"I see a multiplicative effect of misallocation and misperception of risk. "

Arnold Kling:

"He writes,

Tyler Cowen focuses on the misallocation of risk due to government induced moral hazard. My own view is that misallocation of risk did play a role, but I think risk misallocation due to market failures, i.e. the failure of regulation, was more important in generating the crisis than moral hazard brought about by implicit or explicit government guarantees. I also think the misperception of risk was important, perhaps even more important than the misallocation of risk (though these are sometimes hard to separate)

I tend to agree with Mark, at least as far as the mortgage/housing crisis is concerned. I see a multiplicative effect of misallocation and misperception of risk( WRONG ). The primary misallocation was due to institutional factors, especially bank capital regulations, that raised the demand for AAA and AA securities( THE RATINGS WERE FRAUD AND CONFLICT OF INTEREST ). The primary misperception was the view taken by rating agencies, and probably by the key sellers of credit default swaps, that house prices could never fall nationwide( NO ONE REALLY BELIEVED THAT. COME ON. ). These misperceptions allowed the creation of artificially highly-rated securities to meet the artificially high demand.( NO WAY )

A deep, Minsky-esque question is whether misperception of risk is inherently cyclical. It could be that, at certain points in history, an epidemic of bad judgment concerning risk is pretty much inevitable. When the epidemic occurs, it carries with it government regulators as well as private investors."

Let's go over the two view:
1) Misallocation Of Risk: This relies on a counterfactual argument claiming that regulators could have stopped this crisis from occuring. I have already said that this business of investing in investments with lower capital standards would simply have moved offshore, as much of it did. As for mortgages, it is conceivable that regulators or regulations could have stopped some of the more egregious ones, but that leads to the conclusion that this explanation is really a tautology. Now that we see what has gone wrong, if we had prevented those things from occurring, then this crisis wouldn't have happened. That has almost no explanatory power whatsoever. It is really an argument for more government based on the above mentioned tautology. There's no real reason to believe that regulators or regulations could have prevented this crisis in the real world we were dealing with.

On the other hand, Collusion and Fraud by regulators is an important cause of this crisis, as is Conflict Of Interest and Collusion and Fraud in the credit rating agencies.

2) Misperception of Risk: This one is amusing. There is nothing complicated in explaining how CDOs and CDSs work, or in explainig their risk. What's complicated is computing the risk of the individual investments. That takes skill and expertise. And yet, using only 2005 or earlier sources, in two hours on the internet, I discovered that:
A: These investments were based on lowering capital requirements, which is inherently risky.
B: The math models were of recent origin and of limited power and scope. They were inherently risky.
C: These investments were prone to calling runs.
This explanation beggars human belief. That I could discover these facts, and experts and millionaires could not, is truly a laugh.

Why people believe such explanations mystifies me.