So on Thursday I published an article about why the Clinton-era budget surpluses helped fuel the credit boom that (ultimately) led to the crunch and the recession that followed. It's fair to say not everyone agreed. In fact, some people really didn't agree at all.

Here's Bloomberg columnist and CIO of Ritholtz Wealth Management Barry Ritholtz's take:

WRONG The Germans Are Making The Same Huge Mistake Bill Clinton Made http://t.co/DxnsJk6qWS via @bi_politics — Barry Ritholtz (@ritholtz) January 29, 2015

In the (good natured) discussion that followed, it emerged that Ritholtz and I have a fundamentally different take in our narratives of the crisis. We both agree that mortgage originators were not forced to provide loans to people with no credit history, nor were financial firms forced to package those loans up, have ratings agencies stamp the resulting securities with an 'A' rating and flog them to credulous institutions around the world.

However, he followed that up by saying "had the bad loans not been made, there never would have been a problem".

I couldn't disagree more. Indeed I think the most important lessons of the last few years is that the emergence of the subprime crisis was a symptom, not cause, of the global financial crisis.

To understand why, you first need to think about the role that housing plays in the economy. When a bank issues a mortgage it simultaneously creates an asset — the mortgage contract — and a liability — the capital that is then used to complete the transaction. In effect, it brings forward the future earnings of the buyer in order to provide a lump sum to the seller.

The buyer then takes possession of the house with the mortgage obligation, while the seller takes the capital and deposits it in the bank (for the sake of this example). The seller can then use that money to fund current purchases — for example, buying a TV or a car etc. In other words, the housing market can be viewed as the main transmission mechanism for bank-created money into the real economy (your and my pockets in other words).

How does this apply to the Clinton surpluses?

Well, the authors of the new paper that spurred my previous post claim that "following the Asian crisis in the late 1990s, a “glut” of global savings flowed towards US safe assets, finding its way into the mortgage market through the purchase of MBS [mortgage-backed securities]". This is based on the work done by former Federal Reserve chair Ben Bernanke in his seminal 2011 paper on the savings glut, in which he asserts that "international capital flows likely played a significant role in helping to finance the housing bubble and thus set the stage for its subsequent bust".

The theory, in essence, is that following the shock of the Asian crisis, emerging markets started to channel their savings into the US. In particular this money flowed into perceived "safe assets" such as US Treasury securities (Treasuries) and Agency debt (Agencies). This capital inflow showed up as a substantial US current account deficit which increased from $120.2 billion in 1996 to $530.7 billion by 2003.

Simultaneously, the US government of the day under President Bill Clinton elected to begin running budget surpluses. This had the effect of reducing the stock of US government-issued "safe assets" as the state began to pay down its debt. This created an incentive — though not the obligation — for the private sector to meet this demand for "safe assets" by creating some of its own. Thus we come back to mortgage securities.

The authors' of the latest paper write that "the boom in securitisation contributed to channel into mortgages a large pool of savings that had previously been directed towards other safe assets, such as government bonds". As Frances Coppola points out, this misstates what was actually going on. The inflow of capital was not "channelled" into the US mortgage market but, rather, it created the secondary market that gave banks a reason to continue extending mortgage loans into the system.

And here's where the story gets really interesting. The more credit the banks provided through the mortgage market, the more money consumers had available to pay for goods and services (including, for example, clothes and toys produced in China). This spending then fed the current account surpluses in emerging markets, which flooded back into the US in search of safe assets that would provide a steady stream of income.

So the credit market created what looked like a self-fulfilling cycle where banks issued mortgages, that money was spent on goods and services in the US, which provided the cash for emerging economies to buy the mortgage-backed securities that were then created. Glad that's clear.

And this is what happened — real home prices increasing by roughly 40% to 70% between 2000 and 2006:





Critically, this system concentrated risk in the US housing market but because demand for the resulting securities was so high nobody foresaw any problems. But there was a big problem. There is a limit to the amount of future earnings that can be brought forward because people actually have to be able to pay off the debt that they take on.

This poses two related risks — first, once you have a society where as many people who can afford to are already indebted you run out of your source of new assets to sell and; second, if people's expected income in the future fails to materialise then they may fail to be able to service their debt which could wipe out the value of their mortgages.

The key point that Ritholtz misses is that these risks exist even with non-subprime mortgage lending.

So what happened?

Here we have to hypothesise a little. But the majority of subprime mortgages were issued well after the housing market boom was underway at a time when, as the paper puts it, the Great Moderation had led "financial intermediaries to an (ex-post) overoptimistic assessment of the risks faced by their portfolios".

One theory is that when mortgage originators started running out of high-quality borrowers to lend to, they went in search of a new market — subprime. There was nothing necessary about this, it was greed pure and simple. But the fact that the subprime market became an ever larger share of total lending towards the end of the housing boom suggests that the lack of high-quality borrowers was a genuine constraint.

The foolish decision to chase the last pennies of the boom, however, was ultimately to prove the trigger for the collapse. In that way it was a sufficient cause of the crash. But there have been plenty of house price crashes before, not all of which can be simply attributed to the quality of the borrowers at the time the lending took place.

My contention is that the scale of the housing boom had already increased the system's vulnerabilities, and had been exacerbated by the Clinton administration's decision to run budget surplus. In the end as borrowers were maxing themselves out, a hit to future incomes was almost inevitable and with it a correction in the housing market.

And due to the packaging up and re-sale of those mortgage assets to "safe asset" seekers across the world the crash was almost guaranteed to send ripples through global financial markets.