Without the mortgage/real estate meltdown in the U.S. and abroad, there wouldn't be a CDS problem now. The house of cards would still be intact. BSC and LEH would still be in business and life would go on. CDS problem became the elephant in the room because equity on balance sheets evaporated.
You are failing to understand what makes a system unstable. Imagine the following two systems: 1) A man with a balance pole walking on a tightrope 20 feet above the ground and 2) A man without any balance pole walking along a 3-ft wide sidewalk. Both are carrying a monkey on their back, and the monkey wiggles around and causes problems such as yanking their hair, biting, them, etc. The goal for both men is to walk 100ft on their respective "path". Both men have a hat on the ground in front of a crowd of onlookers who toss coins as they choose.
Each system has a set of equations which defines the system dynamics. The equations for the guy with a balance beam on a tightrope are much different than for the guy with his feet on a 3-ft wide sidewalk. These equations are 100% based on the system configuration, nothing else (assume the guys are identical and part of the system). It should be obvious that one system has a much greater stability problem than the other.
The systems also have very difference consequences of a failure. The tightrope chap is likely to be badly injured if he falls, while the other guy is not. Again, this is a direct consequence of the system configuration, nothing else.
Both systems have an identical source of perturbation: The monkey. It does not matter if you want to call this internal or external to the system. I thought of using gusty wind conditions as the source, which would have looked more external, but internal or external does not matter. The point is, the source has the same dynamics for both systems.
The systems will also likely have unequal reward for success. The crowd would most likely throw a good deal more $ to the tightrope guy than to the sidewalk one.
You could call housing the monkey. The tightrope is financial innovation, the distance to the ground is leverage. The differential reward is the higher return for higher risk. But you should not confuse the monkey's behaviour with how the system responds. How the system responds to being bitten on the ass is 100% due to the systems dynamics, nothing else. |
