How investor expectations move markets and the economyThe collapse of Lehman Brothers in September 2008 caught markets and regulators by surprise. Although the government rushed to rescue other financial institutions from a similar fate after Lehman, it could not prevent the deepest recession in...

We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash...