Securitization markets developed where loans could be funded through the market by investors. In addition, money market mutual funds, securities lenders, institutional investors and businesses needed a safe way to deposit funds where they would earn interest but retain ready access to their funds. Repurchase agreements or “repos” developed to serve this need. A repo is a short-term collateralized loan that shares many characteristics with a demand deposit except that repos are not guaranteed. At the same time, large firms increasingly raised funds by issuing commercial paper in the market rather than relying on bank loans – with the money market mutual funds being large investors in this paper. Large banks, as well, came to rely at the margin on non-deposit funding through the interbank funding market. The Fed acted as the lender of last resort for this market. This system of market-based credit intermediation has been called the “shadow banking system”. The shadow banking system grew at a very fast rate over the past several decades. Chart 1 shows that by 1990, mortgage originations in the shadow banking system equaled originations in the banking system, and grew to more than double the level in the banking system by 2008. Chart 2 highlights the growth in securitization across many different asset categories besides residential mortgages, such as commercial real estate loans, auto loans, credit card loans and student loans.
The vast majority of subprime loans were financed by investors through placing the loans into securities that were sold onto the market. Most of the securities derived from these subprime mortgages were deemed to be AAA rated by the rating agencies. The subprime mortgage securities differed in an important way from those based on prime conforming mortgages. For prime conforming mortgage-backed securities, the degree of credit protection for the AAA investors is fixed in advance. In contrast, for subprime mortgage-backed securities, the degree of credit protection for AAA investors started out “thin” and built up over the initial couple of years so long as mortgages did not default early in their life. 9 At the peak of the housing boom, not only was leverage high for the individual subprime borrower, but leverage was high for the investors in lower rated subprime mortgage securities. 10 This dynamic buildup of credit protection worked well so long as house prices kept increasing, but proved to be disastrous for investors in AAA subprime securities when house prices began to decline. The AAA rated subprime securities were then used as collateral against repurchase agreements. Given how safe the assets were thought to be, very small haircuts were required for these loans. In addition, the composition of repo loan terms shifted toward  8  Andrew Haughwout, Richard Peach and Joseph Tracy. 2008. “Juvenile Delinquent Mortgages: Bad Credit or Bad Economy?” Journal of Urban Economics 64 (September): 246–257. 9  Gary Gorton. “The Panic of 2007”.