Minsky’s Cushions of Safety: Systemic Risk and the Crisis in the U.S. Subprime Mortgage Market

Abstract

As financial instability has once again come to the forefront of the world economy, the financial press has often pointed to Minsky’s financial fragility hypothesis to clarify the causes of the current crisis. However, while many elements of Minsky’s vision are indeed of relevance to the United States’ financial crisis, a principle component of his hypothesis, the declining margin, or cushion of safety in financial transactions, has is in fact manifested itself in a different fashion than that proposed by Minsky. Under the traditional banking system, Minsky’s analysis states that in conditions of expansion, optimistic expectations of the ability to meet future obligations cause banks to lower margins of security. However, operating under the “originate and distribute” model of recent years, processes of credit evaluation were transferred from banks to ratings agencies. These too lowered their cushions of safety, not because of positive credit performances over time, but rather due to the mispricing of risk ingrained in the originate and distribute model. As such, while the current crisis has all the attributes of a Ponzi financing scheme and threatens to turn into a fullscale debt deflation, it is not the result of a traditional endogenous Minsky process in which narrowing margins of safety lead to fragility.