In days of old when knights were bold the bank lent the money to the homeowner. You paid your money to the bank who never sold the note. The notes were straightforward - generally a fixed rate for a stated period of time. If you didn't pay the bank told the trustee to sell the property. There were very few defenses for the homeowner to raise because everything was uncomplicated.
Investors are always looking for a safe investment, particularly when they are investing other people's money. For example, if you are investing retirement funds you want to make sure that these funds are safe. There are not that many things that are safer than a mortgage on someone's home. Generally there had to be 20% equity in the property and the foreclosure rate was very low.
The lenders started to group the mortgage loans that they had made and sell these loans, as a group, to a trust. The trust sold pieces of the trust to investors. Enter the investor who wanted a safe investment. Sure there might be a few bad apples in the whole of the mortgage pool, but the values of homes was rising and the pool of mortgages was rated AAA. Moreover, these trusts paid more interest than other forms of investment. The lenders who sold the mortgages had already made money during the lending process and were making more money when they sold the mortgages to the securitized trusts.
Let's use an example. Joe lives in Smallville and sells firewood that he cuts from the forest. Joe has a good business and makes a nice living. Bob, the local builder, decides to start a development in Smallville. Each unit has a fireplace. Bob, being a smart guy, also sets up a store to sell firewood to the people who purchased the properties. Bob purchases the firewood from Joe.
Two years later Smallville was growing rapidly and Bob was on his third development. Fred and Jeff also developed the land, but they did not sell firewood. Everybody bought their firewood from Bob who was placing an ever increasing demand on Joe.
Instead of continuing to sell 100% hardwood, Joe started to mix some pine into the deliveries. Nobody would ever notice - and they didn't. But the forest was starting to thin out and Smallville was expecting a long, cold winter. The price of oil and electricity was rising to the point that the residents of Smallville started buying their firewood in the summer - giving Bob cash to hold the firewood. There was Bob with fists full of cash and Joe could not keep up with the orders.
Joe solved the problem by purchasing large forests, a lot of them containing mostly pine. Joe also started purchasing wood from Sam in Shelbyville and Jimmy in Johnstown. Sam and Jimmy were not the most honest people in the world. In fact, Sam and Jimmy would do anything to get wood, including cutting down decorated trees in front of grandma Wolf's property.
Some of the trees that Sam sold to Joe had signs still attached - "welcome to our home". Joe looked the other way - he didn't care because Bob was buying anything that Joe sold. In fact, Joe's price went from $150 per chord to $500 per chord. Bob was selling everything he could purchase (and even held wood aside for customers who purchased the wood during the summer and were going to pick the wood up each week during the winter) - until winter hit. That is when Bob's customers started to burn the firewood and discovered that there was so much green junk that it wouldn't burn and even if it did in screwed up the chimney.
The citizens of Smallville could not heat their homes and all of a sudden Bob was stuck with whole batches of firewood that was, well, toxic. When the people of Smallville demanded to exchange their green pine for seasoned hardwood Bob refused to do so, for the small amount of hardwood that he had in his piles of junk was going to new customers who were paying cash.
When Bob could not deliver good wood the customers demanded their money so that they could at least afford to say warm with electric heat. Bob didn't have any money to refund to his customers because he spent it on the three B's - booze, betting and beautiful women.
Then President Obama was elected and between President Bush's TARP funds and President Obama's stimulus they rescued Bob - so that Bob could refund money to his customers, buy good wood, and the people of Smallville would not freeze.
The problem is that Bob took the money, bought a whole bunch of 7-11's that sold fake wood and never did anything to help the people of Smallville. Bob did keep on selling wood from grandma Wolf's front lawn, even though each tree was now stamped "property of grandma Wolf." When the FBI asked to see receipts for the wood Bob said that the receipts were lost, or would show phony copies.
And that is the story of securitization.
