What went wrong with the subprime mortgage market? In a nutshell, a lot of the problem was that it wasn’t as sophisticated, in terms of derivatives, as the rest of the bond market.
Let me explain. Investors demanded vast amounts of subprime mortgages in the form of MBSs, and Wall Street did everything it could to meet that demand. Unfortunately, Wall Street met the demand by happily securitizing anything and everything sent to it by originators using ever-laxer underwriting standards. Think of it as the mother of all reverse inquiries: CDOs and other investors essentially went to the originators and told them they would love it if they could originate vastly more in the way of subprime MBSs than they ever had in the past. And so the originators did just that — by writing mortgages which turn out, in restrospect, to have been very bad ideas for the homebuyers, for the originators, and for the investors.
How could all this have been avoided? Quite simply, in theory: Wall Street could simply have started issuing synthetic MBSs. Total subprime originations would not have risen nearly as much, underwriting standards could have remained relatively strict, and the investors would be much happier today. There would also have been less of a housing bubble, as individuals would have found it much harder to buy houses they couldn’t afford.
But financial technology never really got as far as synthetic MBSs. And so we find ourselves in the situation we’re in today.