The catastrophic collapse in our financial system was a morality play in three acts. It reminds us why the Bible begins with the story of Adam and Eve.
Act I: In order to buy a home, most American families require a mortgage. For years, mortgages were issued by a local bank and held until they were repaid. Then banks found investors wanted to buy mortgages because “securitization” and mortgage-based “derivatives” made them attractive financial products. Soon, banks were originating mortgages, not to hold, but to sell to others.
Wall Street investment bankers bought and resold the mortgages. Selling one mortgage at a time is inefficient, because each transfer requires paperwork. So the bankers collected a large number of mortgages in a basket and sold investors notes secured by that basket. Notes secured in this way had two advantages. First, the mortgages stayed in the basket held by a custodian, while the notes moved freely. Second, while some of the mortgages might default, it was unlikely that all would default, so the aggregate package was less risky than an individual mortgage. The notes were known as “mortgage-backed securities,” and the whole process was called “securitization.”
The fact that mortgage-backed securities were readily transferable was important because many institutional investors, such as retirement plans, can only invest...