I do believe, now, that the tranching of aggregated mortgage and loan pools was done in a way to intentionally _and artificially_ create spread differentials and seniority tiers in asset classes for which this made no inherent sense. The goal there, to me, seems to be much what you infer, that buyers would flock to artificially induced ‘advantage potentials’ mapped to assets which said buyers otherwise might have stayed away from. Whether ASBs were or were not liquid in a downstream market for acquirers may have been an issue largely of indifference to the underwriting fee gorgers who produced said (in)securities; juicing demand and clearing the stuff off their own books would seem to me to be the principal goals of the underwriters. I don’t know that tranching is an issue of nonlinear dynamics, but I do hope that becomes labeled as a bad business practice for many if not all securitity classes.

To anon of 10:17, you are right, and indeed I saw some of the same glitches—after the post had gone up. *sigh* I’ve always needed an editor, as we see again . . . .

This will be true and more, unintended modulation, regarding remedies to structural problems in the financial system, but there, too, we should try.

Good points, Richard.

Moe Gamble

As Minsky argues in his ‘Stabilizing an Unstable economy’,(he does not use the word ‘non linear’ anywhere though) an important role the Fed has played since the 1960s is to widen the range of assets it will accept either directly or indirectly through the discount window.

When a crisis hits and threatens the a number of financial institutions, the Fed has often reacted in this way, offering to accept securities which were behind some of the problems in the first place. Thus the recent actions such as the TAF etc are not something which are substantially different from what the Fed has done in earlier decades and in response to earlier crises.

There is obviously a moral hazard problem here. As the number of securities conferred with ‘legitimacy’ by the Fed expands, market participants are effectively insured to some extent against the losses they would have to take.

Couple this with the argument made by Raghuram Rajan that in todays world, one of the major sources of market alpha is the deliberate creation of more and more illiquid instruments. This is because as market instruments become more liquid, standardised and widely traded, (in part due to fed actions maybe…though rajan doesnt talk about this), banks earn less of a spread from developing and selling them. Thus it is CDOs today. but tomorrow it is something else which is also a radical new ‘financial innovation’ which also of course, happens to be highly illiquid, and highly complex.

This puts in perspective the recommendations made by many to force CDS trading onto exchanges. Once the returns from CDS origination fall,banks and traders will merely look elsewhere for better returns. the problems dont lie with CDS per se.