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Nervous laughter.
Sorry, I came of age during the 2007-2008 subprime mortgage crisis, I am overtly sensitive to the whole "Just give money to financially irresponsible people and hope that in the aggregate we make adequate returns to justify the risk" approach.
I'm sure SOME lessons were learned since then. Maybe not the right ones.
I'm sure it'll be fine.
The problem with the '07-08 crisis wasn't with the returns, it's that the loans were packaged into MBS and sold to investors under a false bill of health. The lessons weren't that you can't have high-risk/high-return assets, only that you must not try to pawn them off as low risk with fanciful assumptions. And that buyers of those collateralized debt must do more diligence.
The bill of health wasn't false. It's trivially easy to take a cdo prospectus and simulate what happens in the event of a catastrophic drop in house prices.
It's just that everyone - buyers, sellers, rates, regulators, all assumed that this was a very low probability event. Reality turned out to be worse than nightmare/worst case scenarios in various stress tests cooked up by regulators.
The sellers (who are often accused of fraud) kept the risky tranches on their books while selling the safe ones - the opposite of what one would do if they knew the risk.
No, they assumed it was uncorrelated and that you could lower risk by bundling large tranches of mortgages.
That works until there is a large correlated event that impacts all of them at once.
I don't think you quite understand what was done. The risk reduction comes from being in the senior tranches and taking losses last.
This happened. Folks owning the senior/low risk tranches lost the least, exactly as CDO sellers promised. (This is quite mechanical and unsurprising.) The stress tests at the time did not assume uncorrelated losses - that's dumb, even for a regulator.
CDO sellers who kept the junior tranches (I.e. first losses) went bankrupt. Why would they do that if they were selling the senior tranches with a false bill of health?
I agree that the tranch setup distributed risk as advertised. The problem was that much of market (including CDO sellers) believed in their models that used a gaussian copula, which vastly underestimated the tails as compared to a power law.
This wasn't "sellers pull a fast one on buyers" -- that's too simplistic a model. They got into the business because they convinced themselves of an overall model that didn't put enough weight on the tail risks. Then they kept the most junior tranches because of that belief in the low overall risk.
[ There's a related problem which is that gaussian models are extremely sensitive to parameter changes in ways that power laws aren't. When you get to the CDO-squared (a CDO of CDOs) then you the output of one model being fed as an input to another, with the expected impact to accuracy. ]
See, e.g., this excellent summary: https://www.hks.harvard.edu/sites/default/files/centers/mrcbg/files/Barnett-Hart_2009.pdf
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The issue was that they never really understood the level of systemic risk involved. The whole securitization scheme was based on the idea that, while high-risk mortgages might be too risky on an individual basis, in aggregate only a small percentage of them would default, and the riskiness led to higher interest rates. If you're assuming that a certain percentage of the mortgages are going to default over a given time period, you can price that in. They didn't forsee that there would be a foreclosure crisis that would lead to default rates grossly in excess of what was anticipated, and that this would cause a domino effect whereby the problem would keep getting worse.
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Yes and no. It was obvious from day 1 that those CDOs weren’t good as good. They were labeled AAA but had yields materially higher compared to other AAA. This was attractive for insurance companies who legally were required to have a percentage of assets in AAA. But the only reason why one AAA trades at a yield much higher than other AAA is that the first isn’t really AAA.
Bingo. Pennies are free in front of a steamroller stuff.
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