Recipe for the Panic of 2007
From the introduction of the NBER working paper "The Subprime Panic," by Yale School of Management Professor Gary B. Gorton:
Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers in the U.S. Such borrowers are indeed riskier (also poor and disproportionately minority), and lending to this group involved a particular mortgage design feature, that resulted in linking the outcome to house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique design, reflecting the subprime mortgage design. Subprime securitization tranches were then often sold into CDOs. Tranches of CDOs were, in turn, often purchased by market value off-balance sheet vehicles, and money market mutual funds. Additional subprime risk was created (though not on net) with derivatives.
This nexus of off-balance sheet vehicles, derivatives, securitization, and, in addition, the growth of the repo (repurchase agreement) market constitute what has come to be known as the "shadow banking system." When the U.S. housing prices did not rise as expected, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors or counterparties in the financial system to determine the location and size of the risks. Faced with this lack of information, financial intermediaries refused to deal with each other and began to hoard cash. The panic of 2007 began.
The ingredients of the Panic of 2007 seem to be (data for charts come from the NBER paper):
1. Increase the subprime share of total mortgage originations from 8% to 20% within just a few short years:
2. Increase the percent of subprime mortgages that are securitized, from 50% to 80% within just a few short years:
3. Ingredients #1 and #2 would have been OK, except that house prices started to fall, and the Panic of 2007 started as the subprime mortgage market collapsed: