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19 Week 7 Financial Crisis Notes19.1 Brunnermeier• A very nice concise c h ronology of the crisis, with short descriptions of many m arket problems.We learn a lot about how specific markets work, and sometimes don’t. I’m less enthused about“liquidity spirals” and so forth Also pay attention to terminology (italicized). If you knowwhat each of these terms mean, y ou know most of the stories about the crisis.I Concepts and Markets• p. 77 The central issue: why did “small” mortgage losses cause such big problems? (Answer:the central “crisis” is the run on the “shadow banking system,” whic h w e are here to under-stand. It doesn’t really matter where the loss came from. What matters is those losses wereconcentrated in fragile financial structures.)• p. 78, bottom. The mo ve from “originate and hold”to“originate and sell”andthemovetoshorter financing (of inve stment banks, not traditional banks)• p. 78-79. Securitization. How an MBS works, How a CDO works. (Pool of MBS, tranches)How a CDS works. A CDS on a CDO.1. 80 Why securitization is a good idea(a) Relative to investing in bank stock / deposits. It’s easier for investors to monitora mortgage pool than a whole bank. (Even if they didn’t do a great job last time)(b) Global risk transfer.(c) Separation of “origination” skills from “risk management” skills in the bank. It’sgood that if the mortgage goes sour all the people who (supposedly) know how tooriginate them don’t lose their jobs.(d) Berananke’s famous work: In the great depression, mortgage losses brought downthe local banks, local investors, and blew up the local knowledge of how to makeloans. MBS avoid all this(e) Obviously, we study the failures and try to fix them. Mostly how MBS were held,not the structure itself. How to bring back this market?2. Ratings issues(a) It’s not all the agency’s fault. “1% probability”i. does not tell you about loss given default. Tranches tend to get all wiped out.ii. It does not tell you whether loss happens when the market has tanked vs idiosyn-cratic (systematic vs idiosyncratic risk). Writing an index put with 1% proba-bility is a much riskier security than an individual stock put with 1% probabilityof loss.(b) Don’t expect too much. Why are you getting 2% more yield anyway?(c) Ratings and regulation. Regulating security by security is silly, and you can under-stand pooling as a way to rate the portfolio. (See the negativ ely correlated BBBexample in footnote 1). Some of what happened is “ratings arbitrage”or“reg-ulation arbitrage.” That is good when you’re getting around silly regulations, badwhen you’re getting around good regulations.334• p. 79-80 SIV,SPV MBS (and CDO) held by SIV, funded with commercial paper, and off-balance-sheet liquidity and credit guarantees from the bank.1. This is a bank! (But a very simple one, not commingled with other stuff, which is good)2. But this may be simply avoiding capital constraints. Again, a warning about hopingregulation will do too much.3. Capital controls, regulatory arbitrage: Creates a way to get around capital requirements.Deeper: why are there capital requirements? Answer: one good reason is to protect thetaxypayer’s interest, having provided deposit insurance. There is a nice analogy tocorporate bonds: Corporate bonds have covenants limiting the firm’s access to short termdebt and requiring equity. These protect the bondholder’s interests. Capital controlsare similar covenants designed to protect the governmen t’s interest having guaranteeddemand deposits. If you guarantee demand deposits, you have to regulate risk takinganddemandsufficien t capital.4. Risk is not eliminated! It’s only shifted! Many observers were surprised that so muchrisk was, in the end, on bank balance sheets. (And, really, back to the taxpayer who isproviding the TBTF guarantee. Remember that call option diagram?)• p. 80, middle. Repo financing.1. How it w orks. These are v ery collateralized overnight loans.2. Investment banks hold CDOs (etc) with overnight repo financing.3. Who holds the risk? “We’ll assets on the way down” is not risk management! Astoploss order is not a free put option.• p. 82 Silly mortgages. Really, just products that gave homebuyers a one-way bet on houseprices, shared by investors. Be careful of cause and effect though. Did the “flood of cheapcredit” lead to “lower standards?”• p. 82 “Pipeline risk,” the charge that banks had “no incentive” to monitor loan qualities.1. This might make sense for MBS sold to Fannie/Freddie, but the buyers of equity andlow-rated tranches have every incentive to read the fine print!2. And the bank often keeps the equity tranche — and BB buy ers have ev ery incentive toinsist that it so so.II Timeline• p. 83 Timeline. Phase 1 (summer 2007)1. Spring 2007. House prices start to level off, subprime defaults skyrock e t, ABX indicesplummet.2. Summer 2007. Some hedge funds implode. (Story: lose money on MBS, but they’releveraged so they dump other things to raise cash. They’re all in the same bets, so theydrive prices down. Q: Yes, but where are the deep pockets?)3. Amazingly, (83) Bear bails out its internal hedge funds (Duffie talks about this too).Now we learn something about hedge funds inside banks!3354. (84) ABCP. The SIV and SPV funding mechanism. Banks ha ve to provide liquidity,take back the assets when you can’t roll over the debt.5. Note regular commercial paper is ok — the crisis seemed to be “contained.”6. Fall 2007 Libor, Ted spreads rise. A sign that bank default probabilities are much higher.(86) Central banks step in, Northern Rock Fails. Banks raise more equity to cover losses.(This is an important observation. Banks can and do raise equity after losses!)7. (86) Losses now $200b. (But this is tiny!)• 87 Monoline story1. Monoline insurers and insured assets in funds. Municipal bond funds must hold insuredbonds (like bonds + cds), and insured by AAA rated. If the insurer loses its rating, thefund must sell bonds. But to who? Other funds have the same restriction, so they haveto be held by individual investors. Price goes down.2. Like man y stories we tell, this one isn’t as obvious as it sounds. Why aren’t therecompeting bond insurers? Why can’t the monoline issue equity and restore its AAArating? What is an insurer doing being leveraged at all? Do uninformed sales in facttrigger price declines, an issue


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Chicago Booth BUSF 35150 - Week 7 Financial Crisis Notes

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