Package 5

Question 1

The economics of structured finance

What is structured finance?

Answer 1

Structured finance is a service that generally involves highly complex financial transactions offered by many large for companies with very unique financing needs.

Question 2

The economics of structured finance

Problems with CDOs

Answer 2

The structure amplifies errors (valuation is
sensitive to correlation parameter and the
estimated default rate)

Rating agencies: conflict of interests

Biased valuation

Question 3

The economics of structured finance

Explain the problem of biased valuation

Answer 3

1. overlap in geographic regions (correlation)
2. probability of default and expected recovery values
3. the valuation model assumed constantly rising house prices
4. low credit quality of underlying securities (NINJA loans)
5. systematic risks priced as diversifiable ones (especially in AAA tranches)

Question 4

The economics of structured finance

What is NINJA loans

Answer 4

mortgage where the borrower did not have to supply verification of income, job and asset.

Question 5

The economics of structured finance

Who is guilty in crisis 2008

Answer 5

Credit rating agencies

Investors

Regulators

Question 6

The economics of structured finance

What was the problem of Credit Rating Agencies

Answer 6

– Naïve estimates (based on constantly growing housing
prices)

– Perverse incentives (issuers paid for the rating)

Question 7

The economics of structured finance

What was the problem of investors

Answer 7

– Couldn’t understand the riskiness of CDO and CDO2
– Outsourced due diligence to rating agencies
– “Dance while the music is still playing”

Question 8

The economics of structured finance

What is the difference between CDO and CDO2

Answer 8

CDO - is structured financial product backed by a pool of loans; CDO2 - is structured financial product backed by a pool of CDO’s

Question 9

The economics of structured finance

What is the problem of regulators

Answer 9

– Tied banks’ capital requirements to rating

Question 10

The economics of structured finance

advantages of CDOs

Answer 10

• Credit enhancement
  • Liquidity
  • Diversification

Question 11

The economics of structured finance

disadvantages of CDOs

Answer 11

• 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

Question 12

How debt market have malfunctioned in the crisis

Three areas crucial in all debt market decisions

Answer 12

• risk capital
• counterparty risk
• haircuts in the repo market

Question 13

How debt market have malfunctioned in the crisis

what is the problem for risk capital?

Answer 13

• 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)

Question 14

How debt market have malfunctioned in the crisis

What is counterparty risk

Answer 14

is the risk that the other party in an agreement will default

Question 15

How debt market have malfunctioned in the crisis

what is the problem for counterparty risk?

Answer 15

*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)

Question 16

How debt market have malfunctioned in the crisis

What is repo agreement

Answer 16

Repo agreement is a loan that is collateralize by financial institute

Question 17

How debt market have malfunctioned in the crisis

What is the problem for haircuts in the repo market

Answer 17

-  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)	↑)

Question 18

How debt market have malfunctioned in the crisis

What is the problem for Liquiudity

Answer 18

• 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

Question 19

How debt market have malfunctioned in the crisis

Explain interest rate SWAP influence on the crisis 2008

Answer 19

(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

Question 20

How debt market have malfunctioned in the crisis

Explain GNMA Mortgage-Backed Security spread

Answer 20

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.

Question 21

How debt market have malfunctioned in the crisis

Actions to adress the “limit of arbitrage” problem

Answer 21

1. the Troubled Asset Relief Program (TARP) : the government purchasing equity capital in over 600 commercial banks nationwide.
2. 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).
3. Term Asset-Backed Lending Facility (TALF): repo loans against the collateral of newly issued asset-backed securities.
4. Purchase of MBS by the Fed (purchase directly assets that may be trading below fundamental value).

Question 22

How debt market have malfunctioned in the crisis

Why the government has taken part in all of these losses?

Answer 22

1. To prevent the financial sector from crash (to prevent spillover to the real sector aka externalities of financial sector)
2. The government had no liquidity considerations, so it offered it to the ones who needed it

Question 23

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

What is CDS

Answer 23

CDS – insurance against default of a company

Question 24

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

Main influences on the market

Answer 24

• 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

Question 25

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS | Problems with CDOs

Answer 25

- no need for monitoring | - perverse incentives (drive into bankruptcy)

Question 26

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS | Problems with CDS on Mortgage-backed securities

Answer 26

- hard to price - sellers didn’t have ability to bear the risk they took on (thought it was smaller in CDOs) - support more risk-taking

Question 27

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS | Why Counterparty risk appears

