Subprime assets and financial crisis: theory, policy and the law

In this paper, we explore three specific aspects of the US subprime crisis, using both theoretical models and the outcome of subsequent legal proceedings. First, the role of pecuniary externalities in amplifying shocks to the quality of MBS held by Investment Banks. Second, the role of adverse selection in the marketing of such assets by Investment Banks; and third the role of financial panic in making shadow banking disaster prone. The relevance of these differing perspectives is attested by the nature of state support and, more especially, the findings of law courts. Janet Yellen has recently argued that the vulnerabilities within the US financial system in the mid-2000s were “numerous and familiar from past financial panics”. That the aforementioned threats to stability should be complements and not substitutes is of more than technical interest. It helps to show why the US financial system was so exposed to radical failure.Keywords: Financial Instability, Pecuniary Externalities, Asymmetric Information, Bank run JEL Classification: D52, D53, G01, G12, G13