The Panic of 2007

Here is one of the best papers I have read on the current financial crisis. I have to thank Tyler Cowen of Marginal Revolution for bringing it to my attention. Click Here to Skip the introduction and Read Full Paper as PDF

Article Overview (Via Yale School of Management and Gary Gorton)

“How did problems with subprime mortgages result in a systemic crisis a panic? The ongoing Panic of 2007 is due to a loss of information about the location and size of risks of loss due to default on a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers. Addressing their risk required a particular design feature, linked to a house price appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique deisn reflecting the subprime mortgage design. Subprime securitization tranches were often sold to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional subprime risk was created with derivatives. When the housing price bubble burst, this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most investors to determine the location and size of the risks.

This paper outlines:

  • How asymmetric information between the sell-side and buy-side was created via complexity.
  • How the chain of interlinked securities was sensitive to houseprices.
  • How the risk was spread in an opaque way.
  • Use of ABX indices allowed information to be aggregated and revealed.
  • Article Excerpts (Via Marginal Revolution, Yale School of Management, and Gary Gorton)

    “Gorton is also highly critical of “mark to market” (p.62) and he pinpoints the collapse of certain parts of the REPO market (p.66) as a critical development. He ties it all in to Hayek and Grossman and Stiglitz and discusses how we ended up having assets with non-transparent, non-backwards-translatable prices and what that means for economic calculation. He contrasts a private clearinghouse (and monitoring) vs. rules of accountancy and how we ended up relying too much on the latter.”

    “What is the loss of information? The information problem is that the location and extent of the (2006 and 2007 Q1-2 vintage) subprime risk is unknown to anyone. It is very hard to determine the location of the risk, partly because of the chain of interlinked securities, which does not allow the final resting place of the risk to be determined. But also, because of derivatives it is even harder: negative basis trades moved CDO risk and credit derivatives created additional long exposure to subprime mortgages.”

    Click Here to Read Full Paper as PDF

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    14. October 2008 by Miguel Barbosa
    Categories: Curated Readings, Finance & Investing | Leave a comment

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