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4. Why is the crisis of 2008 so much worse than the dotcom bust of 2001?
Causes of crisis
Suppose two identical bonds, each with probability of NOT default = 0:9
! prob. default = 1 0:9 = 0:1
!"Side e¤ect": tranches become correlated even if underlying assets are not
The trick: can expand to three bonds
!Result: credit enhancement for both senior and mezzanine tranches (2/3
of the capital)
corporate bonds 1%
(source Fitch, 07)
But to assign rating need an assessment on the joint default correlations
The higher the default correlation ! the more likely it is that all assets
default simultaneously ! the more risky the senior tranches
The role of rating agencies
They tell us that this "AA General Electric bond" is more likely to default
than that "A+ General Motors bond"
Result: "AAA CDO" more subject to systemic risk than a single "AAA
corporate bond"
Paradox of securitization
Why housing market collapse generated a much more severe and systemic
crisis relative to the dot-com burst of 2000?
1. Housing wealth more signi…cant portion of household’s wealth
!In a nutshell: securitization lost its soul ! Especially btw. 2002 and 2007
worked more as a way to circumvent regulation than to diversify risk
Paradox: things went badly not because of too much but because of too
little securitization!
Still open: why did banks take such a huge bet on the real estate market?
3. Externality
What do we mean by externality?
Does not internalize that when things go bad ! will have to …re sale assets
! depress prices ! adverse balance sheet e¤ects for all banks
"Fire- sale" externality
Private valuation of liquidity too high in good times and too low in bad
times
1. Why are credit booms ine¢ cient even when …ancial frictions are in place?
2. Why doesn’t economy replicate 1-st best even though full insurance avail-
able?
3. Why …nancial frictions necessary (but not su¢ cient)? Need balance sheet
e¤ects
Useful constrast (I)
Key element in the crisis: liquidity problem for new …nancial intermediaries
Assets Liabilities
traditional banks long-term loans deposits
investm. banks MBS short-term debt
Inv. banks held long-term assets (e.g., MBS) …nanced via short-term
debt (e.g., commercial paper) !Maturity mismatch
2. Market liquidity
Optimal policy
!Pigou-tax argument
Can capital requirements do it?
(i) Yes: but need to be targeted to aggregate/systemic risk ! Very di¢ cult
(probably need close to 100%)
(ii) Problem with Basle II: target individual risk ! incentive VaR