This bubble, which lasted from 1997 to 2007, also created a substantial private market for mortgage-backed securities based on pools of subprime loans. This is because, as housing bubbles grow, rising prices suppress delinquencies and defaults. People who could not meet their mortgage obligations could refinance or sell because their houses were now worth more. Thus, by the mid-2000s, investors had begun to notice that securities based on subprime mortgages were producing high yields — because of their inherent risk — but not showing the large number of defaults that are usually associated with subprime loans. This triggered strong investor demand for these securities, causing the growth of the first significant private market for MBS based on subprime and other risky mortgages.
By 2008, this market — largely made up of MBS securitized by Wall Street firms — consisted of about 7.8 million subprime and other risky loans, about 26 percent of the 28 million that were then outstanding. Although the private financial sector must certainly share some blame for the financial crisis, it cannot fairly be accused of causing the crisis when only a small minority of subprime and other risky mortgages outstanding in 2008 were the result of that private activity.
When the bubble deflated in 2007, an unprecedented number of weak mortgages went into default — those that were held or guaranteed by Fannie and Freddie, and those that had been securitized by Wall Street. This drove down housing prices and threw Fannie and Freddie into insolvency.
Seeing these sudden and unprecedented losses, investors fled from the market for privately issued MBS. Then, mark-to-market accounting required banks and others to write down the value of their mortgage-backed assets to the distress levels that occur in a market without buyers. In addition, firms that had held triple-A-rated MBS, which they used for liquidity purposes, found that these securities could no longer be pledged in repo transactions, seriously reducing their liquidity. This raised questions about the solvency and liquidity of the largest financial institutions.
The government’s rescue of Bear Stearns in March 2008 temporarily calmed the market. But it created significant moral hazard: Market participants were led to believe that the government would rescue all large financial institutions. However, when Lehman Brothers was allowed to fail in September, investors panicked.
They withdrew their funds from the institutions that held large amounts of privately issued mortgage-backed securities, causing banks and others — such as investment banks, finance companies and insurers — to hoard cash against the risk of further withdrawals. The refusal of financial institutions to lend to one another in these conditions froze credit markets, bringing on what we now call the financial crisis.
What happened here is not unprecedented. The weakening of large numbers of financial institutions because of a sudden decline in a widely held asset — in this case mortgage-backed securities based on subprime mortgages — is known to scholars as a “common shock.”
The Dodd-Frank Act is based on the idea that there are “interconnections” among financial institutions, but there is no evidence of this.
None of the large financial institutions that had to be rescued in the financial crisis — Citigroup, AIG, Wachovia, Washington Mutual, Merrill Lynch and Bear Stearns — were weakened by exposure to Lehman.