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KEITH HENNESSEY, DOUGLAS HOLTZ-EAKIN, AND BILL THOMAS 

are also still poorly understood. Important factors include weak disclosure
standards and underwriting rules for bank and nonbank mortgage lenders
alike, the way in which mortgage brokers were compensated, borrowers who
bought too much house and didn’t understand or ignored the terms of their
mortgages, and elected officials who over years piled on layer upon layer of gov-
ernment housing subsidies.
• Mortgage fraud increased substantially, but the evidence gathered by the Com-
mission does not show that it was quantitatively significant enough to conclude
that it was an essential cause.

TURNING BAD MORTGAGES INTO TOXIC FINANCIAL ASSETS
The mortgage securitization process turned mortgages into mortgage-backed securi-
ties through the government-sponsored enterprises (GSEs) Fannie Mae and Freddie
Mac, as well as Countrywide and other “private label” competitors. The securitiza-
tion process allows capital to flow from investors to homebuyers. Without it, mort-
gage lending would be limited to banks and other portfolio lenders, supported by
traditional funding sources such as deposits. Securitization allows homeowners ac-
cess to enormous amounts of additional funding and thereby makes homeownership
more affordable. It also can diversify housing risk among different types of lenders. If
everything else is working properly, these are good things. Everything else was not
working properly.
Some focus their criticism on the form of these financial instruments. For exam-
ple, financial instruments called collateralized debt obligations (CDOs) were engi-
neered from different bundled payment streams from mortgage-backed securities.
Some argue that the conversion of a bundle of simple mortgages to a mortgage-
backed security, and then to a collateralized debt obligation, was a problem. They ar-
gue that complex financial derivatives caused the crisis. We conclude that the details
of this engineering are incidental to understanding the essential causes of the crisis. If
the system works properly, reconfiguring streams of mortgage payments has little ef-
fect. The total amount of risk in a mortgage is unchanged if the pieces are put to-
gether in a different way.
Unfortunately, the system did not work as it should have. There were several flaws
in the securitization and collateralization process that made things worse.

• Fannie Mae and Freddie Mac, as well as Countrywide and other private label
competitors, all lowered the credit quality standards of the mortgages they se-

curitized. A mortgage-backed security was therefore “worse” during the crisis
than in preceding years because the underlying mortgages were generally of
poorer quality. This turned a bad mortgage into a worse security.
• Mortgage originators took advantage of these lower credit quality securitization
standards and the easy flow of credit to relax the underwriting discipline in the
loans they issued. As long as they could resell a mortgage to the secondary mar-
ket, they didn’t care about its quality.