Wayne Passmore and Roger SparksThis paper analyzes a model of the mortgage market, considering 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 mortgage-backed security (MBS), will reduce risk and enhance liquidity, thereby mitigating financial crises. We construct a strategic-game framework to model the interaction between the securitizer and banks. In this framework, the securitizer initiates the process by setting the MBS contract terms, which includes the guaranteed rate and the criterion that qualifies a mortgage for securitization. The bank then selects which qualifying mortgages to exchange for the MBS. Our investigation leads to a key result: government-sponsored securitization, somewhat counterintuitively, is more likely to exacerbate the severity and frequency of financial crises.
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