The meltdown in financial markets may seem scary or mysterious, but it’s part of a time-honored story. In Chapter One, a new financial instrument makes capital available to a new class of borrower, and the result is profits for the innovator along with gains for consumers. In Chapter Two, a group of not-so-smart investors misunderstands the novel instrument and bids its price up too enthusiastically; when the inevitable bust follows, the innovation is denounced as inherently dangerous. Then, in Chapter Three, the complaints blow over. The not-so-smart investors learn their lesson and the new instrument stabilizes. Financial innovation turns out to be beneficial without being scary, but by that time another newfangled instrument has emerged to frighten people, and finance is hauled before the court of public opinion — again.
This is likely to be the story with the current subprime mortgage meltdown, just as it was with subprime’s close cousin, the junk bond.