What We Still Have to Learn from the Credit Collapse (and Other Market Crises)

Abstract

This editorial, which mirrors Bruce Jacobs’s book Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes, finds that “free-lunch” strategies and products that promise to increase returns while reducing risk can attract substantial investments and encourage leverage, especially when complexity and lack of transparency obscure the true sources of risk. But they also have the potential to induce sharp price swings that can destabilize markets and lead to crashes. The structured securitization of subprime mortgage loans, which first helped to inflate the housing bubble before triggering the implosion of the U.S. credit market, shares some important characteristics with strategies and products at the heart of prior crises, beginning with the 1987 stock market crash.

Keywords: financial markets, market crash, credit crisis, mortgage-backed securities, subprime, risk reduction, risk-shifting, free-lunch, leverage, portfolio insurance, arbitrage, non-linear, liquidity, tranching, Lehman Brothers, Long-Term Capital Management, securitization, options, systemic risk

JEL Classification: G, G01, G02, G18, G21, G23, G28