Greenspan Could Have Prevented the Current Financial Meltdown

[samclem]

It was the collateralized mortgage debt that was so improperly rated. Right?

Audrey

I don't think the "regular" corporate bonds were immune either. Should GE bonds really have been AAA in early Mar 2009?

 

[Gone4Good]

I don't think the "regular" corporate bonds were immune either. Should GE bonds really have been AAA in early Mar 2009?

The agencies' track records on corporate bonds are actually quite good. Sure we can pick out some major misses, like Enron. But over the past 100 years default studies show pretty consistently that Aaa corporate bonds default less than Aa's which default less than A's, etc. What this proves is that credit analysis works and that the rating agencies actually know how to evaluate corporate credit. That's not to say that every rating is correct. But on average they are pretty accurate.

But remember, that credit analysis is built upon years of cumulative experience regarding how much leverage specific industries have historically been able to support. When that history is robust, as is the case with most corporates, the analysis is good and so, probably, are the ratings (on average).

Where the rating agencies fall down, typically, is when they are asked to rate something new. It's pretty difficult to look at a financial product that has never existed before and grade how likely it is to default. The rating agencies have proven absolutely horrible at doing this.

 

[serie1926]

Couple of thoughts:

Put your faith in man or money and you will always be disappointed.

The current financial situation was/is caused by the same feeding at the trough mentality that is killing our society. Doesn’t matter if you're talking about food, finances, etc...

My $.02 worth

 

[Independent]

Yes.

The "beauty" of derivatives is that they are not bound by any physical constraint. In order to create a Residential Mortgage Backed Security (RMBS) I need a pool of residential mortgages. So the size of the RMBS market is constrained by the size of the mortgage market. But once I have one RMBS security outstanding I can create as many "synthetic" RMBS securities as the market will bear, all of which use the same pool of assets as a reference point (and perversely enough, the "raw material" for the synthetic RMBS are the other side of CDS contracts from people who want to bet against the original RMBS. Neat huh?)

These synthetic transactions have the effect of magnifying the loss potential of a single default. So while in the real world, only the actual lenders lose money when a mortgage defaults, in the synthetic world all of those who own securities referencing that mortgage can lose too. So $1 lent can yield more than $1 in loses. Of course in the synthetic world someone else stands on the other side as a winner so gains and losses even out in aggregate . . . that is, of course, as long as the losing party stays solvent. Oops.

And there you have a recipe for cascading bankruptcy as defaulting "losers" wipe out the assets of the "winners".

Thanks for the entire series of responses. I'm just getting caught up today.

I'm also trying to think this through more, but right now it seems like a simple bet on whether a mortgage neither bettor owns will pay on time.

I've had a business need for interest rate swaps, but we were hedging a real risk we already had, so we were reducing our total volatility.

I have trouble seeing a hedging purpose for both sides of this mortgage default swap. Is there one? Or is one side always assuming increased total volatility?