The recent financial crisis has been attributed by many analysts to the proliferation of securitization, a process wherein financial assets like mortgages are bundled together and sold as securities. According to these analysts, this practice led to a decline in the credit standards maintained by banks, incentivizing them to pursue riskier ventures. As a result, the risk exposure was not only retained within the banking system but also transferred to other investors.
By packaging mortgages into securities, banks were able to offload the risk associated with these loans onto other investors. This created a situation where the originating banks were less concerned about the quality of the loans they were issuing since they would no longer bear the full consequences of defaults. Consequently, there was a relaxation of lending standards, leading to the issuance of mortgages to individuals who might not have qualified under traditional criteria.
Moreover, the complexity of these securitized products made it difficult for investors to accurately assess the underlying risk. As a result, investors underestimated the potential losses they could incur, leading to a mispricing of risk across financial markets. When the housing market began to decline and borrowers defaulted on their mortgages, the repercussions were felt throughout the financial system, ultimately culminating in the financial crisis of 2007-2008.
(Response: The increased use of securitization weakened credit standards, encouraged excessive risk-taking by banks, and transferred risks to other investors, contributing to the financial crisis.)