At some level, there really isn’t anything wrong with pooling a geographically diverse bunch of mortgages and paying them off in tranches. It doesn’t eliminate any risks, but it does do something to manage them. You really can create bonds that are less likely to end up in default because some local plant closed, or there was a flood or other disaster. Pooling reduces the risk, but trancheing the payments concentrates that risk in lower tranches. And then re-pooling a bunch of those lower tranche bonds does almost NOTHING because the losses of those bonds is highly correlated Even the higher tranches created from them have similar loss profiles to the lower tranches. Either they all go bad, or none of them do, because they are all going to go bad if there is a national decline in RE prices. They are the opposite of fail safe By creating a system that will only fail with a national decline in RE prices and then lending ever more money out, at ever worse terms, to borrowers who have ever less probability of paying off the loans according to the terms, you ENSURE that there will be a national decline in RE prices.
The analogy that I use use is better, stickier tires. When you put them on passenger cars, they improve safety, because the limit on how fast you go is how willing you are to risk getting a speeding ticket. But when you put them on race cars, you do nothing to increase safety, because the limit of how fast the drivers are going is how fast a professional thinks they can go around the curves without getting in an accident. Instead of preventing accidents, you’ve just ensured that they happen at higher speeds.
