Just as the core theory of equity indexing was that diversification could substitute for exhaustive ( and perhaps unreliable) analysis of the underlying companies, the core theory of structured finance was that by combining large piles of individual credits into tradable securities, the packager would eliminate the need for a great deal of expensive and imprecise valuation of individual credits. Once again, thanks to the magic of diversification, a few highly formalized (i.e., information-impoverished) metrics substituted for actually knowing which mortgages one was buying.
The essence of modern investment theory is to ascend to a level of abstraction that makes fallible individual judgment irrelevant. Unfortunately, in the course of rendering such judgments irrelevant, one may also make them impossible. Climbing the ladder of abstraction, one inevitably sheds a heavy burden of information. At 30,000 feet, every security on the ground looks like every other. In 2007, as in 1987, just when it was most urgent to sort the good from the bad, it would become practically impossible for most investors to do so.
From Panic- The Betrayal of Capitalism by Wall Street and Washington by Andrew Redleaf and Richard Vigilante
Investment theories were driven by models which by definition excluded extraneous variables. By relying on an extreme form of diversification, and insurance products to virtually eliminate risk there was no need for analysis and judgment. Panic ensued because the very information excluded from the models now showed them what they did not know , but it now even more unfortunately did not show them what they did know. In the absence of the analysts which they no longer needed they had no idea how to value the assets. Every major firm used the same models of diversification and thus ironically became less systematically diversified. When the “fat tail” violently displayed the extraneous variables omitted from the model, the destruction was system wide.