A comedy of errors: misguided policy, mis-sold mortgages, and more

In Phishing for Phools, Akerlof and Shiller characterise the US subprime crisis as the insolvency that follows when highly-leveraged investment banks mis-sell derivative-style products to low-income US households. That rating agencies qualified many of the Mortgage Backed Securities as triple A was no proof of top quality; just further evidence of distorted incentives. Other observers, however, see it as a direct consequence of financial innovation; or as a liquidity crisis driven by the lack of transparency of Mortgage Backed Securities. To help weigh these views in the balance, three aspects of the situation are explored, using both theoretical models and the outcome of recent legal proceedings. First, we examine the role of pecuniary externalities using a partial equilibrium model of investment banking due to Adrian and Shin, where bank equity induces amplified responses to news on fundamentals. We find that the system may be ‘catastrophic’ in that the simple reversal of a ‘good news’ shock (which has been promptly ‘marked to market’) can lead to insolvency. To interpret these news shocks, we turn to a general equilibrium model of risky asset pricing with heterogeneous beliefs recently developed by Fostel and Geanakoplos. In their framework, a rise in optimism acts as a ‘good news’ shock which raises the price of risky assets; while ‘bad news’ may be attributed to financial innovation that allows for the shorting of risky assets. Finally, to help resolve the contentious issue of whether the striking collapse in the value of MBSs net of insurance costs was due to irrational panic or had its basis in poor fundamentals, we consider the nature of state support and, more especially, the findings of law courts. The need for unprecedented capital injections by the Treasury in 2008 and the substantial fines for mis-selling of MBSs subsequently imposed on the banks suggest that the collapse of confidence in subprime securities had its roots in reality, not unreasoning panic.