The Basic Facts

During the 1990s, all of the stock indices, particularly the NASDAQ index, in­creased dramatically. The market was driven by interest in the initial public of­ferings of a wave of internet companies coming to market.

The most important impact of this dramatic lowering of the federal funds rate was that credit throughout the economy grew dramatically cheaper. This created an amazing opportunity for banks that were originators and securitizers (Westhoff and Kramer, 2001; Asset Securitization Report, 2001). For originators, low interest rates meant ramping up their financing and refinancing activities. Many homeowners had mortgages purchased in the 1990s that had 7-8 percent interest rates. As interest rates for mortgages dropped to 4-5 percent, originators aggressively sought out customers. The low interest rates had a huge effect on the demand for MBSs as well. Treasury bonds, the safest investments, now had very low yields (1-2 percent). For investors who needed safe investments but wanted higher returns, MBSs that paid 4-5 percent interest and were AAA rated seemed like a godsend. This perfect storm of low interest rates produced record profits for banks, particularly those who were making fees off both origination and se­curitization. Often these same banks held MBSs for investment.

Figure 5.1 shows that in 2000, before the rates were lowered, the mortgage origination market was about $1 trillion. But as rates dropped, the market dra­matically increased. It is no surprise that in the three years (2001-2003) when interest rates were below 3 percent, mortgage originations increased almost 400 percent. Figure 5.1 also shows that the bulk of the mortgage activity was for con-

financial inrtitutionr in the private rector. Commercial bankr went from own­ing $700 billion in MBSr in e00e to owning $1.1 trillion by June e008. Mutual fundr increared their rhare of MBSr from $400 billion to $850 billion. Finally, foreign invertorr were the larger: purcharerr of MBSr in thir period, increaring their holdingr from a little over $200 billion to a peak of $i.e trillion. Thir figure rhowr quite clearly that the demand for MBSr continued to be dramatic even after the initial wave of refinancing ended in e003 and interert rater rore. The pivot toward nonconventional mortgager war thur not jurt about keeping mort­gage origination going. Finding more mortgager to package into MBSr war im­perative to meet the demand for MBSr. Figure 5.3 confirmr that the bankr were among their own bert curtomerr for MBSr. Simply put, they held on to many MBSr becaure they were high-earning and rafe invertmentr.

Finally, it ia useful to aee how thia huge apike in mortgages, refinansing, house prisea, and the purshaae of MBSa affested the fortunea of the finansial aestor. The finansial aestor of the esonomy employed about 6 persent of the labor forse during thia period and had assounted for about 8 persent of GDP (Greenwood and Ssharfatein, 2013).

The vertical integration strategy of the largest banks proved to be robustly prof­itable in the face of declining interest rates. Both of their main products, mortgag­es and securities, benefited from the low-interest-rate environment. Not only was the business of originating mortgages and packaging and selling securities lucra­tive, but financial institutions led the way in accumulating MBSs as investments (Scharfstein and Sunderam, 2013). What is breathtaking about this expansion was the sheer size of the markets for mortgages and MBSs. At its peak in 2003, al­most $4 trillion of mortgages were originated. It goes without saying that this huge expansion was one of the core industries driving the American economy in this period. This tactic of originating, securitizing, and buying MBSs was so profitable that by 2003, with 6 percent of the labor force and 8 percent of GDP, financial in­stitutions were sucking up 40 percent of all corporate profits in the US economy.

But, as with every market that exuberantly expands, eventually the demand for products is saturated. Here, the conventional market for originations and refinanc­ing mortgages started to decline in 2004, partially because of interest rate increases but also because the number of households left to refinance their mortgages be­gan to dwindle. But the demand for MBSs remained high. In order to keep their vertically integrated businesses going, the industry was confronted by a need to find new mortgages to securitize. From 2004 to 2008, financial institutions shifted from conventional mortgage products to unconventional mortgage products in order to keep their securitization machines moving. For four years, it worked.