1
The Subprime Credit Crisis of 07by Michel
Crouhy, Robert Jarrow and Stuart Turnbull

• Discussion by Chester S. Spatt
• Carnegie Mellon University
• (former Chief Economist, SEC)
• 8th FDIC Bank Research Conference
• Arlington, VA
• September 18, 2008

2
Overview

• Crisis had many roots
• What are some of the key economic issues
  identified by the crisis?
• How has the crisis altered our thinking about
  economics and our economy?
• What are some of the current challenges?
• One direct commentPlots of the relative
  performance over time of different instruments
  would be useful

3
Systemic Risk

• Potential for correlated defaults across the
  economycounterparty risk huge, forced sales and
  downward valuation pressures
• Many asset managers investors often invest on the
  same side of a positione.g., long the credit
  spread--common training, expertise and tools
• Securities firms incredibly leveredperhaps far
  too leveraged to have been the optimal holder
• Bearing of risk reflects common incentive
  structure for the general partner and moral
  hazard from regulation

4
Compensation Structure

• Compensation reflects short-term metrics
• Option grants and restricted stock value tied to
  subsequent development, but not bonuses
• Focus on how paid by employee and the firm
• Limited employee wealth and risk aversion makes
  it hard to internalize franchise risk
  (compensation lit. theme)

5
Sources of Financial Institutions Risk

• Explicit portfolio holdings
• Do carry trades produce economic profits?
• Profit streams from various businesses
• Production risk from various businesses
• Reputation risk and use of balance sheet

6
Leverage and Capital

• Need for capitaleconomics
• not just accountingdebate about fair value
  accounting
• How realistic are the marks? At the heart of
  poor financing decisions (evaluations of offers
  of capital)
• Reasonable leverage
• -- Does leverage add value (absent taxes) MM
• FNMA, Freddie examples
• What was capital?
• Nominal leverage

7
Opacity

• Who holds what exposures?Counterparty risk
• Reliable and verifiable prices for illiquid
  instruments (standardization of marks)
• Reluctance to sell instruments with largest
  losses due to illiquidity, so selling and
  problems spill to more liquid assets (problems in
  prime jumbo loans!) when need to reduce
  leverageled to collapse of some institutions
• Transmission of liquidity problems across markets
  (including globally)
• Need to create serious transparency

8
Agency and Adverse Selection

• Orginate to distribute model
• Borrowers contract and decision
• What does lender retain?
• What does securitizer retain?
• What does the seller know?
• Tranchingdespite adverse selection and
  illiquidity in secondary trading
• Flexibility for optimal modification--early study
  of optimal modification in Dunn and Spatt, JF,
  1985

9
Credit Ratings

• Scope for mis-valuing an entire asset class
  rather than individual loan and idiosyncratic
  risk
• Many participants relied upon these and so
  potentially a source of systemic risk
• Outsourcing due diligence (especially to few
  players) is an odd basis for asset
  managementcreating diverse signals
• Ratings shopping and selection
• Move toward less regulatory reliance on ratings
• Are ratings triggers optimal contracts?
• Discontinuous structure, death spirals

10
Mortgage Insurers

• Monolines (Ambac, MBIA), AIG
• What is insurable risk? What is diversifiable?
• Academics viewed muni bond insurance as
  puzzlingafter all, risk could be priced and
  diversified through the capital market
• Muni defaults would be very correlated so ability
  to insure seemed questionable
• Similar issues in insuring mortgages (monolines)
  damaged ability of insurers to earn their muni
  profits

11
Maturity Mismatch

• Bank run (e.g., Northern Rock)
• Auction rate municipal market
• Counterparty risk
• Fragility of liquidityfunding short (carry
  trade) is risky
• Distinction between contingent contract and
  dynamic strategy (fragile)

12
Standardization

• Past emphasis on customization specific
  financings
• Liquidity, uniformity and depth
• Transparency on trading platform, spreads
• Less adverse selection (except for cherry picking
  options)
• Settlement, counterparty risk-Bear Stearns
• Basis risk and risk aversion

13
Systemic Risk and the Regulatory Response

• Externalities freezing financial markets
• What is framework for intervention? (e.g., FDIC)
• Whom do we tax for creating systemic risk?
• Importance of time consistency and the cost of
  flexibility (bazooka for FNMA/Freddie)
• Making it up as we lurch from one
  crisisblinking or playing chicken
• Ex ante and ex post are not very far
  apartbargaining with authorities over
  intervention based upon prior ones
• Market discipline re moral hazard, risk taking

14
Blaming the shorts?

• Why do asset prices fall?
• Because buyers are willing to pay less for the
  instruments than previously
• Raise the cost of short-sale executions?
• --Due to liquidity process about 35 of sales are
  short sales, but overall short interest small
• --Return to the tick test and even more strongly
  bar shorts without a nickel up-tick
• --Abusive naked short sells is not a problem in
  liquid stocks
• Regulators need to focus on core challenges