Chapter 5

Current Multinational Financial Challenges:

The Credit Crisis of 2007–2009

 Questions
1. Three Forces. What were the three major forces behind the credit crisis of 2007 and 2008?
The three major forces behind the credit crisis of 2007 and 2008 were a) complex financial
instruments, b) off-balance sheet accounting entities, and c) increased use of leverage.
a. Innovative securities were hard to value in the best of circumstances and had little history to
indicate how they might behave in a severe market downturn.
b. Few in the markets (or perhaps in the regulatory agencies) had an accurate idea of the scope or
nature of off-balance sheet entities and their activities until the credit crisis arrived.
c. Structured Investment Vehicles (SIVs) were a form of highly leveraged speculation, which was
dependent on the assumption that the markets would always supply liquidity. The risks of SIVs
were significantly underestimated.

2. MBS. What is a mortgage-backed security (MBS)?

A Mortgage-Backed Security is a type of securitized asset, typically backed by a portfolio of first
mortgages.

3. SIV. What is a structured investment vehicle (SIV)?

A structured investment vehicle is an off-balance sheet entity. The first SIV was created by Citigroup
in 1988. They are designed to allow a bank to create an investment entity that invests in long-term
and higher yielding assets such as speculative grade bonds, mortgage-backed securities, and
collateralized debt obligations, while funding itself through commercial paper issuances. SIVs were
not on the balance sheet (i.e., were off-balance sheet) of the sponsoring banks. These same SIVs had
to be reabsorbed by their sponsoring banks when the commercial paper market seized-up at the end of
2008.

4. CDO. What is a collateralized debt obligation (CDO)?

A collateralized debt obligation is a type of asset-backed security (securitized asset), backed by a
portfolio of debt instruments, including mortgage loans, corporate loans, and corporate bonds. Once
packaged, the bank passed the security to a special purpose vehicle (SPV) (not to be confused with a
structured investment vehicle). SPVs are often located in an offshore financial center like the Cayman
Islands for legal and tax advantages. SPVs offer a number of distinct advantages, such as the ability
to remain off-balance sheet if financed and operated properly. From there, the CDO is sold through
underwriters. This frees up the bank’s financial resources to originate more and more loans, earning
a variety of fees. A typical fee was 1.1% up-front to the CDO underwriter. The collateral in the CDO
was the real estate or aircraft or heavy equipment or other property the underlying loan was used to
purchase. These CDOs are sold to the market in categories or tranches representing the credit quality
of the borrowers in the mortgage.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

 Chapter 5 Current Multinational Financial Challenges: The Credit Crisis of 2007–2009 23

5. CDS. What is a credit default swap (CDS)?

A credit default swap is a contract, a derivative, which derives its value from the credit quality and
performance of any specified asset. The CDS was designed to shift the risk of default to a third party
and it is a way to bet whether a specific mortgage or security will either fail to pay as agreed. In some
cases, for hedging, it provides insurance against the possibility that a borrower might not pay. In
other instances, it was a way in which a speculator could bet against increasingly risky securities (like
CDOs) to hold their value. And uniquely, you can make the bet without ever holding or being directly
exposed to the credit instrument itself.

6. LIBOR’s Role. Why does LIBOR receive so much attention in the global financial markets?
LIBOR, although only one of several key interest rates in the global marketplace, plays a critical role
in the interbank market as the basis for all floating rate debt instruments of all kinds. This includes
mortgages, corporate loans, industrial development loans, and the multitudes of financial derivatives
sold throughout the global marketplace.
With the onset of the credit crisis in September 2008, LIBOR rates skyrocketed between major
international banks, indicating a growing fear of counterparty default in a market historically
considered the highest quality and most liquid in the world.

7. Interbank Market. Why do you think it is important for many of the world’s largest commercial and
investment banks to be considered on-the-run in the interbank market?
The interbank market has historically operated, on its highest levels, as a “no-name” market. This
meant that for the banks at the highest level of international credit quality, interbank transactions
could be conducted without discriminating by name. Therefore, they traded among themselves at no
differential credit risk premiums. A major money center bank trading on such a level was said to be
trading on-the-run. Thus, on-the-run banks are viewed to have steadfast credit quality. Banks that are
not on-the-run are considered to be of less credit quality, sometimes reflecting more country risk than
credit risk, and pay slightly higher rates in the interbank market.

8. LIBOR Treasury Spread. Why were LIBOR rates so much higher than Treasury yields in 2007 and
2008? What is needed to return LIBOR rates to the lower, more stable levels of the past?
In July and August of 2008, 3-month LIBOR was averaging just under 80 basis points higher than the
3-month interest rate swap index—the difference being termed the TED Spread. In September and
October 2008, however, the spread rose to more than 350 basis points as the crisis caused many banks
to question the credit quality of other banks. Even this spread proved misleading, as many banks were
completely “locked-out” of the interbank market. Regardless of what they may or may not have been
willing to pay for funds, they could not get them. At the same time in the United States, as banks stopped
lending in mid- to late-September, and many interbank markets became illiquid, the U.S. financial
authorities worked feverishly to inject funds into the marketplace. The result was the rapid reduction
in the 3-month interest rate swap index. The TED Spread remained relatively wide for only a short
period of time, with LIBOR actually falling to under 1.5% by the end of 2008. In January 2009, the
TED Spread returned to a more common spread of under 80 basis points.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall