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This paper by Baily, Litan, and Johnson [2] is the best overview I’ve read so far of what went wrong in the housing and financial markets (HT: Arnold [3]). It is a primer of sorts, so if you remain confused, you will find much enlightenment there.
But many questions remain. One is the question they raise:
The lack of due diligence on all fronts was partly due to the incentives in the securitization model itself. With the ability to immediately pass off the risk of an asset to someone else, institutions had little financial incentive to worry about the actual risk of the assets in question. But what about the MBS, CDO, and CDS holders who did ultimately hold the risk? The buyers of these instruments had every incentive to understand the risk of the underlying assets. What explains their failure to do so?
The authors give an answer, the standard one that is not so satisfying–people were careless, profits were huge, the assets were opaque. This all may be true, but I suspect there is more to the story. Consider this picture:
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This is taken from a superb paper by Rossner and Mason [5] on the CDO market. CDO’s are these assets that are bundles of bundles–repackaging of mortgage backed securities. The pictures shows the premium earned by BBB tranches above and beyond LIBOR, a short-term interest rate. What the picture shows is that starting in 2003, the premium plummeted. Then it stayed low throughout 2005 and 2006, a time when the quality of the subprime loans that underlie these assets is deteriorating. Rossner and Mason point out: For example, 38
percent of all subprime mortgage originations in 2006 were for 100 percent of the
value of the home. Adelson and Jacob [6] (another very interesting paper) argue that as these spreads fell and stayed low, the traditional investors in this market who had demanded insurance or other forms of protection from credit risk, stepped to the sidelines and were replaced by investors who didn’t care. Very interesting. Something changed. What was it exactly? What caused it? I have some ideas, but they are very incomplete. I also have many more questions…