Home Mortgages Were Financed by Short-Term Credit, Even Overnight Funding, Made Famous by Lehman Brothers

The financial crisis began with the Panic of 2007, and continued into 2008 with multiple crisis events involving, among others, mortgage giants Fannie Mae and Freddie Mac; failed investment banks like Bear Stearns (bailed out) and Lehman Brothers (not bailed out); and many financial firms whose solvency was in doubt at some point (e.g., Citigroup and Morgan Stanley). The Panic involved a great housing boom financed by innovative financial instruments. After the housing boom ended there was a crisis in housing finance involving actual or perceived insolvency of firms at the center of housing finance.

The crisis occurred in the midst of a period known as the Great Moderation. It was a period in which the growth rates of monetary aggregates moderated. Macroeconomic flow variables, like real GDP,  became less volatile. But it was also a period of a great expansion in the velocity of the M1 monetary aggregate.

The increase in velocity, or decrease in money demand, accompanied the rise of “shadow banking,” in which housing loans (and other bank lending) were securitized. Long-term debt, like home mortgages, was increasingly financed by short-term credit, even overnight funding as was so famously the case with Lehman Brothers. A credit pyramid was erected upon a narrow base of bank money. The possession of Treasury securities or other eligible collateral financed transactions in repo (overnight repurchase agreements) markets. Gorton succinctly described the process.

Another important feature of repo is that the collateral can be rehypothecated. In other words, the collateral received by the depositor can be used — “spent” — in another transaction, i.e., it can be used to collateralize a transaction with another party. Intuitively, rehypothecation is tantamount to conducting transactions with the collateral received against the deposit. There is no data on the extent of rehypothecation. (Gorton, 2010, p. 44)

—Gerald P. O'Driscoll Jr. and Mario J. Rizzo, introduction 2014 to Austrian Economics Re-Examined: The Economics of Time and Ignorance, Routledge Foundations of the Market Economy 33 (London: Routledge, Taylor and Francis, 2015), 4-5.