Once upon a time...

Colleague Bob Driskill tells the story of the financial crisis without invoking bubbles. In particular, the relatively small subprime mortgage sector started a run on Investment Banks who were borrowing short (in commercial paper) and lending long (by buying Mortgage Backed Securities) because it exposed a flaw in the financial engineering. In particular, instead of re-working the defaulted mortgages, as would have been efficient, the lenders began fighting among themselves.

...higher-than-expected default rates led to "tranche warfare:" the mortgage servicers and the various tranche-holders had di¤erent incentives to preserve the overall value of the MBS in the face of higher-than-expected defaults. Furthermore, tax issues complicated any effort to get to Pareto improvements among the different tranche-holders. This seems a little like what happened with railroad bonds and bankruptcy in the late 1800’s: the early bond covenants seemed to be incomplete and poorly designed to stop liquidation of railroads that had value as an operating entity.