Does Government-Sponsored Mortgage Securitization Mitigate or Aggravate Financial Crises?

This paper analyzes a model of the mortgage market, allowing for scenarios with and without government-sponsored mortgage securitization. Conventional wisdom says that securitization, by fostering diversification and creating a “safe” asset in the form of a mortgage-backed security (MBS), will reduce risk and enhance liquidity, thereby abating financial crises. Our contribution is to examine this claim by imbedding the mortgage market with a sequential strategic game played between the securitizer and banks. In this setting, adverse selection arises from the securitizer’s first-mover advantage rather than from informational asymmetries. In the model, the securitizer chooses the MBS contract terms, including the guaranteed rate and the criterion that qualifies a mortgage for securitization. Banks respond by selecting which qualifying mortgages to exchange for the MBS. Our analysis yields a central result: within this framework, government-sponsored securitization is, somewhat counterintuitively, more likely to exacerbate the severity and frequency of financial crises. This outcome arises in particular when mortgage demand is sufficiently low that originators optimally choose not to retain any higher-risk mortgages on their balance sheets.