Foote, Gerardi, and Willen’s subprime manifesto is theoretically enlightening as well as empirically edifying.  Unlike many economists, they understand asymmetric information on an unusually deep level.  Standard adverse selection models suggest that the market for iffy mortgage-backed securities would never get off the ground:

In the securitization process, lenders screen potential borrowers and originate mortgages, then package the mortgages for sale to outside investors. Yet investors cannot verify how carefully the screening is actually done. The problem is worse if the lender retains no skin in the game, so that any credit losses on the mortgages are borne solely by the investor. Given these informational problems, it is reasonable to think that investors would be concerned about purchasing any mortgage-backed securities. This is the prediction of textbook theories of asymmetric information, which imply that if such asymmetries had been a problem for mortgage-backed securities, we would not have seen an explosion of securitized mortgage credit driving housing prices higher while investors were cheated. Rather, the opposite would have occurred. Mortgage credit would have dwindled as investors, like buyers looking over used cars with broken odometers, walked away from the deals.

So why didn’t this asymmetric information “problem” prevent the crisis from happening in the first place?

Yet even though buying and selling mortgages involves some degree of asymmetric information, securitized mortgage credit did explode and house prices did move higher. The best explanation for this correlation places higher price expectations at the front of the causal chain. If investors believed that housing prices would continue rising rapidly, then it didn’t matter what a mortgage borrower’s income or credit score was. In the event that the borrower defaulted, then the higher price of the house serving as collateral would eliminate any credit losses. In the words of Gorton (2010), higher housing prices cause securitized mortgages to become less “information sensitive,” meaning that their profitability depends less on potentially unverifiable characteristics like borrower credit scores and incomes. So in the early 2000s, when price expectations rose, investors became eager to invest in securitized mortgages–even those that were clearly identified as “reduced documentation”‘ or “no documentation,” for which originators avowed that the loans had not been painstakingly underwritten.

You could object that asymmetric information models are overly rational.  What’s wrong with a simple “naive investor” model?

The problem with this theory is that the facts do not support it. To make an obvious point, many Wall Street investors who lost money were seasoned financial professionals, a group generally not known for being overly trusting of those on the other side of high stakes deals. More importantly, facts 3 and 5 showed that the institutional framework behind mortgage securitization was not new. Investors had ample time to discern the relevant incentives and act accordingly. Public discussions of potential moral hazard issues surrounding mortgage-backed securities had been common as well.

Elegant conclusion:

In short, the idea that the underwriting standards of lenders who sold loans might be different from the standards of portfolio lenders is not a sophisticated idea from a graduate seminar in information economics. Rather, it is a simple concept that was understood by virtually everyone. It does not imply that well-informed insiders were able to expand credit by taking advantage of ill-informed or neophyte outsiders. Instead, it implies that higher price expectations expanded credit by lessening the impact of any informational problems inherent in the securitization process.