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Bad and Good Securitization

Working paper #671
Susan M. Wachter

This article describes the causes of the boom and bust in the U.S. housing market that brought down not just the U.S. financial system but the global economy. How did this vicious cycle begin? How did home prices appreciate so far and so fast? Why did rational investors not recognize and stop mispricing and investing in these loans on Wall Street? The author finds that at the root of the subprime problem was a new class of specialized mortgage lenders and securitizers unrestricted by regulations governing traditional lending and securitization. Aggressive lenders piled in by offering loans with low upfront costs, attracting first-time homebuyers previously unable to afford houses, repeat buyers buying pricier homes and second homes, and speculators. These practices drove prices particularly high in Arizona, California, Florida, and Nevada, which had significant land-use regulations and environmental controls that reduced supply elasticity, leading increases in demand to trigger mostly higher prices instead of a greater supply of housing.

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