The Subprime Turmoil: What's Old, What's New, and What's Next

Abstract

This article considers the origins of the subprime turmoil and the way the financial system has responded to it. It explains that there are both old and new components in both the origins and the propagation of the subprime shock. Old components include government financial subsidies for bearing risk, accommodative monetary policy, and adverse selection facilitated by asymmetric information. New components include the central role of agency problems in asset management, the ability of financial institutions to raise new capital from external sources, the activist role of the United States Treasury Department and Federal Reserve, and improvements in U.S. financial system diversification resulting from deregulation, consolidation, and globalization. In light of these old and new elements of the origins and propagation of the subprime turmoil, the article concludes by considering the near-term future of financial and macroeconomic performance, and the implications for monetary policy, regulatory policy, and the future of the structure of the financial services industry.

TOPICS: Legal and regulatory issues for structured finance, portfolio theory, portfolio construction