The origins of a housing credit bubble; Monday-morning quarterbacks are finding plenty to blame for the creation of a housing credit bubble that has dramatically brust. While there's a growing laundry list of causes, there appears to be emerging consensus on some primary drivers, such as monetary ploicy and the unchecked expansion of mortgage credit by non-banks. This two-part series examines the details

Mortgage Banking, Sept, 2008 by Robert Stowe England

Another potential cause of the global glut in savings is the Japanese yen carry trade, which Jones has studied. Japan, worried about deflation in the 1990s, had six years of zero-short-term-interest policy, he notes. "And now, long after that, we're only up half a percentage point on short-term Japanese interest rates," says Jones. "And to some degree, you can argue that even the Japanese carry trade helped keep global long-term yields lower than they otherwise would have been," he says.

"So, there were a whole number of things that did re-enforce Greenspan's conundrum argument and, thus, he said, there wasn't just a housing bubble in the U.S. There was a housing bubble in the U.K. And there's a housing bubble that's bursting right now in Spain, maybe even Ireland. So, to some degree, Greenspan had a point here. There was a global dimension to all this as well," Jones says.

Mortgage credit explosion

One can also get a clearer picture of the causes of the bubble by looking closer into growth in mortgage credit and which players led the extraordinary gains in credit expansion. Jones divides the expansion in housing credit into two categories: banks and non-banks. The smaller piece of the credit expansion goes to "the old-fashioned banking system credit expansion potential based on [money] reserves pumped in by the Fed," he says. "Every dollar of reserves pumped in [was] a potential $10 expansion in credit deposits."

This smaller modest circle within the bubble represents the bank expansion in mortgage credit, Jones explains. "However, there is a much larger circle of non-bank balance-sheet lending that represents the bulk of the bubble above and beyond that portion from bank expansion of mortgage credit," he says.

With securitization, Jones says, "you begin to detach the bank origination of a mortgage loan between a bank and borrower, making an illiquid asset liquid, in effect." The impact of this innovation "is really much more profound than a lot of people give [it] credit for," he says.

By moving loans off the bank balance sheet and trading mortgage-backed securities and derivatives in the market, it separates the "credit judgment on a borrower from the ultimate holder of the mortgage," Jones says. This separation can lead to a breakdown in credit quality, he explains. "So, I guess I would say the securitization process is really a second and critical feature of this housing credit bubble."

The non-bank credit bubble was further expanded by the existence of off-balance-sheet conduits like structured investment vehicles (SIVs) and investment vehicles such as collateralized debt obligations (CDOs), Jones says. "But this non-bank credit bubble was really the key factor, and a huge bubble that expanded," he says.

The innovations in financial structures such as the SIV and the innovations in investment instruments such as CDOs made it possible to expand credit far more from a given capital base than could be done under the banking system, Jones says. He points out that banks had a capital requirement under the Basel I bank regulation agreement, which mandates that banks have a minimum of 6 percent capital in support of risky loans. By pushing the mortgage loans and securities off the balance sheet, it allowed the creation of far more credit than a bank could have done otherwise, Jones contends.