1 answer

Banks and rating agencies seemed to believe that large amounts of risk would disappear when many...

Question:

Banks and rating agencies seemed to believe that large amounts of risk would disappear when many risky loans were pooled together in collateralized debt obligations (CDOs). By 2006-2007 the error in this thinking became clear. What was the error and do you think it was intentional?

In his 2008 testimony to Congress former Fed Chairman Alan Greenspan admitted that he “found a flaw” in his ideology. What was his ideology and the flaw he identified?


Answers

Banks and rating agencies seemed to believe that large amounts of risk would disappear when many risky loans were pooled together in collateralized debt obligations as they pooled various substandard mortgages together and assigned good credit ratings to them as they thought the these securities were backed by mortgages and the chances of default on them is very low. This thinking got a shocking reaction as the entire real estate sector collapsed and the value of mortgage was taking huge cuts.I think this error was intentional as they knew that they were pooling bad assets together and trying to sugarcoat by presenting a good rating to it.

In his 2008 testimony to Congress former Fed Chairman Alan Greenspan admitted that he “found a flaw” in his ideology as his ideology was Free market Ideology and it was flawed .He had earlier advocated that there should always be a free market and there should not be any kind of intervention from government or any external agencies.He later identified that in a free market , Financial institution can involve in malpractices that can cripple the entire economy so government needs to regulate them.

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