Answer 27

- regulations allowed to hold risky securities if had CDSs, have less capital - web exposures - exposed while replacing swaps

Question 28

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS | OTC vs Exhange

Answer 28

``` - exchange o transparency o reduces CP risk o no flexibility, good only for large volume trading - OTC o Disorganized clearing process o Tailoring o Unknown counterparties (exposure) – don’t know who bought/sold ```

Question 29

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS | The conclusion of an article

Answer 29

- CDSs improve price discovery | - Crisis not due to CDS, but due to unexpected fall in real estate prices , too high leverage

Question 30

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM Limited consensus on what caused the crisis

Answer 30

* Wall Street greed and wrong incentives? * ratings agencies? * the government subsidising subprime lending? * the new originate-and-distribute model of mortgage lending?

Question 31

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM How could Wall Street trade in securities that they knew so little about?

Answer 31

* to deceive investors-> hard to believe (The risk that someone in that massive collusion would have pulled the plug seems too big to make this theory plausible) • Rather state of “no questions asked” = the hallmark of money market liquidity (that this is the way money markets are supposed to look when they are functioning well)

Question 32

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM Criteria of REPO

Answer 32

• Large enough haircut -> no need for price discovery! • Functional difference between pawning and repo: pawning the initiative comes from the borrower who has a need for liquidity; in repo - the opposite

Question 33

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM Money markets vs stock markets

Answer 33

``` Stock markets • Risk sharing • Price discovery • Information sensitive • Transparent • Big investments in info • Many traders (exchanges) • Trading not urgent • Volatile volume ``` ``` Money markets • Liquidity provision/lending • Obviating price discovery • Information insensitive • Opaque • Modest investments in info • Few traders (bilateral) • Trading urgent • Stable volume ```

Question 34

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM Explain why panics are information events

Answer 34

Some new info -> debt becomes info-sensitive -> no consensus about the value of the debt -> Multiple reinforcing factors (Information contagion, fire sales, domino effects, interlinked balance sheets… ) -> hard to disentangle what drives what -> panic

Question 35

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM What does the Shadow banking mean

Answer 35

*From “originate to hold” to “originate to distribute” • securitization vehicles, asset-backed commercial paper conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and mortgage companies • All activities that were loosely regulated and were too risky for deposit-taking institutions

Question 36

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM Why has the Shadow banking expanded

Answer 36

* “parking space” for foreign money (in response to global demand for safe assets) • highly scalable (large amounts of high-quality assets can be created) • state-contingent use of capital is more efficient than keeping mortgages on the books of the originating banks

Question 37

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM How to get out of a crisis

Answer 37

``` • getting back to the no- questions-asked state (Transparency would likely have made the situation worse! -> instead the lack of specific information is a key element in the effectiveness of the message, e.g. Mario Draghi “whatever it takes”) • higher capital requirements and regular stress tests is the best road for now ```

Question 38

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM The purpose of money market

Answer 38

The purpose of money market is to provide liquidity for individuals and firms

Question 39

UNDERSTANDING THE ROLE OF DEBT IN THE FINANCIAL SYSTEM The main functional difference between pawning and repo

Answer 39

In pawning the initiative comes from the borrower who has a need for liquidity. In repo the motive is often the opposite: someone with money wants to park it safely by buying an asset in a repo.

Question 40

Credit Default Swaps and the Credit crisis | Advantages of CDSs

Answer 40

``` Increase economic welfare by: • Facilitating risk-sharing (risk is borne by those who can do it) • Providing additional information to the markets -> improving price-discovery • Providing an alternative for shortselling -> improving pricediscovery • Easier for companies to raise capital -> allocating capital more efficiently ```

Question 41

Credit Default Swaps and the Credit crisis | Disadvantages of CDS

Answer 41

Lower incentives to monitor • Perverse incentives (if “debt restructuring” not considered as default) • Counterparty risk of CDS-writer (default is a discrete event -> can lead to large jumps in the value of these contracts) • Excessive risk-taking (built-in leverage) • Web-exposure (even if a dealer’s net derivatives receivables are zero, he might still pose risks to the financial system) • Regulators: less capital required in case of protection by CDS • Naked CDS -> possibilities for manipulation, the markets tend to overreact

Question 42

Credit Default Swaps and the Credit crisis | Conclusion about CDS

Answer 42

“Financial derivatives like credit default swaps reduce the impact of the fall in subprime mortgage and other securities. It might make as much sense to regret that derivatives markets were not larger.”