First, diversification only works to reduce risk if risks are not correlated, but, when housing prices start to fall, all of the sub-prime mortgages turned sour together. Second, securitisation creates asymmetries of information, where those buying the securities know less than those originating them. In the old days, when banks held the mortgages they originated, they had an incentive to make sure that they were good loans.Evidently, the search for greater fools to maximize profit by taking advantage of knowledge asymmetries has many admirers (well Stiglitz won a Sveriges Riksbank Prize in Economic Sciences for his theoretical work in this area).
But with securitisation, if you could find enough fools to take bad mortgages, you had every incentive to lend as much as you could. What is remarkable is how many fools (including banks with supposedly good risk management systems) there were. That game, too, is up, at least for the duration.
Sunday, January 25, 2009
Finger Wags Continued ...
Apropos of my earlier post, Joe Stiglitz had this to say about the financial innovations of the recent past one year ago in the London Times Online: