I am trying to understand this explanation by Professor of Finance Andrew Lo of the 2007-2008 subprime crisis:

Say we have two risky loans, P(default)=0.1 of USD 1000: SP1 and SP2.

An intermediate grant these loans and creates and sell two products:

Senior A safe tranche of 1000 USD that has dibs on SP1 and SP2: P(default)=0.01.

Junior A risky tranche of 1000 USD P(default)=0.19.

The probabilities above are if P(default) of SP1 and SP2 are uncorrelated.

The corresponding expected values/price is: senior: 990USD, junior: 810USD.

In the severe economic crisis caused by a real estate bubble the uncorrelated assumption was clearly wrong. Let us instead assume that P(default) of SP and SP2 were perfectly correlated:

Senior: P(default)=0.19 Junior: P(default)=0.19

The video does unfortunately not discuss how this could cause the subprime crisis. To me it seems that the problem here was that pension funds were exposed to way larger risk than what they expected when they bought Senior tranches?


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