about the recombined lower boston fed researchers note some examples of contrary analysis of subprime abs structures written in 2005 suggesting vulnerability to even a 5 percent fall in house prices. see “ making sense of the subprime crisis ” by paul willen with kristopher s. gerardi, andreas lehnert and shane sherlund ( brookings papers on economic activity, fall 2008 ). bis central bankers ’ speeches tranches of mortgage - backed securities that were billed as triple - a rated collateralized debt obligations ( cdos ). 3 but many investors focused not on the security ’ s underlying components, merely on the ratings. figure 8 shows that triple - a securities remained at par values as the securitization boom gathered steam. however, figure 9 shows that when the severity of the decline in house prices manifested itself, even the triple - a rated mortgage securities collapsed in value. the combination of illiquidity, growing concerns with the real estate market, and ebbing confidence in the ratings resulted in dramatic declines in the pricing of triple - a securities as the financial crisis worsened. 4 myth 3 – the “ originate to distribute ” model limited the balance - sheet risk of banks over the decade preceding the crisis, large commercial and investment banks had become increasingly involved in securitizing mortgage assets. they argued that this provided a steady stream of fee income but generated little risk for the bank. while they packaged mortgages, they were not retaining the risk in their own portfolio – instead, the risk was taken by those that purchased the mortgage securities, particularly the lower - rated mortgage securities. what was frequently ignored by many was the rapid growth of triple - a mortgage securities holdings elsewhere within the banks, as well as in off balance sheet structures. while these off balance sheet structures were considered separate entities, banks found the potential reputational risk of not supporting their sponsored off balance sheet risk sufficiently great that many ended up supporting these off balance sheet structures. in a sense, “ originate to distribute ” was, in practice, something more like “ originate to hold, loosely, somewhat off to the side. ” 5 in addition, risk managers, bank management, and regulators were sufficiently lulled by myths 1 and 2 to develop their faith in myth 3. the unfortunate result was that these banks were not as protected from falling housing prices as many had assumed, and this contributed to the substantial decline in stock prices and the need for government support for many of these large financial intermediaries

eric s rosengren : the role of “ financial myths ” in financial crises remarks by mr eric s rosengren, president and chief executive officer of the federal reserve bank of boston, at the boston university conference on “ the state of financial reform ” ( panel on lessons learned from the global financial meltdown ), boston, massachusetts, 28 february 2011. * * * good morning. i ’ d like to thank boston university and all the conference organizers, particularly larry kotlikoff, for the opportunity to be here to discuss lessons learned from the global financial meltdown. 1 everyone knows that the past three years have been a particularly difficult period for global financial market stability and for the global economy. the financial crisis clearly showed the dramatic impact that financial problems can have on the real economy. and in spite of a fair amount of focus on financial stability prior to the crisis, events highlighted that the private and public sectors both here and abroad were not fully prepared for the kinds of financial shocks we experienced. today i ’ d like to discuss the role of what i call “ financial myths ” in creating financial crises. by financial myths i mean the beliefs, held by most market participants and by regulators, that certain outcomes are so unlikely to occur that they can basically be ignored – essentially that low probability events, based on historical experience, can be reclassified as zero probability events. when these sorts of widespread assumptions – these financial myths – turn out to be wrong, most financial - market participants find themselves poorly positioned for the resulting shocks. the result is insolvency of groups of firms and substantial uncertainty – uncertainty about the exposure of many firms to direct losses, or to indirect losses created by their counterparty exposure to other firms that suffer direct losses. these so - called financial myths are not unique to this time period, or to this country. i would like to briefly mention two among the numerous examples from recent history – examples where financial myths were important in helping to create a potential crisis. the first example involves the assumption of many in japan that real estate prices could not fall in the late 1980s. the second involves the assumption, in the late 1990s, that the internet had completely changed how we should think about company valuation. i will then briefly mention four financial myths that played critical roles in the recent financial crisis. these include the following assumptions : that a diversified portfolio of us real estate had little risk of falling in value ; that triple - a rated securities based on mortgages were so well protected by the structure