EconPapers    
Economics at your fingertips  
 

The Economics of Structured Finance

Joshua Coval, Jakub Jurek and Erik Stafford

Journal of Economic Perspectives, 2009, vol. 23, issue 1, pages 3-25

Abstract: This paper investigates the spectacular rise and fall of structured finance. The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create "safe" assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised. We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe. We highlight two features of structured finance products - the extreme fragility of their ratings to modest imprecision in evaluating underlying risks, and their exposure to systematic risks - that go a long way in explaining the spectacular rise and fall of structured finance. We conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers.

JEL-codes: G10 G21 G24 (search for similar items in EconPapers)
Date: 2009
Note: DOI: 10.1257/jep.23.1.3
References: View references in EconPapers View complete reference list from CitEc
Citations View citations in EconPapers (132) Track citations by RSS feed

Downloads: (external link)
http://www.aeaweb.org/articles.php?doi=10.1257/jep.23.1.3 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:aea:jecper:v:23:y:2009:i:1:p:3-25

Ordering information: This journal article can be ordered from
https://www.aeaweb.org/subscribe.html

Access Statistics for this article

Journal of Economic Perspectives is currently edited by David H. Autor

More articles in Journal of Economic Perspectives from American Economic Association Contact information at EDIRC.
Series data maintained by Jane Voros ().

 
Page updated 2017-02-27
Handle: RePEc:aea:jecper:v:23:y:2009:i:1:p:3-25