Does banks? system risk lead to 2007 financial crisis? Evidence from banks? profit maximizing behavior in the mortgage market

Abstract

The recent financial crisis has witnessed significant systemic risks which arise from the financial intermediaries? risky portfolios. There is substantial evidence that most of financial intermediaries have achieved amazingly high profit in the golden age of mortgage securitization market because they either want to or have to accept much higher risk than before. In this paper, I develop a very stylized theoretical model in which commercial banks originate, securitize, distribute, and trade loans, or hold cash. They can also borrow money by using their security holdings as collateral. The model predicts that banks got themselves into so much trouble in mortgage market not because of their irrationality or misestimate but by taking advantage of extraordinary temporary profit opportunities offered by securitization. Profit maximizing behavior in securitization by banks in the mortgage market creates systemic risk.