Foundation of

risk
management
Anatomy of the Great Financial Crisis of 2007-2009
Credit Risk Transfer Mechanisms
Anatomy of the Great Financial Crisis Credit Risk Transfer Mechanisms
of 2007-2009

• Using off balance sheet credit

derivatives
• Other mitigation strategies

FACTOR LEADING TO CENTRAL BANK

HOUSING BOOM INTERVENTIONS
 Factor 1: Cheap credit

Factor 2: Decline in
Factor leading to lending standard
housing boom Factor 3: Financial
innovation: securitization

Factor 4: Asset – Liability

maturity mismatch
Factor leading to
Factor 1: Cheap
housing boom credit

Capital inflow from

Asia  demand for
treasuries 
decrease i/r

Internet bubble 
deflation  policy:
low i/r
Factor leading • Factor 2: Decline in lending standard

to housing • Originate to distribute model of banking

replaced traditional banking model 
boom transfer default risk  banks cared less
about default
• Sub prime loans
1.Borrower have history of delinquent
pmt
2.Loan to value or loan to income high
3.ARMs : adjustable-rate mortgage
4.Some loans are interest-only
5.Some are ninja loans: no income, no
job, no assets
6.Some are liar loans: not examine
applicants’ information
Factor leading • Factor 3: Financial innovation:
securitization risk transference
to housing • Structured products: MBS, CDO
boom • CDO:
• Collateralized debt obligation
• Securitization steps
• Create a SPV
• Pooling: debt assets to form a
diversified portfolio
• Tranching
• Selling
• CDS: CDO holders can buy CDS  very low
risk
Factor leading • Factor 4: Asset – Liability maturity mismatch

to housing • SIVs (structured investment vehicles)

• Invest in long-term MBS,..
boom • Short term funding: repos or issue short
term CP (To mostly MMFs- Money Market
Funds)  Funding liquidity risk (when roll
over)
• Sponsoring banks granted non
contractual/reputable credit line (called: a
liquidity backstop): off balance sheet item for
banks
• Crisis:
• Repo haircut
• LIBOR overnight index swap (OIS) 0%
increase to 3.6%
• SIVs can not borrow  must sell assets
reduce bond price further  systematic risk
 Lower i/r

Provide liquidity

• TAF (Term Auction Facility) lend to

Central bank depository institutions
• Lend to investment banks & securities
interventions firms via discount window
• Buy ABCP and lend via repos (PDCF –
Primary dealer credit facility)
• Rescue AIG, Fannie Mae and Freddie
Mac: bailout and buy bonds
• Long term loan for high quality
collaterals
• Buy toxic assets (TARP – Troubled Asset
Relief Program) in 2008
 Credit Risk Transfer Mechanisms
Using off balance sheet credit
derivatives Other mitigation strategies
• Buy insurance
• Netting
• Marking to market
CDS CDO
Role in • Collateral for loans
crisis
• Termination clause
• Reassignment
• Syndication
Credit Advantage: innovation,
default swap cash flow, risk price
(CDS)
Disadvantage: false
sense of security,

Historically weak
regulation
 1. Securitization
• Create SPV, Pooling, Trancing, Selling
Collateralize • Also called OTD (originate to
distribute) model
d Debt
Obligation
(CDO) (1)
 2. Advantage
• Bank profitability: optimize capital,
Collateralize lower earnings volatility
• Risk management: distribute credit
d Debt risk to various participants
• Investor options
Obligation • Loan access: more loan products,
lower cost for borrower
(CDO) (2)
 3. Disadvantage
• Moral hazard
• Incentive of OTD # traditional buy and hold

Collateralize strategy (quality)

• Encourage risk taking  low underwriting
standards
d Debt • Misaligned incentives: short term focus
• Risk concentration potential: investor does not know

Obligation
• High complexity and opaqueness: lack transparency,
difficult to understand

(CDO) (3)
 4. Pools of
• MBS: mortgage pooling
Collateralize • CMO (collateralized mortgage
obligation)
d Debt • ABS (Asset backed securities):
mortgage, various loan, corporate
Obligation bonds, credit card receivable,…
• CLO (collateralized loan obligation):
(CDO) (4) bank loans: higher credit ranking
• CDO squared: part of another CDO
that can not be sold
 • Misuse, abuse of credit derivatives
• CDS
• Use for speculation, not hedging (2007: 45
trillion)
• Lehman Brothers vs AIG vs Citadel

Role in
• CDO
• Too many sub prime loans
• Too many adjustable-rate loans: suffer from
i/r raise 2004-2006

crisis
• Dodd-Frank Act 2009
• Volcker rule: prohibited commercial banks
from credit?? derivatives
• Commodity futures trading commission to
regulate all swap (incl. CDS)
• SEC’s new rule: section 15G: originators of
securitized products: must retain at least 5% of
credit risk on balance sheet
 • Buy insurance
• Netting multiple exposures to 1 counter party

Other
• Marking to market (margining): daily basis,
periodically revalue position @ require payments
• Collateral for loans: because of wrong way risk

mitigation • Termination clause: trigger events (downgrade,

financial ratios)

strategies • Reassignment: transfer to 3rd party if trigger

events
• Syndication: Lead bank 20%