages would lose value.
A drop in home prices would degrade the value of these mortgage-backed securities, since the values of homes across the nation ultimately served as the collateral for these mortgage loans. An epidemic of mortgage delinquency would decrease the value of outstanding mortgage-backed securities. This would occur because fewer mortgage payments could be passed down to parties who held the securities. In fact, this was the worst aspect of securitization - that such a large and far reaching group of investors, from banks of all sizes, to government entities like Fannie Mae and Freddie Mac, to insurance companies like AIG, to foreign governments, to employee pension funds, to thousands of others investors all around the world, were now directly exposed to the health of the U.S. housing market. In economic terms, we can say that securitization increased the amount of systemic risk present in the global economy.
Unfortunately, beginning in 2006, this exact worst-case scenario occurred. Declining home prices and rising mortgage delinquency rates depleted the value of mortgage-backed securities and collateralized debt obligations. Consequently, all investors holding these instruments experienced tremendous losses.
In Lesson 3: "The Credit Crunch Unfolds", we see how the devastating combination of the subprime lending boom and securitization ultimately affected economic activity throughout the U.S. and the rest of the world, leading to the greatest economic downturn since the Great Depression -- Go to Lesson 3 now »