The financial crisis in 2008 involved two financial innovations. These were the securitization of mortgages and other debts such as credit card debts and credit default swaps. Fannie Mae and Freddie Mac, two private corporations chartered by the federal government, purchased about one-half of the mortgages issued in the United States and “bundled” them into securities that could be sold to investors. In this way, Fannie Mae and Freddie Mac were able to raise money to buy more mortgages and became a major source of funds for banks and savings and loans to write still more mortgages. Credit default swaps (CDSs) are a type of insurance policy against the default of these mortgage securities and the securities becoming worthless. A buyer of a mortgage-backed security could purchase a credit default swap and feel assured that any risk of loss was covered. This arrangement had three major problems. First, the CDSs are not really insurance. They were created to avoid the regulation that exists in the insurance market – namely, that insurance policies must have adequate reserves to pay off the policies when necessary. Second, the bundled securities were supposed to minimize the risk of loss by taking a fairly large number of mortgages to back each one. Finally, everyone expected mortgage lenders to practice prudent lending practices, such as verifying a potential borrower’s income and credit rating before extending a mortgage. The existence of mortgage-backed securities and the existence of CDSs made buyers of these securities less diligent in verifying the risk of the mortgages in the security going bad. The sellers of the securities likewise believed that securitization combined with CDSs spread out the risk so that no single security would lose much value because it was unlikely that all the mortgagees would default. The same situation existed with the sellers of CDSs.

Because risk seemed to be contained, mortgage originators began applying looser standards for borrowers. The more loans that they originated, the higher were the originators’ profits. Because they did not keep the mortgages to maturity, a default was someone else’s problem, which in any case could be covered by CDSs. The riskiness of subprime mortgages increased. Predictably, many more of these subprime mortgage borrowers began to default, and the supply of homes for sale in the housing market began to increase, and home prices fell. This resulted in many subprime borrowers finding that they owed more than the market value of their homes, so they just walked away from the homes, making the problem worse.

How did moral hazard cause the problem to become a serious problem that could undermine the financial system?