RDP 2013-05: Liquidity Shocks and the US Housing Credit Crisis of 2007–2008 2. Institutional Background

Mortgage securitisation refers to the process of pooling mortgages into securities that are then sold to investors on a secondary market. The securities are backed by the cash flow generated by the borrowers' mortgage payments. Securitisation is essentially a process that allows a loan originator to transform cash flows from a pool of non-tradable assets into tradable debt instruments. In doing so, securitisation provides financial institutions with an additional method of financing mortgages – in this case, through the issuance of mortgage-backed bonds rather than unsecured bonds or deposits.

Securitised bonds backed by home mortgages are known as ‘residential mortgage-backed securities’ (RMBS). In the United States, the RMBS market can be divided into two sectors: agency and non-agency (or private-label) RMBS. The agency market includes mortgages securitised by government-sponsored enterprises (GSEs), such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). The GSEs have traditionally been private corporations with a public charter, operating with the implicit backing of the US Government. They have purchased residential mortgage loans on the secondary market from loan originators (e.g. banks) and then packaged these loans into securities, which they either sell to other investors or hold in their own portfolios. In this paper, I will sometimes refer to the loans securitised by the GSEs as ‘public securitisations’. In contrast, the non-agency market comprises mortgages securitised by private financial institutions, such as commercial and investment banks. I will refer to these securitised loans as ‘private securitisations’.

Loans that are securitised by the GSEs must meet certain eligibility criteria, based on factors such as loan size and other underwriting guidelines. Residential mortgages that are eligible to be purchased by the GSEs are known as ‘conforming mortgages’. Mortgages that are non-conforming because their size exceeds the purchasing limit are known as ‘jumbo’ mortgages. Mortgages that are non-conforming because they do not meet other underwriting guidelines, such as credit quality, are often called ‘subprime’ mortgages. The private securitisation market developed to facilitate the sale of mortgages that did not meet the GSEs' eligibility criteria.^[2]

According to US flow of funds data, around 65 per cent of residential mortgages had been securitised at the time of the crisis (Figure 3). The bulk of these loans were securitised by the GSEs. However, the most recent housing cycle in the United States caused significant changes in the composition of US securitised home mortgage debt. The share of mortgages that were privately securitised rose rapidly around 2004–2006, coinciding with the boom in the US housing market. The increase in the share of private securitisations is likely to reflect several factors, such as an increase in demand for non-conforming mortgages by borrowers, an increase in demand for non-conforming mortgage securities by private investors, and a relaxation of lending standards by mortgage originators (Nadauld and Sherlund 2009).

The share of private securitisations fell dramatically when the subprime mortgage market collapsed in the first half of 2007. The private securitisation market was effectively shut down by late 2007. In contrast, the public securitisation market continued to function due to implicit government backing and, eventually, explicit guarantees by the US Federal Reserve and US Treasury. This substitution away from private securitised lending to public securitised lending during the crisis suggests that the GSEs were able in part to step into the breach caused by the evaporation of the private-label market. This substitution could be important in identifying the effect of a liquidity shock on lending and will be discussed in a robustness test later.

Home mortgage lenders that are reliant on loan securitisation to fund the origination of new loans are often referred to as ‘originate-to-distribute’ (or OTD) lenders (Purnanandam 2011). The mortgage lenders that, instead, rely on other forms of funding, such as retail deposits, to originate loans are known as ‘originate-to-hold’ (or non-OTD) lenders. The non-OTD lenders retain, rather than sell, most of the loans on their balance sheets. This distinction between the two groups of lenders – the OTD and non-OTD lenders – is important in this study. I assume that the OTD lenders were more affected by the disruption to the securitisation market in 2007 than the non-OTD lenders. The distinction, therefore, provides a way to identify the effect of the liquidity shock stemming from the securitisation market. As the OTD lenders were highly dependent on securitisation to finance new lending, these lenders would have become relatively more liquidity constrained when investors withdrew funding from the secondary market.

Footnote

Historically, the conforming mortgage loan limit has been periodically adjusted in line with changes in average US home prices. Higher limits apply for mortgages secured by homes that are: (i) located in high-cost housing areas, (ii) multi-family dwellings, and (iii) located in Alaska, Hawaii, Guam and the US Virgin Islands. [2]