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					                         2007-? Crisis

                       FIN285a: Lecture 9
                            Fall 2009
                     (Jorion, chapter 21-22)
 Jorion, Risk management lessons from the credit crises, forthcoming European Financial
                                    Management, 2009,
  Hull, The credit crunch of 2007: What went wrong? Why? What lessons can be learned?
                         Working paper, University of Toronto, 2009.
                 Campbell, The risk of value-at-risk, Risk, vol 22(4), 42-46.4.
Finger, VaR is from Mars, Capital is from Venus, Research Monthly, Riskmetrics, April 2009
                       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 management’s role
 Policy recommendations
      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
                     Bank Run
 Depositors worry about bank solvency
 Withdraw assets quickly
 Bank
       Needs to liquidate long term assets
       Difficult
       Fire sale conditions
 If it can’t make it, bank becomes insolvent
 Can happen to:
       Good banks
       Bad banks
       Central banks
   The Spark: Residential
  Mortgage backed securities
          (RMBS)
 Portfoliosof mortgage pools
 Tranching
 Originate and distribute
 Other assets built on top of these
     CDO’s and CDO’s squared
Tranches and Ratings


        AAA


         A

         B
  The Power of Securitization
 Large scale diversification
 Concentrate losses in low rated
  tranches
 High rated tranches (hopefully) low risk
Tranches and Ratings
      CDO^2

        AAA

                  AAA
         A

         B
           Other Applications
 Commercial   mortgages
 Creditcards
 Student loans
       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
                          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 management’s role
   Policy recommendations
         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
          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
              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
               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?)
                          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 management’s role
   Policy recommendations
         Crisis Triggers (Spark)
 Real estate prices fall
 Defaults 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
             Crisis Expands:
      Risk Management Connections
 Riskdowngraded for certain securities
 Firms must reduce exposure
     Deleverage, wind back, and shift to less
      risky securities
     "Fire Sale"
           increases, VaR increases
 Volatility
 Need to increase reserves again, go to
  step 2 above
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
            And Global
 Major European banks in trouble
 Iceland problems
 Global recession as consumption drops
  off
 Consumption drops, hit developing
  countries hard
               What Is This?
 Inmany ways a big (global) bank run
 Large asset revaluation
      and collateral reduction
      and counter-party paranoia
      Risk Types in the Crisis
 Credit   risk
     Mortgage backed securities
     Counter party risk
 Liquidity   risk (funding risk)
     Bank runs
 Model risk
 Operational risk
                          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 management’s role
   Policy recommendations
      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
 Bothof these were clear using past
 data, and price/rental ratios
              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
         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
     VaR Exceptions: Banks 99, IBanks 95
                   Horizon =Daily
Institution   Expected   2006   2007   2008
              per year
Goldman       13         3      10     13
Bear          13         0      27
Stearns
JPM           3          0      8      3
Chase
Credit        3          2      9      24
Suisse
UBS           3          0      29     50
B of A        3                 12     2
               VaR Dangers
 Falsesense 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
            Wrong Criticisms
 "Fat   tails"
     Volatility and correlations more important
 Short   horizons
     Long horizons might be a bigger problem
      See Finger, VaR is from Mars
                          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 management’s role
   Policy recommendations
                      Firm Policies
   Robustness
       Think outside the model
       Think extreme data
            Convergence
            Counter parties
       Trader positions -> Future movements
   Organization
       More power to risk management
       Compensation -> long term
   Do not blindly follow quantitative models
         Regulator Policies
 Leverage restrictions
 Over-the-counter -> clearing house
 Macro/systemic risk measures
 Better checks on internal models
 Greater use of expected tail loss
 Proprietary trading separation
 Counter cyclical reserves
 Security design (simplicity)
 Ratings agencies (AAA)
                Wrap Up
 Use   tools wisely
     Careful
     Somewhat humble
 Always   are risks outside of the model

				
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