By now it was clear even to [FedResv Chairman] Bernanke that he had failed to gauge the severity of the situation. As late as June 5, he had declared in a speech that "at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system." The housing problems, he had thought, was limited to the increase in subprime loans to borrowers with poor credit. Although the subprime market had mushroomed to $2 trillion, it was still just a fraction of the overall $14 trillion U.S. mortgage market
But that analysis did not take into account a number of other critical factors, such as the fact that the link between the housing market and the financial system was further complicated by the growing use of exotic derivatives. Securities whose income and value came from a pool of residential mortgages were being amalgamated, sliced up, and reconfigured again, and soon became the underpinnings of new investment products marketed as collateralized debt obligations (CDOs).
The way that firms like a JP Morgan or a Lehman Brothers now operated bore little resemblance to the way banks had traditionally done business. No longer would a bank simply make a loan and keep it on its books. Now lending was about origination - establishing the first link in a chain of securitization that spread risk of the loan among dozens if not hundreds and thousands of parties. Although securitization supposedly reduced risk and increased liquidity, what it meant in reality was that many insitutitions and investors were now interconnected, for better or for worse. A municiple pension fund in Norway might have subprime mortgages from California in its portfolio and not even realize it. Making matters worse, many financial firms had borrowed heavily against these securities, using what is known as leverage to amplify their returns. This only increased the pain when they began to lose value.
Regulators around the world were having trouble understanding how the pieces all fit together. [Alan] Greenspan would later admit that even he hadn't compreheneded exactly what was happening. "I've got some fairly heavy background in mathematics," he state [in 2005] after he stepped down from the Fed. "But some of the complexities of some of the instruments that were going into CDOs bewilders me. I didn't understand what they were doing or how they actually go the types of returns out of the mezzanines and the various traches of the CDO that they did. And i figured if I didn't understand it and I had access to a couple hundred PhDs, how the rest of the world is going to understand it sort of bewildered me".
He was not alone. Even the CEOs of the firms that sold these products had no better comprehension of it all.