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A Closer Look at Markets:
Securitization and Social Welfare
The modern system of financial markets is one of humankind’s greatest inventions.
It not only provides an efficient way to match those who need funds with those
who have extra funds, it allows investment risk to be parceled out to those who
desire that particular type of risk. An example from the home mortgage industry
illustrates these points.

The Financial Market for Home Mortgages

At one time, savings and loan associations (S&Ls) took in deposits from individuals
who lived in nearby neighborhoods. The S&L pooled these deposits and then lent
money to an aspiring homeowner in the form of a mortgage. The homeowner paid
principal and interest to the S&L, which then paid interest to its depositors. This
was clearly a better arrangement than individuals themselves lending money to
aspiring homeowners for two reasons. First, an individual lender might not have
had enough money to finance an entire house; the S&L solved this problem by
pooling money from many potential lenders to make large loans possible. Second,
the individual lender might not have been experienced in evaluating the risk of
the borrower; the S&L specialized in making loans and evaluating risk, and could,
presumably, set loan rates and contract provisions more effectively.
There were two problems with this system, however. First, the amount of
funds the S&L had available to make mortgage loans was limited by the amount
of deposits. In other words, the S&L could not lend out more than it raised in
deposits. Second, the depositors were able to withdraw their money at any time,
and if that money was tied up in a mortgage, the S&L had to raise money from
other depositors to replace it. To make matters worse, suppose the overall level of
interest increased. To keep its current depositors, the S&L would have had to raise
the rates it paid on deposits. However, the mortgages that were supposed to pro-
vide the income to pay the depositors had a fixed interest rate, so the S&Ls could
not have increased the interest they charged to the existing mortgage holders. It is
easy to see that if an S&L paid out more interest on the money it borrowed than it
earned on the money it lent, a financial disaster would be likely. This would put
the S&L in a liquidity crisis: It could not raise interest rates on its deposits enough
to keep depositors from trying to withdraw their money, it could not force the
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1A-2 Web Extension 1A A Closer Look at Markets: Securitization and Social Welfare

homeowners to pay back their mortgages early, and it therefore could not pay the
depositors their money. Since S&L deposits are federally insured, this would have
also put the federal government at risk, requiring it to make good on the S&L’s
deposits.
This exact situation occurred in the 1980s, when many S&Ls went bankrupt.1
The ensuing financial crisis had two results. First, the S&L depositors got their
money back, but only because U.S. taxpayers through the U.S. government ended up
paying hundreds of billions of dollars to bail out insolvent S&Ls. Second, it led to an
evolution of the financial markets, called securitization, to prevent this problem.

Securitization
In a securitization, a third party such as the Federal National Mortgage
Association (FNMA, commonly called “Fannie Mae”) raises money, usually
through a combination of issuing equity and selling bonds. The third party then
uses these funds to buy a pool of mortgages from the S&L. For example, suppose
the S&L is paying its depositors 5% but is charging its borrowers 8% on their mort-
gages. The S&L can take hundreds of these mortgages, put them in a pool, and
then sell the pool to Fannie Mae. The mortgagees can still make their payments to
the original S&L, which will then forward the payments (perhaps less a small han-
dling fee) to Fannie Mae.
Consider the S&L’s perspective. First, it can now use the funds it receives from
selling the first pool of mortgages to make additional loans to other aspiring
homeowners. In other words, the S&L is no longer limited by the amount of
deposits it has taken in, which greatly expands the number of homes it can
finance. Second, if interest rates rise in the economy, the S&L can simply increase
the rate it pays depositors and increase the rate it charges on the new mortgages.
Because it has sold the old mortgages, it no longer is exposed to their risk. The risk
hasn’t disappeared—it has been transferred from the S&L to Fannie Mae (we’ll
explain this soon). Third, the S&L can specialize in evaluating potential homeowners’
credit risks and in processing payments. Because it is able to specialize, it can
become very efficient in these activities. This is clearly a better situation from the
S&L’s perspective and from potential homeowners’ perspectives since there are
now more funds available for lending to homeowners. And because the S&L’s
likelihood of bankruptcy has fallen, it is clearly better for taxpayers.
How does the situation look from Fannie Mae’s perspective? Recall that the
risk has now been shifted to Fannie Mae. If the story ended here, then an increase
in interest rates or an increase in the homeowners’ default rates would cause
Fannie Mae’s shareholders and bondholders to suffer. But the story doesn’t end
here. Fannie Mae will take the mortgages it now owns, put them into new pools,
and sell shares of the pool (often called participation certificates) to investors. In
other words, the homeowner will pay the S&L, the S&L will forward the payment
to Fannie Mae, who will forward a share of the payment to each of the pool’s
investors. Fannie Mae now has cash, which it can use to buy additional pools from

1There were additional issues, such as the S&Ls engaging in very risky commercial real estate lending, but that is a
story for another book.
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S&Ls, which can then make additional loans to aspiring homeowners. In addition,
the mortgage risk has been shifted from Fannie Mae to the investors who now
own the participation certificates.
How does the situation look from the perspective of the investors who own
the participation certificates? It is true that they now have more risk, but their
expected rate of return should be very close to the 8% rate paid by the homeown-
ing mortgages (it will be a little less due to handling fees charged by the S&L and
Fannie Mae). These investors could have deposited their money at an S&L and
earned 5%. Instead, they chose to accept more risk in hopes of the higher 8%
return. The bottom line is that risk has been allocated to those who want it.
There is actually another step in this risk allocation story. Sometimes Fannie
Mae (or a fourth party) will take the mortgage pool and create two new classes of
securities. Instead of an investor buying a share of the pool, one investor might
buy a security that entitles the investor to a share of only the pool’s interest
payments, while another investor might buy a share of only the principal pay-
ments. As you will see in later chapters, the principal-only security has much
more risk than the interest-only security, and therefore the principal-only security
pays a higher interest rate. Notice that the original risk is being divided into seg-
ments with different levels of risk, and that investors with different levels of risk
tolerance are buying different segments. In other words, this continues the process
of allocating risk to those who want it.
This is an example of securitization, in which new securities are created from
existing securities. This particular type of security is called a collateralized mortgage
obligation (CMO). Since the mortgage payments and risk can be sliced and diced in
many ways, there are actually hundreds of types of CMOs. For example, a security
could be created that entitles its investor to only the principal payments made dur-
ing the first three years. Or a security could entitle the investor to principal payments
during the first three years plus a guarantee by the security’s originator (such as
Fannie Mae or another party) that the originator will make up any mortgage
defaults above a certain limit. As this indicates, the terms of these securities can be
tailor-made to match the particular needs of investors and originators.
Many other types of loans can be securitized. For example, there is an active
market in securitization for car loans, student loans, and credit cards. Although
the details vary for different types of securities, the process is similar to that of
home mortgages.
Finally, notice that the securities described above are derivative securities,
because they are derived from the original mortgages. See Web Extension 1B for
more on derivatives.