They fooled themselves into thinking that the risk had somehow been magicked away.
Well…….not quite. Obviously, Modern Portfolio Theory (which is statistically accurate) states that if I bundle enough qualifying loans with a nonprime, then the nonprime does not substantially alter the risk of the CDO. The math on that is pretty simple. To just pull numbers out of a hate for a moment If AAA = < .5% risk of default, and an AAA mortgage = .2% risk of default, and a nonprime has a default rate of about 4% (which is accurate, actually, pre-meltdown) then a CDO with 20 AAA and one nonprime mortgage will have a default rate of (20(.2)+4)/21, or .38%. Still AAA.
According to The Big Short, the CDO’s had, however, much worse ratios than 20/1 AAA to C. I know how to do the stats on that and STILL make them come out pretty highly rated (using a more complex formula than a simple weighting), but what Wall Street forgot (or didn’t care) was that nonprime mortgage failures are highly correlated with the unemployment rate.
IOW, they said “Hell, if 4% fail, which they will statistically, so what? The CDO survives. HOWEVER, if those failures start being caused by joblessness rather than simply irresponsibility of a nonprime buyer………….then they’re ALL going to fail AT ONCE. And they did.
Studying the meltdown in detail for a decade……leads me to the conclusion that very very few people were being dishonest or fraudulent. What they were all doing, however, was playing it slightly loose within their own bubble, and forgetting that their bubble was a part of an interlocking mechanism called “the housing market”, and when EVERYONE’s loosey behavior aggregated statistically, failure was actually *probable* if there was a Black Swan event.
My point is that if the lenders, with their armies of analysts, economists and mathematicians, grossly underestimated the risk, how can it be OK to blame the individual borrowers for (inevitably) having failed to appreciate it too?
Shrugs. I don’t. The slimiest people in the meltdown, in my view, was not the Wall Streeters, but the mortgage lenders who had to know that it was stark, raving madness to give a house and a note to a person who had no ability to pay for the actual, underlying cost of debt service, after all this ARM and balloon and refi nonsense was stripped away.
Of course, if Fannie and Freddie, the biggest players in the game by far, hadn’t signed on and abandoned their own lending standards that they had lived by for decades, the results of all this would have been much more muted.