Mortgage backed securities
Banks that write mortgages can keep them on their books but can also package them together in Mortgage backed securities (MBS) in order to sell the risk and returns to institutional investors or other companies.
Mortgage backed securities attempt to shift and allocate risk away from the mortgage originator, while producing high returns for the security holders. Thousands of partial loan obligations are packaged together into a single security, the risks and rewards of the entire group then become the purchaser's, while the originator deals with the mortgage servicing. Because of the large quantity of mortgage deals integrated into a single security, in an unregulated environment, there is no way to practically estimate the value of the collateral represented by each property, the ability of the mortgagor to pay, or the veracity of stated income or creditworthiness of each borrower.
Mortgage Default Cycle in 2007 and 2008
Because of the ability to hide poor credit risks in MBS's and then to sell those MBS's over-the-counter via credit default swaps (CDS's), large quantities of borrowers of lower and lower quality were allowed to acquire large loans based on very low qualifications during the 2003-2007 time period. Several large investment banks collapsed in the latter part of 2008 due to the mortgage defaults that ensued as these buyers' rates or circumstances changed and their new incomes did not match their new payment levels. As defaults flooded the markets, their sale prices were low, pushing down property values in neighboring homes, making current home prices lower than buyers had remaining to pay on their mortgages, pushing them underwater, and creating new defaults and short sales as homeowners realize that they are paying a $500,000 mortgage on a property now worth only $400,000. For more discussion, read about 2008's subprime mortgage debacle.