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An intriguing argument can however also be made that

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Unformatted text preview: deepening financial system in which markets and intermediaries increasingly complemented each other.57 Banks commoditized credit risk through the originate‐to‐distribute model and retained some credit risk to overcome agency problems.58 At the same time, they used their ability to provide first resort liquidity to help markets overcome the remaining liquidity gap associated with the yet nascent and still overly heterogeneous instruments. The pressures of competition, boosted by the steady entry and rapid growth of unregulated (or less regulated) brokers and intermediaries (particularly investment banks), were clearly at the heart of such a remarkable process of financial deepening and market completion. However, the creation of new instruments and forms of intermediation went faster than the ability of market participants and supervisors to fully comprehend their implications and handle the risks and uncertainty associated with such a rapidly changing world. The opacity, complexity, and hidden interconnectedness of the Subprime world can thus be seen in the mood swings paradigm as bad side effects of an innovative process, but side effects that were either not intended or, if intended, not necessarily maliciously pursued.59 The inability to think through the potential systemic implications and fragilities of the new universe was the fundamental and critical failure. This problem was compounded by a failure to fully comprehend the links between financial sector dynamics and the underlying asset price dynamics, and to adequately understand the feedback loop between rising asset prices and expanding credit. The possibility of a large and nation‐wide synchronized decline in housing prices (and the devastating implications this would have for the risk correlation assumptions underlying the presumed safety of credit default protections) was unthinkable because it had never happened since the Great Depression.60 Moreover, when delinquency rates on mortgages started to rise during the mini‐recession of 2002, the losses on mortgages were minimal because the housing market continued to boom.61 From this perspective, falling housing prices and their implications for the housing finance market appear not as “tail risk” but as a “black swan” event, a new reality that could not be anticipated from historical series.62 Faced with the world of the new and unknown, market participants involved in the Subprime process no longer had a steady frame of reference. On the way up, they found themselves in a truly new and wonderful territory which fueled a mood of optimism and exuberance. This was reinforced by the decline in observed macro‐financial volatility, predictable pricing and deep market liquidity, which further fed risk appetites and gave rise to pro‐cyclical leveraging.63 The low volatility environment not 57 Through securitization, markets benefit from the screening done by intermediaries and the latter benefit from the more efficient parceling and tailoring of risk carried out through the markets. See Gorto...
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