Quote:
Originally Posted by Rococo
I don't really see it that way, and I think that implicit government guarantees of bank solvency was only a minor factor in the financial crisis.
There have been financial meltdowns that were caused by participants knowingly taking on excessive risk. But I don't think this was really one of those situations.
Mortgage originators didn't think they were taking on excessive risk because they were originating mortgages that they knew they could sell into securitizations. The lenders weren't intending to hold the risk, and in most cases, they weren't holding the risk. Issuers of MBS didn't think they were taking on excessive risk because, again, they were holding mortgages on their balances sheets for only a short period. They weren't intending to hold the risk long-term (except for perhaps the residual), and in most cases, they weren't holding the risk long-term.
Purchasers of AAA securities didn't think they were taking on excessive risk. Sure, the spreads on AAA MBS were wider than any other AAA paper you could buy in 2006, but it was still AAA paper. Most purchasers ran internal models and concluded that it was virtually impossible to break the AAA tranche, even if there was a historic decline in housing prices, historic levels of defaults, and historic loss severity.
What most market participants failed to anticipate were the knock-on effects, in particular the total lock up of credit markets and the extreme illiquidity in the market. Holders of AAA MBS found themselves in a situation where they simply couldn't exit their positions without taking a huge loss, even though, in many cases, their long term models showed that the securities would probably be OK if held to maturity. (As an aside, they weren't necessarily wrong. There was an extended period when AAA MBS were trading lower than they probably should have been trading. If you had a lot of cash, and you gobbled up a lot of that stuff at the right time in 2008, you made a lot of money.) And holders of those MBS usually had to mark those securities to market at fire sale prices, which caused all sorts of turmoil.
Oh it wasn't about only guarantees on mortgages specifically.
It's about counterparty risk in the daily inter-bank settlement, and counterparty risk more generically.
Where there is no explicit/implicit state guarantee sophisticated dynamic models exist to ask for collateral from trading partners and whatnot. When hedge funds collapse (and they do) it's not systemic because counterparties to trade don't collapse in domino. When crypto collapses, same thing.
The financial meltdown wasn't because of mortgages default rates. It was because markets froze as LB being allowed to fail changed the rules of the game, as all participants thought that was impossible (otherwise they wouldn't have had naked counterparty exposure with opaque institutions upon which they didn't apply due diligence, collateral rules and so on).
"TBTF" institutional paper traded like tbills with micro spreads over that before. And it all traded the same. It was allowed as collateral on par with tbills or actual cash. And all of that was because of creditors feeling guaranteed by the state.
The mortgage aspect per se, with the failures of rating agencies, the repackaging and so on was problematic, but that alone would have been a mid-sized crisis.
When what you mentioned happened (necessity to liquidate at "firesale" prices and so on), markets froze because you had no way to assess what was what. If any counterparty can fail tomorrow with no state intervention, all the previously banal operations overnight to settle liquidty between institutions become risk management nightmares.
Even if you recoup your money in case of counterparty failure, it isn't necessarily there immediatly, you face liquidity risks at unprecedented scale.
The risk buildup at "systemic risk" threshold i previously mentioned repeatedly wasn't only "mortgage default risk" (although that was excessive for AIG and DB). It was in all counterparty risk including intraday not linked to MBS paper.
Back to why the FDIC, basically at the time it became (ex post) clear to institutions that the government had changed the implicit/explicit rules of the game (by allowing LB to fail) , and it LB had been a normal bank they would actually have saved it.
Look at what the possibly smartest operators at the time did: LB collapses september 15 2008, Goldman Sachs becomes a bank holding company september 21 lol.
https://www.goldmansachs.com/our-fir...ive%20position.
LOOK AT THIS
We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources,” stated Chairman and CEO Lloyd Blankfein. He noted that the move addressed
market perceptions that placed a premium on the value of oversight by the Federal Reserve Board and the ability to source Federal Deposit Insurance Corporation (FDIC)-insured bank deposit to increase funding capacity
, while also providing access to a broader set of liquidity and financing alternatives.
This is what i meant! the market just had previously generalized that to TBTF institutions even if not explicitly covered by the FDIC. LB is left dying, you have to get FDIC coverage to play the game as before (be trusted as counterparty without due diligence by other agents so your paper trades like t bills and so on and on)
