the traditional investors in this market who had demanded insurance or other forms of protection from credit risk, stepped to the sidelines and were replaced by investors who didn't care. Very interesting. Something changed. What was it exactly? What caused it?
Earlier, Roberts refers to a paper by Mason and Rosner, who wrote in early 2007,
annual issuance of CDOs has grown from nearly zero in 1995 to over $500 billion in 2006. In fact, CDO issuance is growing so fast that new issuance in 2006 amounted to approximately the total of the three preceding years summed together.
The phrase "Minsky moment" comes to mind. I don't care much for Minsky myself. I heard him give a talk back when I was at the Fed in the early 1980's. He was predicting doom, as seems to be the wont of both left-Keynesians and Austrians. He seemed to make a great deal of what I think of as a simple accounting identity, namely that private saving plus government saving equals foreign saving. In standard notation,
(S-I) + (T-G) = (X-M)
Minsky breaks S into two components--personal saving and corporate profits. He then points out that when the government runs a deficit, corporate profits are high. This is true, other things equal, given the accounting. But I personally don't think that taking an accounting identity and holding other things equal is a very good way to do macroeconomic theorizing.
Profits are important to Minsky, because he says that when firms finance investment out of earnings that is the safest form of finance. The next safest is when they finance investment out of debt. The least safest is what he calls Ponzi finance, which means that they will have to keep obtaining new financing to keep going.
Anyway, reading the Mason-Rosner paper, two things struck me. One was how irrational the investors were. The other was how rapidly the market grew.
A rapidly-growing, irrational market suggests a Ponzi scheme. People are drawn to it because they see others getting rich, and as more people get drawn to it, more people get rich.
I think there is something to be said for thinking of the 2005-2006 period in the mortgage market as Ponzi finance. The observation that the seasoned investors dropped out and new investors came in during that period would be consistent with that.
I always keep coming back to my hatred of the bailouts. As central to the economy as the financial system is supposed to be, why is it necessary to keep the folks who fell for a Ponzi scheme in business? Why must we dread that these fools would have to shut their doors? Why don't we think of it as a good thing?