Dissecting the Global Financial Crisis: A Case in Risk Management

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Dissecting the Global Financial Crisis A Case in
Risk Management

• 21 May 2009
• Felixberto Bustos Jr., DBA, CFA, FRM

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Nobel Laureates Take

• Edmund Phelps (2006)
• Crisis caused by overvaluation of assets and
  financial instruments
• Banks exported the crisis to the rest of the
  world through the financial instruments
• But more regulation of the entire financial
  industry is not the key innovative financing by
  angel investors and venture capitalists should
  not be constrained

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Nobel Laureates Take

• Robert Lucas (1995)
• Issue on subprime is ancient history
• Focus now on providing cash reserves
• We need a competitive banking system with
  government-insured deposits
• But in the future, assets of the banks must be
  tightly regulated

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Nobel Laureates Take

• Reinhard Selten (1994)
• Regulation of the financial market is important
• Markets do not value complex securities correctly
• The entire financial industry must be regulated
• Regulations must be straightforward but can not
  be circumvented

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Nobel Laureates Take

• Joseph Stiglitz (2001)
• Banks have proven to be incapable of
  self-regulation (Basle 2)
• Global financial crisis requires a global
  solution even though Made in America
• International financial institutions need to
  coordinate their efforts
• Myth Deregulation breeds innovation.

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Nobel Laureates Take

• Paul Samuelson (1970)
• There is no satisfactory alternative to market
  systems as a way of organizing both rich and poor
  populations.
• However, markets cannot regulate themselves.
• The only solutions lie in the dynamic moving
  center.
• Not too tight (leftist), not too loose (rightist)

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Pop Quiz

• What is the maximum reasonable leverage ratio
  (DebtEquity) for a financial institution?
• A. 51
• B. 101
• C. 501
• D. 1001
• E. None of the above.

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Wall Street Said

• What is the maximum reasonable leverage ratio
  (AssetEquity) for a financial institution?
• A. 51
• B. 101
• C. 501
• D. 1001
• E. None of the above. 4001

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Pop Quiz 2

• Does the quality of collateral matter?
• Yes
• Sometimes
• No

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Wall Street Said

• Does the quality of collateral matter?
• Yes
• Sometimes
• No

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How CDOs Work Step 1
Mortgage-Backed Bonds (MBBs)
Wall Street
Loan Originator
Borrower 1
Borrower 2
Borrower 3
Borrower 4
Borrower 5
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How CDOs Work Step 2
Super Senior
Investment Grade
Non-Investment Grade
Equity
Collateralized Bond Obligation (CBO)
Wall Street
MBB 1
MBB 2
MBB 3
MBB 4
MBB 5
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How CDOs Work Step 3 to n
Super Senior
Investment Grade
Non-Investment Grade
Equity
CBO squared (CBO2)
Wall Street
CBO 1
CBO 2
CBO 3
CBO 4
CBO 5
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Is the CDO, in itself, evil?

• Nothing sinister about the structure, in fact,
  its kind of clever
• Took advantage of low interest rates which led to
  greater demand for houses, and therefore
  increased housing prices
• But it neglects what we know from portfolio
  management that we should not put all our eggs in
  one basket

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So what went wrong?

• Low interest rates beginning 2001 encouraged the
  growth of the housing market
• The brokers incentives were geared towards
  generating volume
• Offered schemes that allowed low payments up
  front
• Credit quality assessment fell because the value
  of the collateral was increasing, and banks sold
  the assets to Wall Street anyway

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Why was Wall Street so keen on CDOs?

• Glass-Steagal Act was enacted in 1933 to separate
  banks from non-banks
• Non-banks, particularly investment banks, enjoyed
  spectacular profits in the late 1980s
• Wanting in on the action, banks lobbied for the
  repeal of Glass-Steagal they succeeded in 1999
• Investment banks, now facing competition from
  banks, drove themselves to find other sources of
  high profits
• FEES from packaging mortgage-backed securities,
  and CDOs, presented the opportunity

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Why did investors buy securities backed by
subprime?

• Structuring!
• Enhancements, like insurance, increased the
  investment grade or super senior portion
• In general, mortgage-backed securities with
  investment grade ratings had higher yields than
  corporate bonds with the same ratings

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Then interest rates increased

• The subprime, turned out to be sub-subprime
• Houses, used for collateral, turned out to be
  overvalued
• CDOs rated Triple A defaulted
• Insurers and enhancers of the bonds and CDOs had
  their capital eroded
• Counterparty risks escalated

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The Excuses

• Loan originators
• We told them these where subprime!
• I ask How honest were you in the documentation?
• Wall Street
• We trusted the originators!
• I ask Whatever happened to due diligence?
• Rating agencies
• You dont pay us enough to check each and every
  borrower!
• I say You should not have taken the job!

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Three Major Areas of Risk Management

• Credit Risk Management
• Market Risk Management
• Operational Risk Management
• How were these subverted or lulled into sleep?

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Credit Risk Mismanagement

• At loan origination
• Probability of default (PD) willfully lowered
• At CDO packaging
• PD of bonds incorrectly estimated
• At CDO squared packaging
• Loss Given Default (LGD) mdels incorrect
• Exposure at Default (EAD) increasing rather than
  decreasing

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Market Risk Mismanagement

• Really, interest rates are not going to rise
  soon
• The CDO market is too small to have a severe
  impact
• Black swan or extreme value event not properly
  considered

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Operational Risk Mismanagement

• Loan originator had bad incentives
• Wall street had bad incentives
• Rating agencies had bad incentives
• Investors trusted all three of the above a little
  too much

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But risk silos really dont make sense

• Bad incentives to the loan originator (ORM) led
  to PD being lowered at origination (CRM)
• Incorrectly low PDs (CRM) reinforced by interest
  rates are not going to rise soon. (MRM)
• Wall street, rating agencies, and investors only
  too readily accepted (ORM) that interest rates
  are not going to rise soon (MRM)

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Next Level

• Loss of Confidence leading to lower stock prices
  leading to more loss of confidence to lower stock
  prices, etc
• Questions on fair value accounting?
• Accomplice or innocent bystander?
• More or less regulation?

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Next Next Level

• Countries turning inward
• Flight to quality flight to familiarity
• Resources used for rescue packages, instead of
  promoting more productive activities
• Exports consequently suffering
• World demand for goods and services falling
  RECESSION

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My Limited Take can we prevent this from
happening again?

• Only if we finally heed the lessons of history
• All these have happened before
• In the US, with the junk bonds
• In Asia, during the 1997 financial crisis
• Analyzed via TRICK framework
• Transparency
• Risk Management
• ICT
• Customer
• Kapital

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(No Transcript)
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Solution Re-application of the TRICK framework

• Transparency --- more not less!
• Risk Management --- more and from varied sources
• Information, Communication and Technology ---
  more uses
• Competion for customers --- diversify!
• Kapital Adequacy --- economic (risk-based) rather
  than regulatory (rules-based)

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Thank you!

• felix_at_crisp.com.ph
• ACCM Room 501
• 813-6014
• 0919-556-4824
• 0917-523-0328
• felix.bustos_at_gmail.com