Dividing things into different senior/junior tranches or grouping together things to reduce uncorrelated risks is not a recent innovation. It’s been important to finance for a long time. I don’t think this has much to do with CDOs.
Still, CDOs are the most recent example where they went wrong on a very large scale, enough to wreck the USA's real estate market in 2008... and then topple down a lot of banks as well.
To be clear, the great majority of investment bank losses in 2008/2009 did not come from CDOs and even CDO^2s ("CDO squared"). It came from CDS on ABS/CDO. Roughly, you could get long/short on an ABS/CDO/whatever bond that you didn't own. It's like selling fire insurance on your neighbor's home. By itself, not as crazy as it sounds in the financial derivatives landscape, but the underlying collateral were a pile of garbage. There was (and still is) already a huge and healthy CDS on corporate names market, so it seemed reasonable at the time to expand the CDS product. Unfortunately, once the fraud with underlying loans started to unravel, the losses became so large that many CDS counterparties went bankrupt, so the whole thing backed up the investment banks themselves. (See: Fed/Treasury bailouts / bank firesales!) To me: CDOs and CDS on ABS/CDO is just the tip of the fraud iceberg.
2008 was caused by systemic risk. And geniuses in the banks failed to see it. So I guess, I fail to see why I should believe some $RANDOM_INTERNET_COMMENTER could figure out if an asset class has systemic risk.
Apply Lenin's maxim... the banks made it through 2008; in fact Lehmans were really shocked that they got thrown under the bus. The miscalculation was that the authorities would act irrationally in the crisis and let a broker dealer go under. All the banks had tested this with LTCM and were confident that they would get bailed and could collect on both sides. They were mostly right. The lesson for me is that authorities need to act a bit like an old testament god. Some random smiting would change market behaviour significantly, and for the good.
The argument there was that LTCM was "too big to fail". Really they probably weren't, but they had 1.25T derivative positions off-book apparently.
Love or hate Paul Krugman, he argued that TARP could have been better put to use as a social safety net. The banks who took the risky investments can burn to the ground, but the citizens could be just fine.
I think it's like doctors arguing about what skin cream to use to treat smallpox. The requirement is to prevent market participants from being able to act like this, and the way to do that is to make the people who trade with them face nasty penalties like sudden liquidation of their businesses. That mechanism would make counterparties very careful about other people's business models.
I'm kinda more of a 'provide regulations and let the courts settle this out with the shareholders' kinda guy.
Also a true free market allows trading strategies that let you bet against something. Yes, they're abused, but in many cases they provide the best form of market regulation.
Two obvious reasons - 1) the market cap of all cryptocurrencies (prior to the ongoing crash) was only around $2-3T. And 2) there’s relatively little leverage in cryptocurrency at this point (compared to Wall St prior to GFC).
Tiny market cap + comparatively low leverage = no systemic risk in the same league as the banking system leading up to the GFC.
This is not so difficult to see or understand that you need some authority to claim it to believe it. $RANDOM_INTERNET_COMMENTER is sufficient. Easily verifiable.
There’s also actual empirical evidence - Bitcoin has lost 50%+ of its value five times now (counting the most recent crash), a massive loss. But it doesn’t collapse the entire global economy and require trillions in govt and Fed bailouts to prevent the end of civilization. Even in this current crash with stablecoins like UST failing, it won’t collapse the entire economy or require bailouts.
Whatever systemic risk there is in cryptocurrency right now is not remotely in the same league as in the banking system.
Thanks for replying back. I'm not saying your stupid, because you're most likely not. What I am saying is that a lot of smart people were misled during 2007/2008. And most likely $RANDOM_INTERNET_COMMENTER is not hired by wall street -- not on this board anyway. And even if you were, you probably missed signs anyway as you drank the wall street "everything is turning up Milhouse" kool-aid.
What I find interesting is that the volume you're talking about is in that anal pucker range for systemic risk. $US1.6T of CDO's were issued between 2004 and 2007 [1]. That's still less than the number you're talking about.
There was ~$1.6T of CDOs, plus some amount of separate MBS’s that weren’t re-securitized into CDOs, and over $30T of CDS’s, and the main Wall St. banks were over-leveraged up to 33:1, and Fannie and Freddie were over-leveraged by around 100:1. Between the banks and Fannie/Freddie, there was about $9T in over-leveraged debt with insufficient equity or collateral, almost half the US GDP at the time.
The conditions back then dwarf the current crypto market. But I am worried the crypto market is doing its best to not learn anything and to repeat those same mistakes anyway.
And I actually got lucky and in late 2006, as I was getting interested in investing for the first time, discovered an online community of forensic accountants piecing together from public filings what was happening with all the house flipping.
Shortly before I found them they had concluded it was a massive unsustainable bubble forming, which would inevitably end in collapse. Their research and evidence convinced me and formed my worldview before I even had a chance to drink the Wall St koolaid. All credit to them though, I just got lucky in discovering them.
