by Chris Bodenner

A reader writes:

I think that Mr. Posner missed a critical component of the housing bubble. He notes, rightly in my opinion, that low interest rates were a key component. He then posits that low rates also caused an asset bubble in common stocks (also true) and concludes that this newfound wealth increased demand for housing (potentially true). His analysis is all demand side - demand for housing and debt. What is missing is the supply side of the equation, particularly the supply side of debt.

Historically, banks lent to borrowers and in many cases held the mortgage. Therefore, institutions had a strong incentive to ensure the creditworthiness of borrowers. The possibility of holding bad debt was a disincentive to lending and held lending in check. As securitization increased in popularity, the incentives changed. Because most lending institutions or originators did not hold most mortgages after closing, but rather sold them off to be securitized, the threat of bad debt was greatly diminished (for originators), thus the incentive to ensure creditworthy borrowers diminished correspondingly. As a result, the incentive system was altered.

The creditworthiness of borrowers became less important because the threat of holding bad debt evaporated with the magic of securitization. Securitization (and the foolishness of ratings agencies) allowed the risky mortgages of marginal borrowers to be sold in packages that made them appear a lot less risky. From the originators perspective, then, lending (to anyone) became the dominant incentive. And lend they did.

Combining my argument with Mr. Posner's yields: low interest rates, warped incentives that increased supply of debt and the mispricing of risk via securitization as the key components of the debacle. On the most basic level, it seems about right to me.

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