Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Becoming unbalanced: Securitisation and asymmetric information

You may wonder after reading the preceding section why banks and other financial institutions were falling over themselves to make these subprime loans. After all, lending large amounts of money to people on low incomes with unstable jobs and a history of not paying back their loans seems like a very risky business! To comprehend why they did so, you need to understand a big innovation that was occurring in the world of finance at the time called securitisation.

Explaining the role of securitisation


Securitisation refers to the packaging of a number of illiquid assets (ones that are difficult to turn into cash) into a liquid asset (that’s easy to turn into cash). (Chapter 14 describes in more detail liquid and illiquid assets.)

Here’s a concrete example to clarify. In the past when you took out a mortgage with a bank, it lent you money and you paid it back over a number of years. Your mortgage was a valuable asset for the bank – giving the right to a stream of monthly payments from you. However, the bank couldn’t easily sell on this right to someone else – in economist speak, no well-functioning secondary market existed for your mortgage.

Selling on the mortgage meant that instead of making repayments to the original bank that made you the loan, you repaid the current holder of your

mortgage. A secondary market didn’t develop because a single mortgage isn’t really an attractive proposition for an investor. A potential buyer would have to do quite a lot of research into you and your family circumstances to try to work out whether you were likely to repay or not. Of course, For Dummies readers would never renege on their loans, but the potential buyers don’t know that! The hassle of finding out just wasn’t worthwhile.

Moreover, the bank that originally made the loan had much better information about the credit-worthiness of the borrower than the potential buyer. It therefore had a strong incentive to sell on only those mortgages that were least likely to be repaid. Economists call this situation an information asymmetry.

So the clever people in the City had an idea that took off in the 2000s (later on you can decide just how clever, or not!). Here are the main attributes of this brainwave:


Instead of trying to sell one mortgage at a time, let’s package together a whole bunch of mortgages.


With, say, 100 mortgages packaged together, most of them will repay, even though some will be duds (say 10 per cent).


Someone who buys one of these packages can be confident that 90 per cent of the mortgages will be repaid.


Clearly, a potential buyer wants a discount on the package of loans to take into account that some of them won’t repay, but other than that, they don’t need to research each family’s individual circumstances.


What matters to the potential buyer is that 90 per cent of the mortgages are repaid; it doesn’t matter which 90 per cent.

That was how it was supposed to work in theory. In practice, however, banks and other financial institutions quickly realised that they could easily sell on any loans they made. This meant that the risk of default (the risk that the borrower doesn’t repay) was no longer the bank’s problem. Now, when a mortgage application was received, the bank wasn’t too bothered about carefully assessing it to see how affordable it would be for the borrower.

Instead it was eager to lend, safe in the knowledge that selling the mortgage on would be a piece of cake.


Banks started to outdo each other as to who had the most liberal lending policy. No deposit? No problem! Don’t have a stable job? That’s fine! No proof of income? Just self-certify (sign a piece of paper saying what your income is)! Things went from bad to worse; ultimately some banks were willing to make so-called NINJA loans – that is, loans to people with No Income, No Job or Assets! Crazy stuff indeed, but it happened.