Risk ManagementUniversity of Economics, Kraków, 2012

Tomasz Aleksandrowicz

risk at financial markets

world financial crisisfinancial risk management

Biggest XX centaury financial crises

• 1929 - Wall Street Crash (Great Depression)• 1973 – oil prices crisis (1973 – 1974 market crash)• 1987 – Black Monday (19 October)• 1989 – 1991 - savings and loan crisis (US)• 1990 - Japanese asset price bubble• 1992–93 – Black Wednesday (16 September)• 1994 - economic crisis in Mexico• 1997 - Asian financial crisis• 1998 - Russian financial crisis• 2001 - dot-com bubble

world financial crisis

case story: dramatic turn of events of 2008

• 17 February – UK government nationalized struggling Northern Rock bank

• March 14 – Bear Stearns gets $30bn Fed funding as shares plummet

• March 16 – Bear Stearns is acquired for $240m a by JPMorgan Chase in a fire sale to avoid bankruptcy (worth $18bn year earlier)

• March - July – more banks around the world starts to announce huge losses many of them seek financing by issuing stock or from governments

• September 7 - US government takeover of Fannie Mae and Freddie Mac

• two companies at that time owned or guaranteed about half of the US $12 trillion mortgage market

• this move causes panic on the markets

• September 14 – Merrill Lynch, 158-year old investment bank is sold to Bank of America for $50bn

• September 15 – Lehman Brothers goes bankrupt

• Stock Exchange collapse: DIJA down 500 points, FTSE100 down 400 points

• September 16 – AIG credit ratings downgraded

• September 16 – $140bn withdrawn from money market funds which causes freeze of CP market

• September 17 – US FED lends $85bn to AIG to prevent bankruptcy

• September 18 – HBOS plc the biggest UK mortgage provider took over by Lloyds TSB for £12bn

US government response

• September 18 - Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke meets with legislators with proposal of $700 billion emergency bailout of toxic assets

• September 25 – due to bank run and $16.4bn deposit withdrawn in 10 days Washington Mutual is closed down by regulator – remaining assets sold to JP Morgan Chase for $1.9bn

• at that time bank assets were worth $307bn

• September 29 - Citigroup Inc. announced that he would acquire banking operations of Wachovia

• Later October 3: Wells Fargo makes a higher offer for Wachovia paying $15bn

• September 29 – September 31: As crisis hits Europe – more banks nationalized

• First days of October – Iceland banking sector nationalized

• stock exchange operations suspended

• rating agencies downgrades

• economic downturn • Iceland first country

to seek IMF help

US solution to liquidity crisis

• October 3 – President George W. Bush signs act creating a $700 bn Troubled Assets Relief Program (TARP) to purchase failing bank assets

• October 6 – Fed announces that it will provide $900 billion in short-term cash loans to banks

• October 7 – Fed makes emergency move to lend $1.3 trillion directly to companies outside the financial sector (effect of freeze in CP)

October 6 2008 – October 10 2008

• Worst week for the stock market in 75 years• The Dow Jones loses 22.1%, its worst week ever

on record, down 40.3 % since reaching a record high of 14,164.53 October 9, 2007.

• The Standard & Poor's 500 index loses 18.2 %, its worst week since 1933, down 42.5 % in since its own high October 9, 2007

world financial crisis

banking and financial sector crisis become global crisis

World Recession in 2009 (% GDP change)

Europe sovereign debt crisis

roots of world financial crisis

causes of crisis in risk perspective

causes of financial crisis

• no simple answer• many direct and indirect factors• variety of narratives describing the crisis• highlights from risk management perspective

main factors

• policy of deregulation of financial sector• government actions to help house purchase• historically low interest rates after 2001 (household

debt ratio up)• speculation (buying houses on investment purposes)• extensive use of sub-prime loans• raise of shadow banking system• predatory lending• housing bubble (peaked in 2005-2006, burst in 2007)

ARM (adjustable-rate mortgages)

• standard mortgage product• mortgage loan with variable (adjustable) interest rate• direct link to the underlying index or to bank policy• initial discounts (e.g. first year payments are interest

only)• variable rate of the loan to offset variable interest

rates of deposits• standard banking product commonly offered to

customers

sub-prime lending

• making loans to customers who might have difficulty with repayment schedule

• compensate for higher credit risk– higher interest rates– less favourable than ordinary terms

• targeting people with little or no assets, bad credit history, lower or unstable income

• traditionally isolated from regular loans

securitization

• Securitization - process in which loans or other income generating assets are bundled to create bonds which can be sold to investors.

• What could be securitized:– home equity loans– mortgages and sub-prime mortgages– student loans– car loans– credit card payments– other

securitized instruments

• ABS (asset-backed security) a security where value and income payments are derived from and collateralized (or "backed") by a specified pool of underlying assets

• MBS (mortgage-backed security) as above ABS but used for mortgages

• CDO (collateralized debt obligation) type of ABS with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans

CDO/SPV model

SPV (special purpose vehicle) - a separate institution created to handle the securitization of ABS

shadow banking system

conclusions

• systematic assumption of house price increase• real estate investment and speculation• too liberal credit policy for mortgages

– NINA loans (no income, no assets customers without down payment)– SIVA loans (stated income not verified) - based even only on credit

rating

• extensive sub-prime lending using also ARM lending• predatory loans activities• too extensive and complex securitization• failed to regulate shadow banking system• CDO - mixing up prime and sub-prime assets

risk management specific factors• rise of financial engineering and complexity of the

securities• derivatives market not regulated• rating agencies paid by security issuer model• financial sector salaries and incentives connected

with short term performance (not regulated)