Over-leveraging, credit default swaps and collateralized debt obligations as causes Another probable cause of the crisis -- and a factor that unquestionably amplified its magnitude -- was widespread miscalculation by banks and investors of the level of risk inherent in the unregulated Collateralized debt obligation and Credit Default Swap markets. Under this theory, banks and investors systematized the risk by taking advantage of low interest rates to borrow tremendous sums of money that they could only pay back if the housing market continued to increase in value.
The risk was further systematized by the use of David X. Li's Gaussian copula model function to rapidly price Collateralized debt obligations based on the price of related Credit Default Swaps. This formula assumed that the price of Credit Default Swaps was correlated with and could predict the correct price of mortgage backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies. According to one wired.com article: "Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril...Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees."
The pricing model for CDOs clearly did not reflect the level of risk they introduced into the system. It has been estimated that the "from late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds...[o]ut of that pile, around $305bn of the CDOs are now in a formal state of default, with the...
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