One of the first narratives to emerge in the wake of the financial crisis was that the collapse of the global financial system centered around mortgage securitization. Banks handed out mortgages to homeowners and then sold those mortgages to large financial institutions like Fannie Mae and Freddie Mac, who then pooled these mortgages into "mortgage backed securities" (MBS), and sold them to investors. But the with the loans completely off the banks' books, those institutions didn't care whether the loans were any good. If there was a default, it wasn't any skin off their back. Their business was originating mortgages and collecting fees from subsequent sales.
Lets pause first to explain why securitizers like Fannie Mae and Freddie Mac wanted to purchase these loans and what the appeal of MBS was and is to investors. A single mortgage is a fairly risky investment. It's difficult to know whether a person will be able to make regular interest and principle payments. Even if a local bank diversifies this risk by issuing many mortgages in the local community, that bank is still betting that the local economy will hold up. The factory in town closing could cause a large number of the mortgages to go bust. However, if a national organization can buy up mortgages from all across the country, and then chop those mortgages up into bits and paste them together, so that one security represents cash flows from many mortgages, then geographical risk is neutralized. With this new mortgage backed security, the number of investors willing to back home loans increases greatly. This lowers borrowing costs from consumers.
However, even these mortgage backed securities have unique types of risks that other investments like a corporate bond don't have. For instance, when corporations borrow money by issuing bonds, there are often restrictions on paying back that money. This is so an investor can have some amount of certainty as to the returns from an investment. If an investor lends money by buying a 20 year bond, they want to be able to expect interest payments from 20 years and to get back the principle at the end. If the borrower pays back the money early because interest rates have fallen, now the investor didn't get the return or yield they expected to get, and they also have to reinvest their money at a lower interest rate. This uncertainty isn't acceptable for investors who have certain liabilities they have to meet on a regular basis (think pension funds). But as we all know, when you take out a mortgage, you have a great degree of flexibility as to when you can pay it back. If you move, or interest rates drop, you can pay back your mortgage. To help create more certainty for investors in mortgages, securitizers will create what is called "collateralized debt obligations," which is basically a further chopping up of these mortgage backed securities so that the cash received from these investments pays out more certainly. For instance, one "tranche," or portion, of this CDO, will receive all of the principle payments (any unexpected prepayments) before the second tranche, and so on.
These processes are very complex and to the average reader of news post-crisis, they seemed unnecessarily complicated. It's logical to the average man on the street that if a bank doesn't suffer if a mortgage they issue fails, then they have no incentive to vet those mortgages properly. One of the more memorable journalistic explanations of this phenomenon was an NPR production called The Giant Pool of Money. And there was academic research that backed up the claims of reports like this. A 2008 paper called "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans" by Benjamin Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig, argued that this processes explained above led to less vigilance on the part of issuers. But it seems that the academic debate on this subject isn't quite settled. (Are the academic debates ever settled?) In a new post on the Harvard Law Blog, Ryan Bubb, Assistant Professor of Law at NYU and Alex Kaufman, economist at the Board of Governors at the Federal Reserve, take aim at the narrative of securitization causing the crisis.
I'm certainly not qualified to arbitrate this discussion, but I do think its important that journalists and other observers of the regulatory system stay abreast. Its very easy to fall under the sway of a convincing narrative and then to stop considering its validity. I am convinced, however, that journalists did a poor job of explaining the benefits of securitization. Many chalked it up as simply a fee manufacturing machine for big financial institutions. No doubt, Wall Street made truckloads of money of this process, but its important to understand why sophisticated investors wanted these securities and how it helped them manage their liabilities. Only then can we properly critique the system and aid in the process creating a good regulatory structure.
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