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The Alphabet Soup of the Sub-Prime Crisis

Marti SubrahmanyamCharles E. Merrill Professor of Finance, Economics and International Business

Stern School of Business New York University

For presentation at the Bangalore International Centre

January 24, 2008

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Outline• Introduction• Institutional structure: The players• Credit-sensitive instruments• Regulatory environment• Credit and liquidity• The role of correlation• The crisis unfolds …• Policy solutions - Micro• Policy solutions - Macro• Q & A

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Introduction

• Rumblings about credit situation in late 2006-June 2007

• Assurances from crediting rating agencies and regulators

• Crisis hit the headlines in July 2007 with write-downs by major financial institutions e.g. Citigroup, UBS, Bear Stearns, Goldman Sachs etc.

• Despite some up-ticks from time to time, the crisis continues to this day, with no end in sight

• Spread to other markets, including the global equity markets

• Fear that this financial crisis will spread to the real economy in the US/Europe/Japan and trigger a recession

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Introduction (Contd.)

• Focus on:

- What are nuts and bolts of this crisis?

- Who are the major players?

- What structures are used?

- What financial instruments are used in these markets?

- What are the drivers of the valuations and how have they changed?

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Institutional structure: The players• Borrowers: Mortgage loans

- Fixed vs. Adjustable rate mortgages- Credit quality: sub-prime, Alt-A and A-paper- Securitization

• Borrowers: Corporate, agency and sovereign debt- Securitization: pooling and tranching- Rating of tranches- Targeting of tranches to particular customers, e.g. hedge funds, bank SPVs (SIVs, other

conduits) etc.

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Institutional structure: The players (Contd.)

• Investors: hedge funds, banks, municipalities, non-profits etc.- Arbitrage between tranches- Investors in senior and super-senior tranches

• Rating agencies- Models for assessing default risk- New relationship ofrating agencies and issuers

• Regulators- Impact of Basle II- Bank supervision

• Low credit spreads after 2002: search for yield

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Credit-sensitive instruments

• Mortgage loans – prepayment and credit risks• Mortgage-backed securities (MBS)• Corporate debt instruments• Collateralized debt obligations (CDOs)• Tranches: super-senior, senior, mezzanine,

equity (first loss)• Credit default swaps (CDSs)• Exotic CDOs e.g. synthetic CDOs, CDO squared

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Regulatory environment

• Basle II: Risk weighting based on credit rating – the greater the credit risk, the lower the rating

• Overall capital adequacy of 8%, limits on Tier 1 versus Tier 2

• Bank supervision of SIVs and conduits• Accounting treatment of off-balance sheet

vehicles• Emphasis on credit ratings• Ignoring yield curve risks • The moral hazard issues

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Credit and liquidity

• Determinants of spreads on bonds- Credit- Liquidity- Market frictions- Tax

• Measurement of credit risk- Models: structural and reduced form- CDS prices

• Measurement of liquidity premium and liquidity risk

• Interaction between credit and liquidity risk

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The role of correlation

• Multiple assets numbering in the 100s• Two factors :

- probability of default (hazard rate)

- recovery rate (loss given default)• Correlation in defaults across assets• Number of correlations – estimation problems

and dimensionality• Attachment points

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The crisis unfolds …• Falling real estate prices• Losses in hedge funds• Inability of SIVs/banks to refinance their CP

borrowings• “Freezing-up” of the CP market• Bank’s recognition of credit losses: liquidity or

credit?• Unraveling of SIV structures – move to balance

sheer e.g. HSBC• Pressures on rating agencies

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The crisis unfolds … (Contd.)

• Broader liquidity/credit crisis – LIBOR/Fed Funds and LIBOR/TBill spreads explode

• Discount rate/Fed Funds target rate cuts do not quell fears

• TAF and concerted action by central banks• Credit crisis turns into liquidity crisis and then

into a crisis of confidence

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Policy solutions - Micro

• Better models for credit in regulation and risk management

• Regulation of rating agencies to avoid conflicts of interest

• Better accounting disclosure of risks• Encouragement of loss recognition including

bringing structures on to balance sheet• Infusion on new capital from long term strategic

investors• Joint venture to manage liquidity risk

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Policy solutions - Macro

• Coordinated actions by major central banks• Reducing the stigma of borrowing at the

discount rate• Extending the range of assets qualifying for

collateral• Extending the maturity of loans• Fed funds rate cuts and infusion of liquidity by

central banks• TAF facility• Fiscal stimulus

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Q & A