On the surface, the meltdown of the U.S. subprime mortgage market should not have triggered a worldwide financial crisis. Worst-case estimates put subprime mortgage losses at $250 billion—a drop in the bucket compared to the many trillions of dollars worth of financial instruments traded around the globe.

What’s more, savvy investors knew there would be some defaults; after all, subprime mortgages, by definition, go to high-risk borrowers.

So how did things become such a mess?

New research from Arvind Krishnamurthy, the Harold Stuart Professor of Finance at the Kellogg School of Management, argues that the rapid adoption of financial innovations—in this case, subprime mortgage-backed securities—set the stage for crisis.

His report with coauthor Ricardo J. Caballero, the Ford International Professor of Economics at the Massachusetts Institute of Technology, found that when popular new financial instruments behave unexpectedly, investors flee the market. The liquidity supply tightens, making it hard for market participants to get the capital they need.

The consequences can be far-reaching, as the current crisis shows.

Their study in the Journal of Finance has implications for regulatory reform. It suggests that regulators worried about systemic risk should limit the proliferation of new financial products until investors have enough experience with them to understand how they work.

“We should worry about the new stuff that becomes big stuff,” Krishnamurthy said.

Three Crises in Liquidity

The study looked at three of the deepest liquidity crises of the last forty years.

The first was the 1970 default by the Penn Central Railroad on $82 million of prime-rated commercial paper, a relatively new product at the time. The default cast doubt on the entire commercial paper market, and investors retreated. The specter of a potentially damaging liquidity crunch loomed—but the Federal Reserve stepped in and instructed banks to make corporate loans until investors in the commercial paper market sorted things out.

The second case involved the stock market crash on October 19, 1987, which was widely blamed on an innovation called portfolio insurance—a form of computerized hedging that triggered automatic stock sales as the market declined. On that day, computerized sales in a sinking market touched off a full-scale rout, an outcome no one expected. As in the Penn Central case, investors fled to safety and stockpiled Treasury bills. The Federal Reserve averted a liquidity crisis by ensuring that commercial banks made necessary funds available to Wall Street.

The final case focused on the collapse of Long Term Capital Management (LTCM), a giant hedge fund that used a complex strategy to profit from small movements in security prices. The Russian bond default in fall 1998 unexpectedly caused the prices of securities issued by countries around the globe to move in the same direction—triggering multibillion-dollar losses at LTCM. Fearing those losses would ripple through the financial system, the Federal Reserve organized a bailout of the hedge fund.

Valuable Lessons

Krishnamurthy’s analysis offers two valuable insights.

First, investors learned from the painful liquidity crises and improved their methods of handling risk. They acquired a better understanding of how financial innovations behaved, knowledge that protected the financial system during later, similar events. Thus the 1997 Mercury Financing commercial paper default, the October 13, 1989, stock market drop, and the 2006 collapse of the Amaranth hedge fund caused little liquidity disruption.

Second, all three crises highlight the importance of swift action by the Federal Reserve. “The central bank’s role as lender of last resort is critical,” Krishnamurthy said. “In an uncertainty-driven crisis, the lender of last resort’s commitment acts as a backstop for markets. The central bank provides ‘certainty,’ and gives investors time to sort things out.”

Fast-forward to summer 2007. When subprime mortgages started defaulting, investors reacted as they had in the three previous cases. Unable to determine what their subprime investments were worth, investors stampeded from that market as fast as they could while trying to figure out what went wrong.

Investors acted to insulate themselves from what economists call “Knightian uncertainty,” a concept used to describe risks that are unknowable or immeasurable. It is impossible to accurately price securities carrying this sort of risk.

Even so, the financial system would have withstood subprime mortgage tumult if investor uncertainty had been confined to that sector. But investors panicked and retreated from other structured, asset-backed instruments, such as those secured by auto loans or credit cards.

“They didn’t understand how any of this stuff should be priced and they backed away from all of it,” Krishnamurthy observed. Credit markets froze.

Krishnamurthy compared the situation to the children’s game of musical chairs. “Children know that one of them will be left without a seat when the music stops. But suppose the children became confused or uncertain about the rules. The game changes. Some children may grab chairs. Others may refuse to play.”

Similarly, in a credit crisis some financial players, uncertain of the rules, hoard liquidity. Others stay out of the market entirely. The result is chaos.

Application to Today’s Crisis

The current credit crisis is more complex than those Krishnamurthy studied previously. The collapse of the real estate market and trouble in the commercial banking sector complicate any resolution.

Still, inconsistent actions on the part of government regulators—the decision to bail out Bear Stearns but not Lehman Brothers, for example—contributed to the uncertainty in the markets.

“Authorities were slow to recognize the scale of the crisis and never laid out what they would do if things got worse,” he said.

Krishnamurthy is confident, however, that financial markets will recover in time. Innovation is critical to economic growth and should not be stopped. But, as past liquidity crises have shown, innovation needs to be managed.

The systemic risk regulator proposed by the government should use its authority to limit the proliferation of risky new financial instruments. It could do so by requiring that banks maintain greater capital reserves for new financial products.

“If an asset is a huge part of the world portfolio and it blows up, you have a problem,” Krishnamurthy said. “So it makes sense to limit the economy’s exposure.”