tbh. If it wasn't CMOs it would have been something else.
The fundamental problem here is systematic risk, a bank should be able to fail without bring down other banks, unfortunately the system wasn't able to cope with the failure of a large number of banks who were all exposed to the same risk.
If a bunch of the big US car companies failed we may well have seen the same thing, because a lot of the US banks are heavily exposed to that sector. It just so happened it was mortgages that happened to be the tipping point this time.
Imagine your a bank and you have a bunch of other banks you deal with, you assign them all individually a "credit risk score" so you know how much extra to charge them to protect you against the risk of them failing before they have a chance to pay you what they owe you (much the same way as credit scores work for people).
But you have no-way of understanding the correlation between the risks, if all the banks your dealing with are actually exposed to the same underlying risk (i.e the CMO market) then the risk your exposed to is actually far higher than the sum of the individual risks. But obviously the banks you're dealing with can't tell you what their underlying risks are because that's propriety information, so all you have to go on is the risk rating given by ratings agencies.
This is a fundamentally hard problem to solve. No-one really has a good solution. It's much easier to say "let's ban CMOs" than to admit we don't really know how to solve the problem.
> The fundamental problem here is systematic risk, a bank should be able to fail without bring down other banks, unfortunately the system wasn't able to cope with the failure of a large number of banks who were all exposed to the same risk.
Note that some of the systemic risk was caused by regulation.
The US govt gave fannie and freddie stock special treatment when held by banks as part of their assets. As a result, banks overloaded on Fannie and Freddie. When Fannie and Freddie went down, that took a lot of banks into technical insolvency. (It didn't help that Fannie and Freddie lied about the loans in their portfolios, which threw off everyone's risk analysis of the market as a whole.)
Bond insurance was encouraged by regulators because it let banks and pension funds hold bonds as "safe" assets. (When you're pushing mortgages, you need to make them appear safe so more folks will buy them.)
The SEC gave a ratings monopoly to three ratings institutions. When they got it wrong....
Almost All of the systemic risk was caused by regulation. Too big to fail messed up with "the role of market discipline in financial markets" (3rd pillar of Basel II). Firms were even picking their own regulators (through loopholes) so they got the most lax ones. And so on.
I actually think that---since we cannot regulate for every contingency---then it's much better to avoid having too big to fail firms.
> then it's much better to avoid having too big to fail firms.
If a company that is, say 10x the size of Goldman Sachs, is "too big to fail" and therefore too big to allow to exist, what does that tell us about the US govt?
Company investment and banking accounts aren't protected by FDIC, so that alone could wipe out a lot of companies.
Credit would go from "hard" to "near-impossible". Investment banks finance all sorts of things you would never think about. For example the kitchen equipment in your local fast food chain (The pizza chain Dominos ended up buying the leasing arm of an investment bank which financed it's kitchens to ensure it's own stability).
Larger companies rely on their investment banks for all sorts of things, from FX to protecting against counter-party risk (i.e. providing insurance against your main customers or suppliers going bankrupt).
The fundamental problem here is systematic risk, a bank should be able to fail without bring down other banks, unfortunately the system wasn't able to cope with the failure of a large number of banks who were all exposed to the same risk.
If a bunch of the big US car companies failed we may well have seen the same thing, because a lot of the US banks are heavily exposed to that sector. It just so happened it was mortgages that happened to be the tipping point this time.
Imagine your a bank and you have a bunch of other banks you deal with, you assign them all individually a "credit risk score" so you know how much extra to charge them to protect you against the risk of them failing before they have a chance to pay you what they owe you (much the same way as credit scores work for people).
But you have no-way of understanding the correlation between the risks, if all the banks your dealing with are actually exposed to the same underlying risk (i.e the CMO market) then the risk your exposed to is actually far higher than the sum of the individual risks. But obviously the banks you're dealing with can't tell you what their underlying risks are because that's propriety information, so all you have to go on is the risk rating given by ratings agencies.
This is a fundamentally hard problem to solve. No-one really has a good solution. It's much easier to say "let's ban CMOs" than to admit we don't really know how to solve the problem.