Package 5 Flashcards
The economics of structured finance
What is structured finance?
Structured finance is a service that generally involves highly complex financial transactions offered by many large for companies with very unique financing needs.
The economics of structured finance
Problems with CDOs
The structure amplifies errors (valuation is
sensitive to correlation parameter and the
estimated default rate)
Rating agencies: conflict of interests
Biased valuation
The economics of structured finance
Explain the problem of biased valuation
- overlap in geographic regions (correlation)
- probability of default and expected recovery values
- the valuation model assumed constantly rising house prices
- low credit quality of underlying securities (NINJA loans)
- systematic risks priced as diversifiable ones (especially in AAA tranches)
The economics of structured finance
What is NINJA loans
mortgage where the borrower did not have to supply verification of income, job and asset.
The economics of structured finance
Who is guilty in crisis 2008
Credit rating agencies
Investors
Regulators
The economics of structured finance
What was the problem of Credit Rating Agencies
– Naïve estimates (based on constantly growing housing
prices)
– Perverse incentives (issuers paid for the rating)
The economics of structured finance
What was the problem of investors
– Couldn’t understand the riskiness of CDO and CDO2
– Outsourced due diligence to rating agencies
– “Dance while the music is still playing”
The economics of structured finance
What is the difference between CDO and CDO2
CDO - is structured financial product backed by a pool of loans; CDO2 - is structured financial product backed by a pool of CDO’s
The economics of structured finance
What is the problem of regulators
– Tied banks’ capital requirements to rating
The economics of structured finance
advantages of CDOs
- Credit enhancement
• Liquidity
• Diversification
The economics of structured finance
disadvantages of CDOs
- Claims are highly sensitive to:
(a) probability of default, recovery value,
(b) correlation of defaults,
(c) relation between the payoffs and economic states
• Systematic risks are concentrated in senior tranches
How debt market have malfunctioned in the crisis
Three areas crucial in all debt market decisions
- risk capital
- counterparty risk
- haircuts in the repo market
How debt market have malfunctioned in the crisis
what is the problem for risk capital?
- risk capital refers to funds used for high-risk investment
- loss in risk capital (systematic events) => Risk aversion, downwards pressure on prices => downwards in liquidity in debt markets (investor redemption)
How debt market have malfunctioned in the crisis
What is counterparty risk
is the risk that the other party in an agreement will default
How debt market have malfunctioned in the crisis
what is the problem for counterparty risk?
*Increasing counterparty risk -> demands for greater collateral;reduced volume of transactions.
* To address this risk -> CDS, however
during the crisis:
• The failure of Bear Stearns -> other
investment banks may also fail
• AIG downgraded from being AArated
insurer to near-bankruptcy in one week. (AIG was the counterparty on a large volume of swaps)
How debt market have malfunctioned in the crisis
What is repo agreement
Repo agreement is a loan that is collateralize by financial institute
How debt market have malfunctioned in the crisis
What is the problem for haircuts in the repo market
- Repo agreement ~ pawn shop deal – repo lending side: looking for a relatively safe place to invest a large amount of cash for a short period. – repo haircuts considerations: 1) the probability of a borrower defaulting on the repo loan; 2) the recovery value when liquidating the collateral in the secondary market if default occurs . – Rising haircuts + shrinkage of the repo market (“deleveraging”) – Why do haircuts ↑? The average borrower is less creditworthy (p (default) ↑)
How debt market have malfunctioned in the crisis
What is the problem for Liquiudity
- During the crisis: many investors become more averse to owning illiquid investments
- > Price of illiquid assets fell relative to the price of illiquid assets.
• Maturity relationship: a gradual shift towards overnight financing (repo↑), debt maturity↓
• Reduced liquidity (little risk capital, high haircuts, high counterparty risk) -> hard to borrow
-> “limit of arbitrage” (anomalous price patterns not corrected by arbitrage) -> 2 examples : interest rate SWAP or GNMA Mortgage-Backed Security Spread
How debt market have malfunctioned in the crisis
Explain interest rate SWAP influence on the crisis 2008
(a) Interest Rate Swap spread
Swap rate reflects an interest rate from
major banks (LIBOR) Treasury rates (normally)
BUT since September 2008, this normal
relationship has been overturned
How debt market have malfunctioned in the crisis
Explain GNMA Mortgage-Backed Security spread
GNMA securities carry the explicit “full faith
and credit of the U.S. government” -> no
default issue, the remaining risks are
prepayment risk and interest rate risk.
Nevertheless Spread went up dramatically.
How debt market have malfunctioned in the crisis
Actions to adress the “limit of arbitrage” problem
- the Troubled Asset Relief Program (TARP) : the government purchasing equity capital in over 600 commercial banks nationwide.
- Federal Reserve “discount window”: commercial bank may receive loans while pledging some collateral to the Fed (essentially a repo loan from the Fed with a broadened class of debt instruments accepted as collateral).
- Term Asset-Backed Lending Facility (TALF): repo loans against the collateral of newly issued asset-backed securities.
- Purchase of MBS by the Fed (purchase directly assets that may be trading below fundamental value).
How debt market have malfunctioned in the crisis
Why the government has taken part in all of these losses?
- To prevent the financial sector from crash (to prevent spillover to the real sector aka externalities of financial sector)
- The government had no liquidity considerations, so it offered it to the ones who needed it
CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS
What is CDS
CDS – insurance against default of a company
CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS
Main influences on the market
- Over-the-counter (off exchange – trading is done between two parties between any exchanges)
- Can be “naked” – allow to sell debt short (but if prohibited – market destroyed, as no counterparties if no speculators)
- Supposed to make markets more efficient (risk born by those who can, separation of funding and risk) – should reduce cost of capital
- Provide information