Title: Dissecting the Global Financial Crisis: A Case in Risk Management
1Dissecting the Global Financial Crisis A Case in
Risk Management
- 21 May 2009
- Felixberto Bustos Jr., DBA, CFA, FRM
2Nobel 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
3Nobel 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
4Nobel 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
5Nobel 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.
6Nobel 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)
7Pop 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.
8Wall 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
9Pop Quiz 2
- Does the quality of collateral matter?
- Yes
- Sometimes
- No
10Wall Street Said
- Does the quality of collateral matter?
- Yes
- Sometimes
- No
11How CDOs Work Step 1
Mortgage-Backed Bonds (MBBs)
Wall Street
Loan Originator
Borrower 1
Borrower 2
Borrower 3
Borrower 4
Borrower 5
12How 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
13How 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
14Is 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
15So 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
16Why 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
17Why 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
18Then 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
19The 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!
20Three Major Areas of Risk Management
- Credit Risk Management
- Market Risk Management
- Operational Risk Management
- How were these subverted or lulled into sleep?
21Credit 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
22Market 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
23Operational 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
24But 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)
25Next 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?
26Next 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
27My 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
28(No Transcript)
29Solution 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)
30Thank you!
- felix_at_crisp.com.ph
- ACCM Room 501
- 813-6014
- 0919-556-4824
- 0917-523-0328
- felix.bustos_at_gmail.com