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Financial Economics > Package 5 > Flashcards

Package 5 Flashcards

1
Q

The economics of structured finance

What is structured finance?

A

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

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2
Q

The economics of structured finance

Problems with CDOs

A

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

Rating agencies: conflict of interests

Biased valuation

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3
Q

The economics of structured finance

Explain the problem of biased valuation

A
  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)
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4
Q

The economics of structured finance

What is NINJA loans

A

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

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5
Q

The economics of structured finance

Who is guilty in crisis 2008

A

Credit rating agencies

Investors

Regulators

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6
Q

The economics of structured finance

What was the problem of Credit Rating Agencies

A

– Naïve estimates (based on constantly growing housing
prices)

– Perverse incentives (issuers paid for the rating)

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7
Q

The economics of structured finance

What was the problem of investors

A

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

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8
Q

The economics of structured finance

What is the difference between CDO and CDO2

A

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

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9
Q

The economics of structured finance

What is the problem of regulators

A

– Tied banks’ capital requirements to rating

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10
Q

The economics of structured finance

advantages of CDOs

A
  • Credit enhancement
    • Liquidity
    • Diversification
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11
Q

The economics of structured finance

disadvantages of CDOs

A
  • 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

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12
Q

How debt market have malfunctioned in the crisis

Three areas crucial in all debt market decisions

A
  • risk capital
  • counterparty risk
  • haircuts in the repo market
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13
Q

How debt market have malfunctioned in the crisis

what is the problem for risk capital?

A
  • 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)
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14
Q

How debt market have malfunctioned in the crisis

What is counterparty risk

A

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

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15
Q

How debt market have malfunctioned in the crisis

what is the problem for counterparty risk?

A

*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)

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16
Q

How debt market have malfunctioned in the crisis

What is repo agreement

A

Repo agreement is a loan that is collateralize by financial institute

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17
Q

How debt market have malfunctioned in the crisis

What is the problem for haircuts in the repo market

A 
-  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)	↑)
18
Q

How debt market have malfunctioned in the crisis

What is the problem for Liquiudity

A
  • 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

19
Q

How debt market have malfunctioned in the crisis

Explain interest rate SWAP influence on the crisis 2008

A

(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

20
Q

How debt market have malfunctioned in the crisis

Explain GNMA Mortgage-Backed Security spread

A

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.

21
Q

How debt market have malfunctioned in the crisis

Actions to adress the “limit of arbitrage” problem

A
  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).
22
Q

How debt market have malfunctioned in the crisis

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

A
  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
23
Q

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

What is CDS

A

CDS – insurance against default of a company

24
Q

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

Main influences on the market

A
  • 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
25
Q

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

Problems with CDOs

A
  • no need for monitoring

- perverse incentives (drive into bankruptcy)

26
Q

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

Problems with CDS on Mortgage-backed securities

A
  • 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
27
Q

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

Why Counterparty risk appears

A
  • regulations allowed to hold risky securities if had CDSs, have less capital
  • web exposures
  • exposed while replacing swaps
28
Q

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

OTC vs Exhange

A 
-	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
29
Q

CREDIT DEFAULT SWAPS AND THE CREDIT CRISIS

The conclusion of an article

A
  • CDSs improve price discovery

- Crisis not due to CDS, but due to unexpected fall in real estate prices , too high leverage

30
Q

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

A
  • Wall Street greed and wrong incentives?
  • ratings agencies?
  • the government subsidising subprime lending?
  • the new originate-and-distribute model of mortgage lending?
31
Q

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

A
  • 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)
32
Q

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

A

• 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

33
Q

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

A 
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
34
Q

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

A

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

35
Q

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

A

*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

36
Q

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

A
  • “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
37
Q

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

A 
• 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
38
Q

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

A

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

39
Q

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

A

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.

40
Q

Credit Default Swaps and the Credit crisis

Advantages of CDSs

A 
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
41
Q

Credit Default Swaps and the Credit crisis

Disadvantages of CDS

A

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

42
Q

Credit Default Swaps and the Credit crisis

Conclusion about CDS

A

“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.”

Financial Economics (28 decks)

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