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Dissecting the Global Financial Crisis: A Case in Risk Management
21 May 2009
Felixberto Bustos Jr., DBA, CFA, FRM
Nobel Laureates’ Take
• Edmund Phelps (2006)– Crisis caused by overvaluation of assets and
financial instruments– Banks exported the crisis to the rest of the
world through the financial instruments– But more regulation of the entire financial
industry is not the key; innovative financing by angel investors and venture capitalists should not be constrained
Nobel Laureates’ Take
• Robert Lucas (1995)
Issue on subprime is ancient history– Focus now on providing cash reserves– We need a competitive banking system with
government-insured deposits– But in the future, assets of the banks must be
tightly regulated
Nobel Laureates’ Take
• Reinhard Selten (1994)– Regulation of the financial market is important– Markets do not value complex securities
correctly– The entire financial industry must be
regulated– Regulations must be straightforward but can
not be circumvented
Nobel Laureates’ Take
• Joseph Stiglitz (2001)– Banks have proven to be incapable of self-
regulation (Basle 2)– Global financial crisis requires a global
solution even though Made in America– International financial institutions need to
coordinate their efforts– Myth: Deregulation breeds innovation.
Nobel Laureates’ Take
• Paul Samuelson (1970)– There is no satisfactory alternative to market
systems as a way of organizing both rich and poor populations.
– However, markets cannot regulate themselves.
– The only solutions lie in the dynamic moving center.
– Not too tight (leftist), not too loose (rightist)
Pop Quiz
What is the maximum reasonable leverage ratio (Debt:Equity) for a financial institution?
A. 5:1
B. 10:1
C. 50:1
D. 100:1
E. None of the above.
Wall Street Said:
What is the maximum reasonable leverage ratio (Asset:Equity) for a financial institution?
A. 5:1
B. 10:1
C. 50:1
D. 100:1
E. None of the above. 400:1
Wall Street Said
Does the quality of collateral matter?
A. Yes
B. Sometimes
C. No
How CDOs Work – Step 1
Borrower 1 Borrower 2 Borrower 3 Borrower 4 Borrower 5
Loan Originator
Wall Street
Mortgage-Backed Bonds (MBBs)
How CDOs Work – Step 2
MBB 1 MBB 2 MBB 3 MBB 4 MBB 5
Wall Street
Collateralized Bond Obligation (CBO)
Equity
Non-Investment Grade
Investment Grade
Super Senior
How CDOs Work – Step 3 to n
CBO 1 CBO 2 CBO 3 CBO 4 CBO 5
Wall Street
CBO – squared (CBO2)
Equity
Non-Investment Grade
Investment Grade
Super Senior
Is the CDO, in itself, evil?
• Nothing sinister about the structure, in fact, it’s kind of clever– Took advantage of low interest rates which
led to greater demand for houses, and therefore increased housing prices
• But it neglects what we know from portfolio management that we should not put all our eggs in one basket
So what went wrong?
• Low interest rates beginning 2001 encouraged the growth of the housing market
• The brokers’ incentives were geared towards generating volume– Offered schemes that allowed low payments up front
• Credit quality assessment fell because the value of the collateral was increasing, and banks sold the assets to Wall Street anyway
Why was Wall Street so keen on CDOs?
• Glass-Steagal Act was enacted in 1933 to separate banks from non-banks
• Non-banks, particularly investment banks, enjoyed spectacular profits in the late 1980s
• Wanting in on the action, banks lobbied for the repeal of Glass-Steagal – they succeeded in 1999
• Investment banks, now facing competition from banks, drove themselves to find other sources of high profits
• FEES from packaging mortgage-backed securities, and CDOs, presented the opportunity
Why did investors buy securities backed by subprime?
• Structuring!
• Enhancements, like insurance, increased the investment grade or super senior portion
• In general, mortgage-backed securities with investment grade ratings had higher yields than corporate bonds with the same ratings
Then interest rates increased
• The subprime, turned out to be sub-subprime
• Houses, used for collateral, turned out to be overvalued
• CDOs rated Triple A defaulted
• Insurers and enhancers of the bonds and CDOs had their capital eroded– Counterparty risks escalated
The Excuses
• Loan originators – We told them these where subprime!– I ask: How honest were you in the documentation?
• Wall Street – We trusted the originators!– I ask: Whatever happened to due diligence?
• Rating agencies – You don’t pay us enough to check each and every
borrower!– I say: You should not have taken the job!
Three Major Areas of Risk Management
• Credit Risk Management
• Market Risk Management
• Operational Risk Management
• How were these subverted or lulled into sleep?
Credit Risk Mismanagement
• At loan origination – Probability of default (PD) willfully lowered
• At CDO packaging – PD of bonds incorrectly estimated
• At CDO squared packaging – Loss Given Default (LGD) mdels incorrect– Exposure at Default (EAD) increasing rather
than decreasing
Market Risk Mismanagement
• “Really, interest rates are not going to rise soon”
• “The CDO market is too small to have a severe impact”
• “Black swan” or extreme value event not properly considered
Operational Risk Mismanagement
• Loan originator had bad incentives
• Wall street had bad incentives
• Rating agencies had bad incentives
• Investors trusted all three of the above a little too much
But risk silos really don’t make sense
• Bad incentives to the loan originator (ORM) led to PD being lowered at origination (CRM)
• Incorrectly low PDs (CRM) reinforced by “interest rates are not going to rise soon.” (MRM)
• Wall street, rating agencies, and investors only too readily accepted (ORM) that “interest rates are not going to rise soon” (MRM)
Next Level
• Loss of Confidence leading to lower stock prices leading to more loss of confidence to lower stock prices, etc
• Questions on fair value accounting?
• Accomplice or innocent bystander?
• More or less regulation?
Next Next Level
• Countries turning inward– Flight to quality= flight to familiarity– Resources used for rescue packages, instead
of promoting more productive activities
• Exports consequently suffering
• World demand for goods and services falling = RECESSION
My Limited Take: can we prevent this from happening again?
• Only if we finally heed the lessons of history• All these have happened before
– In the US, with the junk bonds– In Asia, during the 1997 financial crisis– Analyzed via TRICK framework
• Transparency• Risk Management• ICT• Customer• Kapital
7
BANK OF INDONESIA30 JUNE 2006
III. Qualified TRICK
APITAL ADEQUACY, met primarily through mergers, privatization and lesser risk taking
RANSPARENCY, with difficulty
ISK MANAGEMENT, only with strong government support
NFORMATION TECHNOLOGY, response that is country specific
OMPETITION FOR CUSTOMERS, providing services beyond credit delivery
The qualifications of Sinkey’s framework captured by the first two yearbooks of the JBF Center maybe listed as follows:
Solution: Re-application of the TRICK framework
• Transparency --- more not less!• Risk Management --- more and from
varied sources• Information, Communication and
Technology --- more uses• Competion for customers --- diversify!• Kapital Adequacy --- economic (risk-
based) rather than regulatory (rules-based)
Thank you!
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