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

The result of all these financial innovations, Jones explains, is a company like Carlyle Capital, a $21.7 billion fund with less than $1 billion in capital invested entirely in Fannie Mae and Freddie Mac triple-A securities. Carlyle Capital collapsed March 12. The same kind of highly leveraged involvement with mortgage securities and derivates brought down Bear Stearns a few days after the collapse of Carlyle Capital, leading the Fed over the weekend of March 15 and March 16 to engineer the acquisition of Bear Stearns at a deep discount by JPMorgan Chase, a firm with much lower leverage.

The underlying problem for the markets is that the innovations in structures and investment products had never been stress-tested, according to Jones. It was next to impossible to mark the investments to market when so few were trading after the global meltdown in the summer of 2007 and many firms at first marked them to model. The model, unfortunately, is built on an average of historic delinquency and default rates, Jones says.

"With models built on quicksand, and investors hungry for higher bond yields and no effective limits on leverage, there was nothing to hold back the formation of a very big bubble," he concludes.

The originate-to-distribute business model

Fed Chairman Bernanke addressed the question of the "origins of the current turmoil"--as he gently put it--in a May 15 address at the Chicago Fed's annual conference on bank structure and competition. While many factors played a role, Bernanke noted, he identified as the chief culprit the "problematical implementation [of] the originate-to-distribute model" of mortgage finance.

The Fed chairman noted that the originate-to-distribute model "in principle, and indeed often in practice," is a good thing. It "spreads risk and reduces financing costs, offering greater access to capital to a wide range of borrowers while allowing investors greater flexibility in choosing and managing credit exposures," he said. Yet, increasingly, the model, as practiced, fell short--"resulting ultimately in a broad retreat from this method of credit extension last summer," Bernanke said.

That was putting it mildly. In fact, as everyone in the mortgage business knows, the private-label mortgage-backed securities market collapsed with virtually no new issues of private-label residential mortgage-backed securities (RMBS) since Aug. 9, 2007.

The "problematical implementation" Bernanke described in his address at the Chicago Fed targeted the incentives by originators to ease underwriting in order to keep up volume. Revenues, he said, "were often tied to loan volume rather than to the quality of the underlying credit." This, in turn, "induced some originators to focus on quantity rather than the quality of the loans being passed up the chain."

When house prices stopped rising and began to fall, it exposed this underlying weakness. Bernanke, it seems, was just stating the obvious, although it is undeniably a good thing that he--and presumably the Fed--understand this underlying weakness. At the same time, however, it is interesting to note that Bernanke did not acknowledge the chorus of critics pointing to Fed monetary policy as a leading cause of the housing credit bubble.