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  • Thumbnail for Systematic risk through the 2007 financial crisis: increasing leverage in the subprime mortgage market and rating agencies' ignorance of default correlation
    Systematic risk through the 2007 financial crisis: increasing leverage in the subprime mortgage market and rating agencies' ignorance of default correlation by Athey-Lloyd, William

    Homes are a permanent fixture in the “American Dream”, representing security, wealth, and social placement. However, the growing number of subprime mortgages that were granted over the past decade has been blamed for the financial crash of 2007 from which we are still recovering. These subprime mortgages carried too much “systematic risk”. I define systematic risk herein as the risk of collapse of an entire financial system or an entire market due to an external factor such as falling house prices or a failing economy. After the financial crash, the packaging of these mortgages into collateral debt obligations (CDOs) has received intense scrutiny. Only after housing prices started deteriorating did the rating agencies that rated these CDOs issue substantial downgrades to securities that, even a year before, they had rated as safe as government-issued bonds. Could a crisis this severe have been the result of the sheer size of the subprime market? Did rating agencies not see a decline coming? I will address these questions, and make my case that within the last twelve years, increasing leverage within the subprime mortgage market had the most substantial impact on increasing systematic risk. This will include a comparison of my research to the revised 2009 Moody’s rating agency model that accounts for increased levels of correlation in its ratings.