You have identified the most significant part of the events and something which is not very well understood about the crisis. The number of subprime mortgages in existence was actually not large enough to topple the financial system, as Ginevra explains this was enabled by the creation of various classes of ABS. There are different views as to what occurred during the panic, the most convincing is that there was a run in the repo market caused by the hidden risks in structured products. Due to their structuring, the holders of these complex products could not ascertain their risk exposure and potential losses, so they were devalued in response to the defaults on the underlying assets. Their reduction in value caused fire sales and haircuts which amounted to a run on repo. This is what is referred to in the 'Game of Jenga' section of the publication:
'So what happens when even what is supposed to be the most secure investment in the system turns out to be worthless? Well panic ensues. In turn this means investors and creditors become wary and scared of the financial system and the product it sells.'
'No one knew what they were holding or who they could trust.'
To answer your question:
Banks rely heavily on the repo market to satisfy many of their funding mismatches. When that market became illiquid and the securities used to obtain funding (ABS) were devalued, the banks could no longer access capital and their maturity mismatches were exposed. Secondly, banks actually retained a number of structured products on their balance sheets and bore direct losses on the products. They used these products as collateral in the repo market to obtain cash, the structured assets were broadly used because the volume of repo transactions outweighed the supply of highly-rated government and corporate bonds. Third, the transfer of risk to off-balance sheet SPVs was incomplete and banks retained a high level of exposure to the risk of default. This is because a bank would, often implicitly, guarantee the losses of an SPV and make payments to investors in the case of default. If you are interested in becoming a structured finance lawyer, the transfer of this risk will be your top priority.
I have attached an essay which explains the shadow banking system and outlines its role in the crisis. If you look at the footnotes you will find some valuable insight into the issue. Gary Gorton's work, specifically 'The Panic of 2007' <
https://www.nber.org/papers/w14358.pdf> is seminal, but 93 pages long... I do not pretend to scratch the surface of that work.
Commercial awareness:
Last week the FT published an article about the downgrading of bonds underlying CLOs due to the current pandemic( Financial Times, 'CLOs: ground zero for the next stage of the financial crisis?' <
https://www.nber.org/papers/w14358.pdf>). The article itself is an interesting exposition of facts but is a bit lacking in analysis. If you wanted to discuss this issue, it simply isn't adequate to state that downgrading the CLOs will cause a crisis. You must question which parties are heavily invested in these CLOs and what they use these assets for. In 07 these products were widespread in the repo market, causing it to freeze when they were downgraded which arguably set off the whole crisis. What could happen next? If the insurance companies holding 40% of all triple B tranches in the US face downgrades and defaults on their CLOs, would that expose a funding mismatch? If CLOs are downgraded en masse will the investors in these CLOs be downgraded too? Who is invested in these insurance companies, and how are they rated? How is the Fed's role in buying corporate credit supporting CLO prices?
I do not have the answers to these questions. It seems to me the best starting point should be to explain what a CLO is and why the economic sudden stop has caused some underlying corporate debt to be downgraded. One could then move to discuss the effect of the downgrade of underlying debt on the rating of different CLO tranches, also the impact on the originator (often required to retain an exposure to the assets known as 'skin in the game') and the current investor. When discussing the downgrades, the role of central banks in supporting credit markets should not be neglected. Then explain how these products were used in wholesale funding markets. After that, you could discuss the questions posed above or others you have identified. At this final stage, we are dealing with hypotheticals.
I hope this is a helpful explanation and provides you with a starting point to read up on if it is something that interests you. It is not a topic which is easily simplified, although perhaps a more knowledgeable person could. As with any other topic, I would not bring this up in discussion/interview unless it is something you are particularly interested in. However, understanding the securitisation process should be quite impressive to any structuring lawyer. On a final note, it should be clarified that all of this explanation fits within the 'A Game of Jenga' section of Ginevra's work. Specifically, where she refers to 'panic'. Hers is a much broader and comprehensive view of the whole crisis.
