UNKNOWN CONTENTS ON UNSPECIFIED WAGONS. I have appealed to a maxim of Gen^l Sherman to the effect that no army dependent on wagons can operate more than 200 miles from its base because the teams in coming and going consume the contents of the wagons (I say "to the effect" because a quick online search turns up no exact quote: corrections or references are welcome in the Suggestion Box) as a quick way of explaining the arbitrary nature of the various buyouts and bailouts of financial institutions, particularly those of institutions heavily invested in subprime mortgages and securities backed by subprime mortgages. I have interpreted those bailouts as being motivated by speed: by the time the accountants and the lawyers have picked the various rotting carcasses of the underlying mortgages and the securities derived therefrom, there will be very little left to make the initial lenders whole or to clear the names of the responsible borrowers.

Now comes Yale's Gary Gorton, with his working paper, "The Panic of 2007", (91 page .pdf) and a money quote that Marginal Revolution's Tyler Cowen expands on.

What is the loss of information? The information problem is that the location and extent of the (2006 and 2007 Q1-2 vintage) subprime risk is unknown to anyone. It is very hard to determine the location of the risk, partly because of the chain of interlinked securities, which does not allow the final resting place of the risk to be determined. But also, because of derivatives it is even harder: negative basis trades moved [collateralized debt obligations] risk and credit derivatives created additional long exposure to subprime mortgages.

I downloaded the paper and attempted to work through it this afternoon, while I was administering an examination. Those chains of interlinked securities involve the layering of various kinds of subprime mortgages, some of which the rating services evaluated as investment grade, others of which earned more speculative ratings, and all of which were re-evaluated downward as house prices started falling and the incentive for the borrower to walk away got stronger.

The paper will reward careful study. The Marginal Revolution team have been following the financial situation carefully. If you're following the major macroeconomic event that has been unfolding before our eyes, it's worth your time to visit them each day.