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2007-? Crisis

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Also, see the summary section on the. Crisis in the New York Times ... August 17, 2007: Run on Countrywide Bank. September 9th, 2007: Run on Northern Rock Bank ... – PowerPoint PPT presentation

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Title: 2007-? Crisis


1
2007-? Crisis
  • FIN285a Lecture 9
  • Fall 2009
  • (Jorion, chapter 21-22)

2
Outline
  • A few basics
  • Economics of bank runs
  • Securitization and mortgage backed securities
  • Accounting regulations
  • Events of the last few years (brief)
  • Causes and mechanisms
  • Quantitative risk managements role
  • Policy recommendations

3
A Little Economic Theory Bank runs
  • Bank institution who borrows short term and
    lends long term
  • Usual commercial bank
  • Investment bank
  • Hedge funds
  • Others
  • Banking beyond usual boundaries

4
Bank Run
  • Depositors worry about bank solvency
  • Withdraw assets quickly
  • Bank
  • Needs to liquidate long term assets
  • Difficult
  • Fire sale conditions
  • If it cant make it, bank becomes insolvent
  • Can happen to
  • Good banks
  • Bad banks
  • Central banks

5
The Spark Residential Mortgage backed securities
(RMBS)
  • Portfolios of mortgage pools
  • Tranching
  • Originate and distribute
  • Other assets built on top of these
  • CDOs and CDOs squared

6
Tranches and Ratings
AAA
A
B
7
The Power of Securitization
  • Large scale diversification
  • Concentrate losses in low rated tranches
  • High rated tranches (hopefully) low risk

8
Tranches and RatingsCDO2
AAA
AAA
A
B
9
Other Applications
  • Commercial mortgages
  • Credit cards
  • Student loans

10
New Accounting Twists
  • Leverage
  • SEC 15c3-1 The net capital rule
  • 1975-2004 Mandated capital liquidity rule for
    broker dealers (Leverage close to 12)
  • Eliminated in 2004 (Leverage expands to 30)
  • Mark to market FASB 157
  • Balance sheets must reflect current market values
    of traded assets

11
Outline
12
Rough Time Line
  • June 10th-12th, 2007 Moody's downgrades ratings
    on 5 billion of RMBS
  • June 20th, 2007 Two Bear Stearns hedge funds
    invested in subprime mortgages go down
  • Aug 2007 Quant hedge fund turmoil and
    deleveraging in equity markets
  • August 17, 2007 Run on Countrywide Bank
  • September 9th, 2007 Run on Northern Rock Bank

13
Rough Time Line
  • March 7-16, 2007 Federal Reserve increases term
    auction lending facility by 40 billion
  • March 17 Bear Sterns bought by JP Morgan
  • July 11th, 2008 IndyMac Bank seized by regulators

14
Rough Time Line
  • September 2008 Lehman bankruptcy
  • September 2008 Goldman and Morgan Stanley become
    banks
  • October/November
  • Global equity markets fall drastically
  • Central banks taking equity stakes in banks
  • Buying many securities
  • U.S. auto bailout considered
  • All countries considering fiscal stimulus packages

15
More Timeline
  • Nov 9th, Iceland collapses
  • Dec 11th, Madoff arrested
  • Feb 17th, Obama signs stimulus
  • March 9th, Stock market bottoms
  • Dow 6500
  • May, Chrysler bankruptcy
  • June, banks begin repaying bailouts
  • August, stocks recovering, Dow 9500, signs of
    recovery
  • November, unemployment still high, foreclosures
    hit record, (double dip?)

16
Outline
17
Crisis Triggers (Spark)
  • Real estate prices fall
  • Default rise
  • RMBS downgraded, and valuations fall (to the
    extent these are traded)
  • Every so often
  • New bad assets discovered at various financial
    institutions
  • Institutions are run (whether solvent or not)
  • Credit and money supply starts to unwind

18
Crisis Expands Risk Management Connections
  • Risk downgraded for certain securities
  • Firms must reduce exposure
  • Deleverage, wind back, and shift to less risky
    securities
  • "Fire Sale"
  • Volatility increases, VaR increases
  • Need to increase reserves again, go to step 2
    above

19
More Expansion Mechanisms
  • Two big events in Sept 2008
  • Lehman goes bankrupt
  • AIG revealed to be major writer of credit default
    swaps (insuring debts)
  • Counter-party risk intense market lockdown
  • Stock markets plummet as deleveraging continues

20
And Global
  • Major European banks in trouble
  • Iceland problems
  • Global recession as consumption drops off
  • Consumption drops, hit developing countries hard

21
What Is This?
  • In many ways a big (global) bank run
  • Large asset revaluation
  • and collateral reduction
  • and counter-party paranoia

22
Risk Types in the Crisis
  • Credit risk
  • Mortgage backed securities
  • Counter party risk
  • Liquidity risk (funding risk)
  • Bank runs
  • Model risk
  • Operational risk

23
Outline
24
The Role of Quantitative Models
  • Underestimated risk on RMBS
  • No probability on real estate price falls
  • Underestimated the common impact on defaults if
    prices did fall
  • Both of these were clear using past data, and
    price/rental ratios

25
Ratings Agencies
  • Completely missed risk measures
  • AAA ratings are special
  • AAA instruments can be used as collateral
  • Also, can be purchased by many cash management
    (low risk) funds
  • Risk is misallocated
  • Firms that want low risk/low return stuff ended
    up with high risk
  • Compare with dot com bubble

26
Key Issues with Risk Management
  • U.S. (and others) implicitly bought into the
    internal models methods for setting reserves
  • Thought large banks and investment banks had risk
    well under control
  • Allowed large amounts of leverage
  • Some banks had shoddy risk measurement

27
VaR Exceptions Banks 99, IBanks 95Horizon
Daily
28
VaR Dangers
  • False sense of precision
  • Traders gaming the system
  • Adjust positions to specific VaR target
  • Systemic risk problems
  • Current volatility at min
  • Reserves at min
  • Systemic risk at max

29
Wrong Criticisms
  • "Fat tails"
  • Volatility and correlations more important
  • Short horizons
  • Long horizons might be a bigger problemSee
    Finger, VaR is from Mars

30
Outline
31
Firm Policies
  • Robustness
  • Think outside the model
  • Think extreme data
  • Convergence
  • Counter parties
  • Trader positions -gt Future movements
  • Organization
  • More power to risk management
  • Compensation -gt long term
  • Do not blindly follow quantitative models

32
Regulator Policies
  • Leverage restrictions
  • Over-the-counter -gt clearing house
  • Macro/systemic risk measures
  • Better checks on internal models
  • Greater use of expected tail loss
  • Prop trading separation
  • Counter cyclical reserves
  • Security design
  • Ratings agencies (AAA)

33
Wrap Up
  • Use tools wisely
  • Careful
  • Somewhat humble
  • Always are risks outside of the model
  • Black Swans

34
VaR Limitations
  • Not absolute worst case
  • Poor tail information
  • Poor correlation information
  • Discrete event risks
  • Data
  • Data not available (RMBS)
  • Data no longer relevant to world
  • Model risk
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