US housing market overheating would decimate US financial stability

This is bad news. After all, the housing market overheats every decade or two. If the system is stable enough, it can cool off without catastrophe. Now, however, the trillion-dollar overnight repo market in housing mortgages is so large that, when the housing market retreats, financial stability could be threatened. Existing reforms do not adequately mitigate this risk, largely because they depend on the authorities and the banks to complete a complex and untested repayment process within 48 hours of a bank’s collapse. This would be extremely difficult to achieve if multiple banks failed simultaneously. In the face of a housing crisis, it is plausible that lenders would again panic, deciding that they cannot depend on untested processes to stabilize the banks and withdrawing their overnight loans. Banks, stripped of cash, would then cut lending, as they did in 2008 and 2009, plunging into a recession yet again. The grim irony here is that, prior to such a shock, preparing for restructuring encourages lenders to provide more overnight loans. This expands the overnight market, makes mortgage lending easier, and increases the costs of collapse. This is not mere speculation. Most observers of the mortgage market believe that its growth accelerated in 2005, after Congress exempted mortgage bonds from most bankruptcy procedures – a move that would eliminate waiting time for repayment. That change convinced mortgage lenders that their activities were ultra-safe: they no longer even had to worry about the quality of the borrower. When crisis struck, that confidence quickly faded, and investors fled.