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The Subprime Credit Crisis of 2007 Michel Crouhy Head of Research and Development NATIXIS Corporate and Investment Bank

The Subprime Credit Crisis of 2007 Michel Crouhy Head of Research and Development NATIXIS Corporate and Investment Bank. Issues to be addressed to avoid a repeat of the “subprime” crisis. Rating agencies

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The Subprime Credit Crisis of 2007 Michel Crouhy Head of Research and Development NATIXIS Corporate and Investment Bank

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  1. The Subprime Credit Crisis of 2007 Michel Crouhy Head of Research and Development NATIXIS Corporate and Investment Bank

  2. Issues to be addressed to avoid a repeat of the “subprime” crisis

  3. Rating agencies • Rating of bonds vs. rating of structured credit products (close to half of their income came from the rating of structured credit products) • Rating of a corporate bond based largely on firm-specific risk and relies on analyst judgment • Rating of a CDO tranche relies on quantitative models as it is a claim on cash flows from a portfolio of correlated assets • Ratings were based on expected loss: a bond and a CDO tranche with the same expected loss have different unexpected losses that depend on the correlation structure, prepayment behavior and the position in the capital structure of the CDO • How to deal with the volatility of ratings? What is the usefulness a very volatile rating? • Rating agencies did not perform any due diligence on the quality of the underlying loans: took for granted the accuracy of the information provided to them by the structurers

  4. Valuation • Better models are clearly needed to generate the loss distribution of correlated credits • Parameter estimation – forward looking: PDs, LGDs, prepayment behavior, default correlations • Transparency • Disclosure: underlying assets of CDOs and SIVs, commitments provided by banks

  5. Instrument design • Going forward we can expect that investors will shy away from complex structures: CDOs squared, CPPI, CPDOs and other structures exposed to “gap risk”

  6. Regulators and Risk Management • Lending standards • Put options to allow banks to put back mortgages to originators in the case of delinquency within a short period • Need for several risk metrics to assess the risk of complex exposures: • VaR for “normal market conditions” • Stress testing and scenario analysis to account for liquidity risk and other complexities (e.g., digital nature of the risk involved in holding a CDO tranche) in extreme market conditions, very unlikely, but still realistic

  7. The Future of Securitization • The objective of the business model “Originate & Distribute” is to allow banks to focus on what they do best originate, structure financial products and redistribute the risks to end-investors by tailoring CRT instruments to their needs • SIVs did not allow banks to redistribute the risks to the end-investors as the securitized assets are coming back to the balance sheet of the banks when liquidity evaporates

  8. Conclusion “Dad was in ABS securitization”

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