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Assigning Blame For The Financial Crisis

The Center for Public Integrity has a new report out today that asks my favorite question about the current mess: The Roots of the Financial Crisis: Who Is to Blame? Here is an excerpt:

The top subprime lenders whose loans are largely blamed for triggering the global economic meltdown were owned or bankrolled by banks now collecting billions of dollars in bailout money — including several that have paid huge fines to settle predatory lending charges.

The rest of the report is largely an exercise in (not unjustified) bank-hating, but it unfortunately doesn't get into what I find most fascinating about the "roots" question. The leading explanation for why the world stopped working was put forth by Hank Paulson's Treasury Dept. last year, pinning the blame on a decline in lending standards in the subprime industry in 2004. But why did a problem in a relatively small part of the financial sector infiltrate the rest of the global economy?

Yale economist Gary Gorton questioned Paulson-style views and argued in a paper last year that it wasn't so much a decline in lending standards that could be blamed, but that there just wasn't enough reliable information about the subprime market to know what was really going on. The way mortgages were sliced and diced made it nearly impossible to track them even if you wanted to. It wasn't until the ABX index tracking subprime-backed securities was created in early 2006 that some of the relevant information was synthesized. From Gorton's paper:

For the first time information about subprime values and risks was aggregated and revealed. While the location of the risks was unknown, market participants could, for the first time, express views about the value of subprime bonds, by buying or selling protection. In 2007 the ABX prices plummeted. ...

The ABX information together with the lack of information about location of the risks led  to a  loss of confidence on the part of banks in the  ability of their counterparties to honor contractual obligations. 

Gorton's story seems plausible, but there is reason to read it with a dose of skepticism: Gorton was also the man behind the computer models that gave AIG a disastrously false sense of security.

-- Zubin Jelveh