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Briefly explain mortgage securitization and how it contributed to the economic crisis.

Homeowners wanted better homes than they could afford. Mortgage brokers encouraged homeowners to take mortgages that would reset payments that the borrowers might not pay because the brokers got a commission for closing the deal. Appraisers thought the real estate boom would continue and over-appraised house values, getting paid at the appraisal time. Originating institutions (like Countrywide) quickly sold the mortgages to investment banks and other institutions. Investment banks created CDOs and got rating agencies to help design and then rate the new CDOs, with rating agencies making big profits despite conflicts of interest. Financial engineers used unrealistic inputs to generate high values for the CDOs. Investment banks sold the CDOs to investors and made significant profits. Investors bought the CDOs but either did not understand or care about the risk. Some investors bought insurance via credit default swaps.

Whenever mortgages are reset and borrowers defaulted, the values of CDOs plummet. Many of the credit default swaps failed to provide insurance because the counterparty failed. Many originators and securitizers still owned subprime securities, which led to many bankruptcies, government takeovers, and fire sales, including New Century, Countrywide, IndyMac, Northern Rock, Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and Merrill Lynch.

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