Mortgage Securitization – explained and how it factored in the financial crisis


Thanks to Ezra Klein’s blog on washingtonpost.com for the link – the paper is a great read (once you get past the economics) to understand exactly the mortgage back securites (MBS) market fell apart – essentially it was due to (1) bad assumptions of defalut rates, (2) poor ratings of each MBS pool by the rating agencies, and (3) the differences between the single-name bond market and the MBS market, part of which is an amplification of risk when you create an MBS from another MBS.

I’d point to another factor – the unprecedented increase in real estate property values in the last twenty years (see The Economist’s survey of real estate prices from their May 29, 2003 edition). As this real estate bubble started to deflate, it significantly increased default probabilities, especially in the subprime market where most mortgages were for 100% (or more) of the contract purchase price.

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The short version is that speculation got too far ahead of actual value, and finally some promoters defaulted. The remaining question is whether or how public policy should be changed based on this experience. Seems to me that no one, from Obama to the low credit rating consumer is ready to concede that credit expansion isn’t economic growth.