Abolish Mortgage-Backed Securities (and Offspring)
CDOs and credit default swaps don't kill financial systems, mortgages kill financial systems.
There has been altogether too much opproprium directed at CDOs, credit
default swaps and other structuring techniques that spread financial
contagion, and not enough directed at the underlying collateral. The
record seems to be, however, that Dick Pratt was correct when he called
the mortgage "the neutron bomb of financial products."
Don't believe it? Ask the foremost
experts in credit derivatives, such as:
1) The inventors of credit default swaps and CDOs at JPMorgan: As Gillian Tett describes in Fool's Gold, while they truly believed in the CDO structure, they did not believe that the credit risk could be accurately measured on underlying mortgages. Other banks felt...differently, and this classic Felix Salmon post is the best synopsis of what happened.
2) The long-time heads of AIG Financial Products: no that was not a typo. For most of the history of AIG FP, they
absolutely refused to enter into any transactions, CDOs included, backed
by real estate. It is worth excerpting the following from Roddy Boyd's definitive Fatal Risk, referring to Joe Cassano's predecessor as head of AIG FP:
[A]nything mortgage related left [Tom Savage] cold. He took a literal view of the issue: any security backed by a house or building was verboten. His colleagues saw it as a quirk of his personality...It was anything but that. As a groundbreaking modeler in the mortgage departments at First Boston and Drexel, he had come to see that all of mortgage trading was just a way to make money until the next unanticipated blow up. Time after time, the same thing happened: rates changed and entire trading desks, whole fixed income divisions were blown out of the water because of one or two mortgage trading positions. Savage had a litany of reasons why: hedges -- if they were even available -- always underperformed because the securities were too leveraged to interest rates. In turn, brokers and hedge funds, trying to squeeze every last dime of profit out of a trade, used too much leverage in positioning the bonds, so when the market reversed, they were always forced to sell in a panic.
Savage saw his former specialty, modeling mortgages, as little more than folly. The models the bank touted assumed that rates would move in sequential, orderly patterns and that market prices would follow. The opposite happened, of course, with panic, greed and liquidity flowing into or out of the market at a second's notice. Somehow those inputs never seemed to make it into the models.
Similarly, the founder of AIG FP, Howard Sosin, refused to allow FP to invest in anything mortgage-related, believing that they would always be subject to risks they could neither analyze nor quantify.