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Financial crisis

Financial crisis. How to m ake sense of it. Objectives. Scan literature Organize using graphical representation Build up Collapse Identify likely solutions. Short term incentives for managers. Bad compensation schemes. Lax lending practices. More lending Low Interest rates.

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Financial crisis

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  1. Financial crisis How to make sense of it

  2. Objectives • Scan literature • Organize using graphical representation • Build up • Collapse • Identify likely solutions

  3. Short term incentives for managers Bad compensation schemes Lax lending practices More lending Low Interest rates Higher housing demand Higher home prices Higher collateral , Bad stress testing High profits Shift risk originators to investors High demand for CDOs More loans securitized in CDOs Overconfidence about repaying loan Over reliance on credit rating High credit rating on ABS/CDO tranches Lack of transparency Lower expected loss & probability of loss due to defaults Securitization Bad modelling Build up

  4. Short term incentives for managers Bad compensation schemes Lax lending practices More lending Low Interest rates Higher housing demand Higher home prices Higher collateral , Bad stress testing High profits Shift risk originators to investors High demand for CDOs More loans securitized in CDOs Overconfidence about repaying loan Over reliance on credit rating High credit rating on ABS/CDO tranches Lack of transparency Lower expected loss & probability of loss due to defaults Securitization Bad modelling Build up – fundamental causes

  5. Short term incentives for managers Bad compensation schemes Lax lending practices More lending Low Interest rates Higher housing demand Higher home prices Higher collateral , Bad stress testing High profits Shift risk originators to investors High demand for CDOs More loans securitized in CDOs Overconfidence about repaying loan Over reliance on credit rating High credit rating on ABS/CDO tranches Lack of transparency Lower expected loss & probability of loss due to defaults Securitization Bad modelling Build up – self sustaining reaction

  6. Cannot honour contractual obligations Default High leverage Counterparty defaults increase Can’t sell off House prices fall No lending between financial institutions Low liquidity on credit instruments Institutions’ books shrink Foreclosures increase High loss aversion Default rates increase, correlation of default increases Losses to credit instruments ARMs reset after teaser period ends Collapse

  7. Cannot honour contractual obligations Default High leverage Counterparty defaults increase Can’t sell off House prices fall No lending between financial institutions Low liquidity on credit instruments Institutions’ books shrink Foreclosures increase High loss aversion Default rates increase, correlation of default increases Losses to credit instruments ARMs reset after teaser period ends Collapse

  8. More info For a more in-depth discussion see Irina I, Alex F. (2009) Financial Crisis event chains

  9. Short term incentives for managers Bad compensation schemes Lax lending practices More lending Low Interest rates Higher housing demand Higher home prices Higher collateral , Bad stress testing High profits Shift risk originators to investors High demand for CDOs More loans securitized in CDOs Overconfidence about repaying loan Over reliance on credit rating High credit rating on ABS/CDO tranches Lack of transparency Lower expected loss & probability of loss due to defaults Securitization Bad modelling Focus for this presentation - Models

  10. Gaussian Copula • Default events described by Poisson distribution • Defaults are correlated • Hard to draw correlated Poissons • Easy to draw correlated Normals (Gaussian dist.) Gaussian copula: • Transform to Normal (CDF Poisson  CDF Normal) • Draw correlated Normals instead

  11. Gaussian Copula - Problem Problem: Correlations change, in particular they increase during extreme events (Tail correlation) Solutions: • Use higher static correlations • Use time-varying correlations (GARCH etc..) • Different copula (double-t copula etc..)

  12. Models weren’t REALLY the problem • Institutions did use higher static correlations! • We know this by implying correlations from (high) yields. • So what was the real problem?

  13. Ratings • Credit rating based on probability of default (or expected loss) – a single number! • Rating of bond can be same as of CDO tranche but probability distributions are different

  14. Real problem • Misunderstood credit ratings • Didn’t do own models • Thought high yield came without risk • Models vindicated! (somewhat)

  15. More info Again, for a more in-depth discussion see Irina I, Alex F. (2009) Financial Crisis event chains as well as bibliography.

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