The 2007 Meltdown in Structured Securitization: Searching for Lessons,

The intensity of the crisis in financial markets has surprised nearly everyone. The authors search out the root causes of the crisis, distinguishing them from scapegoating explanations that have been used in policy circles to divert attention from the underlying breakdown of incentives. Incentive conflicts explain how securitization went wrong, why credit ratings proved so inaccurate, and why it is superficial to blame the crisis on mark-to-market accounting, an unexpected loss of liquidity, trends in globalization, and dereg-ulation in financial markets. The authors ’ analysis finds disturbing implications of the crisis for Basel II and its implementation. They conclude by drawing out lessons for developing countries and identifying reforms that would improve incentives by increasing transparency and accountability in government and industry alike. JEL codes: G21, G28, G32 Since August, 2007, after a long period of relative quiet in world markets,1 a spreading financial crisis has nearly monopolized the flow of economic news. Beginning during a period of strong world macroeconomic growth and low inter-est rates, the crisis appears to have surprised financiers and regulators alike. The turbulence was triggered by a sudden and widespread loss of confidence in securi-tization and financial engineering and by the manifest failure of respected statisti-cal models for assessing and pricing credit risk. Most astonishingly, these now-doubtful techniques had previously been hailed as the cornerstones of modern risk management. The turbulence proved greatest in countries whose supervision of credit risk had been thought to be the best i