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Friday, May 13, 2011

Thoughts?

At some point I would like to know (with high probability at least) whether or not the following statement is true:
By spreading risk to those most able to bear it, creating new markets for financial assets (i.e, market completion) increases the productive capacity of the economy.
I came across the statement in a very nice paper by John Geanakoplos.  To provide a bit of context, the quote was lifted from a section of the paper where Geanakoplos was discussing ways in which splitting mortgage promises (i.e., tranching) into collateralized mortgage obligations (CMOs) increase the number of buyers.  The first way is the effectively the above quote.

The second way is that tranching allows investor to speculate on the movements of things like interest rates.  The utility of CMOs as a speculative hedge, raises the value of the CMO to the bank because the bank knows that it will be easier to sell the mortgage on after it has been tranched.  This encourages banks to lower interest rates (or credit standards! or both!) in order to create the CMOs to sell to speculators.  Not surprisingly, Geanakoplos points out that this whole process is not necessarily welfare enhancing. 

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