The second concept we need to understand is securitization. The seller of a securitized asset gets up-front cash while the buyer gets the right to a stream of future payments. Sometimes mortgage loans are “securitized,” or bundled together and sold on the market as financial assets. Banks may wish to sell or “securitize” their loans for several reasons. On the positive side, the bank gets more liquid cash, makes its balance sheet safer, and the securitized assets can be held as investments by institutions with a long-term perspective, such as pension funds. It’s a way that a lot of institutions can invest indirectly in the American economy. Alternatively, the critics charge that too often banks securitize because they made bad, sloppy, or under-researched loans in the first place and they wish to dump them on unsuspecting suckers somewhere else.

Once assets are securitized, the revenue streams from them can be sliced and diced and sold in all manner of ways. Mortgage securitization in the 2000s meant that dentists in Germany could easily invest in home mortgages in America. The increased ability to sell mortgages around the world was good for American home buyers because it kept interest rates low and it seemed good for investors who thought they were buying safe and secure assets. What could be safer than American homes? In reality, many of these securitized mortgages turned out to have had much higher risk than had been advertised. In part, some of the securitized bundles were sold on false terms or where the risk was obscured, in part the credit rating agencies performed poorly, and in part people simply estimated risk incorrectly by assuming that house prices would continue rising more or less indefinitely.

When housing prices started to fall dramatically in 2007, many people began to default on their mortgages. Overall delinquency (failure of payment) and foreclosure rates more than doubled. In parts of California, Florida, and Nevada more than 40% of the homes entered foreclosure. Remember that many buyers had only a little equity in their homes so as house prices fell they quickly came to owe more on their mortgage than their house was worth and many chose to default. As a result, the U.S. economy suddenly ended up in a situation where many banks and other financial intermediaries were holding loans and assets of questionable value. Moreover, since the banks themselves were highly leveraged, as the value of their assets declined, many banks quickly approached insolvency.

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