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How did problems with subprime mortgages result in a systemic crisis, a panic? The ongoing Panic
of 2007 is due to a loss of information about the location and size of risks of loss due to default on
a number of interlinked securities, special purpose vehicles, and derivatives, all related to subprime
mortgages. Subprime mortgages are a financial innovation designed to provide home ownership opportunities
to riskier borrowers. Addressing their risk required a particular design feature, linked to house price
appreciation. Subprime mortgages were then financed via securitization, which in turn has a unique
design reflecting the subprime mortgage design. Subprime securitization tranches were often sold
to CDOs, which were, in turn, often purchased by market value off-balance sheet vehicles. Additional
subprime risk was created (though not on net) with derivatives. When the housing price bubble burst,
this chain of securities, derivatives, and off-balance sheet vehicles could not be penetrated by most
investors to determine the location and size of the risks. The introduction of the ABX indices, synthetics
related to portfolios of subprime bonds, in 2006 created common knowledge about the effects of these
risks by providing centralized prices and a mechanism for shorting. I describe the relevant securities,
derivatives, and vehicles and provide some very simple, stylized, examples to show: (1) how asymmetric
information between the sell-side and the buy-side was created via complexity; (2) how the chain of
interlinked securities was sensitive to house prices; (3) how the risk was spread in an opaque way;
and (4) how the ABX indices allowed information to be aggregated and revealed. I argue that these
details are at the heart of the answer to the question of the origin of the Panic of 2007.
Gary B. Gorton
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