Really great links - Financial innovation and instability - Synthetic CDOs - Detecting bubbles - Greece

Nicola Gennaioli, Andrei Shleifer, and Robert Vishny - Financial Innovation and Financial Fragility - (H/T Salmon) - "We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second (less crucially), investors demand securities with safe cash flows. In the model, security issuance is excessive, and financial markets become extremely fragile. As the previously unattended to risks are recognized, investors fly to safety and the excessive volume of innovation accelerates this flight. Financial innovation can make both investors and intermediaries worse off, and lead to instability even without leverage or fire sales. The model mimics several facts from recent historical experiences, and points to new avenues for possible financial reform."

Felix Salmon - The silver lining to synthetic CDOs - "Think about it this way: both CDOs and synthetic CDOs resulted in losses for investors on the long side. But In the world of CDOs, demand for paper ended up creating a disastrous building boom which diverted resources from more productive activity, skewed local tax revenues, and created the precondition for the wave of foreclosures which is likely to continue for the foreseeable future.
In the world of synthetic CDOs, by contrast, demand for paper just ended up making a bunch of shorts extremely rich: all the other real-world repercussions of the CDO market were actually avoided.
I’m not saying that the world of synthetic CDOs was a good thing. In fact, I’ve explained why I think that it was harmful. But the point that investors started moving from CDOs to synthetic CDOs marked the point at which the housing bubble stopped growing: the move played a significant role in ending the real-world housing insanity. If banks could create synthetic CDOs out of thin air, they no longer needed to encourage subprime originators in the Inland Empire to give $600,000 mortgages to itinerant strawberry pickers, just to keep their channels full."

Edward Chancellor - Detecting bubbles - "And bear in mind Mr Odlyzko’s wise advice. You don’t need any special skills or complicated models to detect a bubble. All that is required is “common sense, an ability to do simple arithmetic, and knowledge of a few basic facts about the economy”."

Baseline Scenario - Greece saved for now - is Portugal next? - "The Greek government, helped by the market threat of a near term collapse, appear to have strong armed the other eurozone countries into a generous package without making efforts to change seriously their (Greek) fiscal policy. This is good for near term calm, but it does not solve any of the inherent problems now manifest in the eurozone.
Often assistance packages of this nature just help “smart money” to get out ahead of a default. This could be the case here; 40-45 billion euros total money could last roughly one year. Both Russia and Argentina got large packages in the late 1990s but never regained access to private markets, so eventually everything fell apart.
Sunday’s package should make it possible for Greece to borrow short-term but it takes courage to lend for 5 or 10 years to the Greeks unless there is much more fundamental change."