Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

CHAPTER 5

The Systemic Disaster of 2007–2008

5.1 OVERVIEW

There can be little question that the global financial disaster of 2007–2008 stemmed fundamentally from events in the market for collateralized debt obligations (CDOs) backed by subprime mortgages. Firms that failed or needed government rescue either had large losses in these CDOs or else got caught up in events triggered by the difficulties of firms that did have large losses on these CDOs. In examining the crisis, this chapter therefore begins with a section (5.2) focusing on CDOs backed by subprime mortgages. Section 5.3 looks at how this crisis then spread from the institutions with heavy losses in the CDO market to other institutions—by contagion through credit exposure and by contagion through impact on markets. Then, Sections 5.4 and 5.5 examine lessons from the crisis for, respectively, risk managers and government regulators. Section 5.6 takes a brief look at lessons from the crisis that go beyond the scope of risk managers and government regulators.

Just to attempt to clear up one confusing bit of nomenclature at the beginning—CDOs on subprime mortgages were termed asset-backed securities (ABSs), so what were called ABS CDOs were actually CDO-squared products (see Section 13.4.2 for explanation of a CDO-squared). In fact, as documented in Cordell, Huang, and Williams (2012), a very substantial portion of subprime mortgage securities were CDO-squared products. But since the economic and analytic characteristics ...