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Essay, Protecting Financial Markets: Lessons from the Subprime Morgage Meltdown

By Steven L. Schwarcz. Full text here.

Why did the recent subprime mortgage meltdown undermine financial-market stability notwithstanding the protections provided by market norms and financial regulation? This Essay attempts to answer that question by identifying anomalies and obvious protections that failed by examining hypotheses that might explain the anomalies and failures. Although some of the anomalies and failures result from a type of tragedy of the commons (in which the benefits of exploiting finite capital resources accrue to individual market participants, whereas the costs of exploitation are distributed among an even wider class of persons), most result from three sources: conflicts, complacency, and complexity, all exacerbated by a possible fourth source known as cupidity. This framework of understanding provides critical insights into protecting financial markets.