With emphasis on that word "exactly," here is Gary Gorton’s superb paper The Panic of 2007.
Go ahead and read and read and read and the more you feel confused the more, in fact, you are being instructed. You are confused because it is confusing. Then I got to p.45 (!) and I almost split a gut (and cried, simultaneously) when I read the sentence:
Now we come to the first information issue.
It then goes like this:
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.
His examples show this in detail but I do not know a simple way to blog it. Scroll to pp.23-30, and p.35 for a dose of how these securities were structured.
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.
Starting on p.67, there is a sustained and mostly convincing argument that securitization has not been much at fault.
If you are interested in the nuts and bolts of the current financial crisis, and its origin in 2007, this paper is essential reading.
Additionally, it’s worth reading Ashcraft and Schuermann’s 2008 paper for reference.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1071189
I bet that once a risk completes a circle, there isn’t a unique solution any longer. So what determines what something is worth is no longer an underlying value, but rather which of many solutions the system stumbles into.
Separate areas can come up with differing evaluations, and then interact to fight out whose solution prevails, if either. It’s not an averaging process but a winner-take-all encounter.
Just to say that careful analysis can no longer get very far. I mean, it might be able to sketch out the various static solutions that the system has, but no dynamics are available to figure out which one prevails or what happens.
You want to build as few of these systems as possible.
This is a great paper. And this kind of paper shows the difference in the type of complexities that face practitioners and academics. Trust me, that’s not a knock on academics.
I still don’t understand why it took so long for the ABX indices to get up and running? Or more fundamentally, why were so many, and for so many years, content to buy blindly into subprime securities? I believe he points to the essential misjudgment that home prices would never decline. That’s hard to swallow. I mean I’m just a home owner, not a mortgage derivatives expert, and I tried to sell my place in DC in 2003 because I thought the prices were unsustainable. The deal fell through, and I decided not to sell because I figured the DC market would be the last to turn down. I’ve been right on that. Now it looks like the whole thing is going to @#$^. I just don’t understand why high flying bankers with kabillions on the line would expect home prices nation wide to continue up forever.
I’m thinking if you don’t understand what you’re buying, don’t buy it.
And, make sure there’s another way to make money when things go wrong. Basic Warren Buffet stuff.
I can’t wait to read this paper. Thanks for the link.
thanks Tyler, and Alex, for all your blog postings and the valuable links and opinions herein. I’ve been out of the profession of economics for many years, but have been trying to catch up by rapidly devouring all the economists’ perspectives on this current crisis, so your blog has been a great help.
This paper, The Panic of 2007+, is an excellent read.
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Thank you for the links. They were interesting posts…
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I read a similar article on the Oregon reverse mortgage website and my opinion is that in the future we could have insurance companies that offer insurance for property mortgage in case the value of your property goes down and you want to pay in full the sum of money you owe to the bank… This could be a possibility, don’t you think?
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