Website Thesis

The Great Recession was a result of the institutional framework of our financial system, which was continuously regulated through Government intervention in a fashion that made the process of creating and securitizing mortgages much easier. These created distortions in the way firms participating in the market place raised capital, securitized assets and engaged in risk. Fannie and Freddie were the facilitators of this securitization process and enabled the housing bubble to expand by providing a secondary market for banks to sell their mortgage portfolios.

The Economics of Securitization

Securitization is a tool used by financial engineers in order to overcome a major problem in a lot of markets, asymmetric information. Transactions where one party has more information about a specific product than the other party describes a situation of asymmetric information. A market where asymmetric information is prevalent can possibly cause markets to fail. In the case of home mortgages, bankers who originate the mortgage and have constant interactions with their customer become extremely informed about this particular customer. If a bank decides it wants to sell this mortgage in order to free up capital with the purpose of originating new mortgages, it essentially has a problem involving asymmetric information. At this point the original bank has critical information about each and every mortgage it owns and any prospective buyer is much less informed about the mortgages they might want to purchase. Because the buyer is weary of purchasing a "lemon", the buyer does not engage in as many transactions as he otherwise would which could be deemed a market failure.

Securitization is a tool used by financial institutions as a way to "solve" the information problem. Securitization distributes risk among a certain amount of aggregated debt instruments and then securities are sold based on the debt that was pooled. This is the act of morphing heterogeneous mortgages into homogenous securities. Essentially, investors are pooling risk with the sole purpose of trying to overcome the information problem. This is much like insurance pooling. The agencies used conforming standards and explicit insurance as a way to help solve the information problem in mortgages. By creating “standards”, the agencies want each prospective buyer to conform to certain criteria before they would purchase the mortgage. Since these agencies were Government Sponsored Enterprises, they had an implicit backing from the federal government; at least this was the frame of mind of most investors in the marketplace. The main problem with securitizing mortgages is the model that was used assumed "independent observations", which meant investors assumed if one mortgage failed than this would not have any effect on the other mortgages. (This will be discussed later)