Wall Street's Death: Suicide? Murder? Accidental Death? or a Case of Organ Failure?

By Rodrik, Dani | The International Economy, Fall 2008 | Go to article overview

Wall Street's Death: Suicide? Murder? Accidental Death? or a Case of Organ Failure?


Rodrik, Dani, The International Economy


You don't have to break a sweat to be a finance skeptic these days. So let's remind ourselves how compelling the logic seemed of the financial innovation that led us to our current predicament not too long ago.

Who wouldn't want credit markets to serve the cause of home ownership? So we start by introducing some real competition into the mortgage lending business. We allow non-banks to make home loans and let them offer creative, more-affordable mortgages to prospective homeowners not well-served by conventional lenders.

Then we enable these loans to be pooled and packaged into securities that can be sold to investors, reducing risk in the process. We divvy up the stream of payments on these home loans further into tranches of varying risk, compensating holders of the riskier kind with higher interest rates. We then call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in. In case anyone is still nervous, we create derivatives that allow investors to purchase insurance against default by issuers of those securities.

If you wanted to showcase the benefits of financial innovation, you could not have come up with better arrangements. Thanks to them, millions of poorer and hitherto excluded families became homeowners, investors made high returns, and financial intermediaries pocketed the fees and commissions. It might have worked like a dream--and until about a year and a half ago, many financiers, economists, and policymakers thought that it did.

Then it all came crashing down. The crisis that engulfed financial markets in recent months has buried Wall Street and humbled the United States. The near $1 trillion bailout of troubled financial institutions that the U.S. Treasury has had to mount makes emerging-market meltdowns--such as Mexico's "peso" crisis in 1994 or the Asian financial crisis of 1997-98--look like footnotes by comparison.

But where did it all go wrong? If our remedies do not target the true underlying sources of the crisis, our newfound regulatory zeal might end up killing useful sorts of financial innovation, along with the toxic kind.

The trouble is that there is no shortage of suspects. Was the problem unscrupulous mortgage lenders who devised credit terms--such as "teaser" interest rates and prepayment penalties--that led unsuspecting borrowers into a debt trap? Perhaps, but these strategies would not have made sense for lenders unless they believed that house prices would continue to rise.

So maybe the culprit is the housing bubble that developed in the late 1990s, and the reluctance of Alan Greenspan's Federal Reserve to deflate it. Even so, the explosion in the quantity of collateralized debt obligations and similar securities went far beyond what was needed to sustain mortgage lending. That was also true of credit default swaps, which became an instrument of speculation instead of insurance and reached an astounding $62 trillion in volume. …

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