from HuffPost:
Steven Schwarcz
Markets, Systemic Risk, and the Subprime Mortgage MeltdownPosted March 18, 2008 | 06:10 PM (EST)
The subprime mortgage meltdown is undermining financial market stability and has the potential to cause a true systemic breakdown, collapsing the world's financial system like a row of dominoes. I use this crisis to demonstrate that existing protections against systemic risk, which focus on banks and largely ignore financial markets, are anachronistic and misguided. Because companies increasingly access financial markets without going through banks, an effective framework for containing systemic risk must focus on markets.
In a forthcoming article, I have examined financial-market anomalies and obvious market protections that failed, seeking insight into the subprime mortgage crisis. The crisis can be explained in large part by three categories of factors: conflicts, complacency, and complexity. Running throughout these categories is a fourth factor, cupidity; but because greed so ingrained in human nature and so intertwined with the other categories, it adds little insight to view it as a separate category.
For example, the excesses of the originate-and-distribute model of mortgage securitization -- under which mortgage lenders sell off loans as they are made which are then packaged into mortgage-backed securities and sold to investors -- can be managed by avoiding conflicts, such as aligning the interests of the mortgage lenders and investors. The excesses of the form of complacency perhaps most responsible for the subprime mortgage crisis -- widespread investor infatuation with securities that have no established market and, instead, are valued by being marked-to-model--have at least in the near-term been discredited by the losses associated with the subprime crisis itself. Complexity, the third category, was a central culprit responsible for the failure of disclosure in the subprime crisis, but viable solutions appear to be second best.
The subprime crisis, however, is increasingly likely to trigger an even more systemic collapse of our financial markets for reasons that go beyond these categories. The risk of this collapse ("systemic risk") is, more generally, regarded as the risk that an economic shock -- in the present case, the subprime mortgage crisis -- can trigger a chain of market and/or financial institution failures, resulting in increases in the cost of capital or decreases in its availability. Because systemic risk is positively correlated with markets, investors cannot diversify it away.
Governments in the United States and abroad are seriously concerned about the subprime crisis and its potential systemic consequences. The near-failure of Bear Stearns is just a recent example of these consequences. I will use this crisis to demonstrate, however, that existing protections against systemic risk are insufficient. ......(more)
The complete piece is at:
http://www.huffingtonpost.com/steven-schwarcz/markets-systemic-risk-a_b_92198.html