Housing Bubble Déjà Vu

CAMBRIDGE – The 2008-2009 financial crisis exposed a serious weakness in the global financial system’s architecture: an overnight market for mortgage-backed securities that could not handle the implosion of a housing bubble. Some nine years later, that weakness has not been addressed adequately.

When the crisis erupted, companies and investors in the United States were lending their extra cash overnight to banks and other financial firms, which then had to repay the loans, plus interest, the following morning. Because bank deposit insurance covered only up to $100,000, those with millions to store often preferred the overnight market, using ultra-safe long-term US Treasury obligations as collateral.

But overnight lenders could command even higher interest rates if they took as collateral a less-safe mortgage pool, so many did just that. Soon, America’s red-hot housing market was operating as a multi-trillion dollar money market.

It soon became clear, however, that the asset pools underpinning these transactions were often unstable, because they comprised increasingly low-quality mortgages. By 2009, companies were in a panic. They balked at the idea of parking their cash overnight, with mortgage pools as collateral. This left the financial system, which had come to depend on that cash, frozen. Lending dried up, fear intensified, and the economy plunged into recession.