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Assignment on:
Credit Crunch
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COPY I
Abstract
This paper will focus on the basic principles of credit risk transfer, the factors
that lead up to the ongoing global credit crisis, the dire consequences
resulting from the crisis, and suggestions on preventive measures to avoid a
repeat scenario.
A key finding from this paper is that the speed of transmission and severity
of the credit crisis can be traced to the fundamental issue of asymmetric
information within the structure of the credit market that lead to moral
hazard and adverse selection exacerbated by a climate of low interest rates,
a boom in the housing sector and poor corporate governance.
A simple message from this current credit crunch should be clear to all the
key players within the financial marketplace: “There is no such thing as a
free lunch.”
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Table of Contents
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This paper will focus on the how credit risk transfer works , the factors
that lead up to the crisis, the dire consequences resulting from the
crisis , and provide some suggestions on future preventive measures
to avoid a repeat scenario.
Credit risk arises whenever a lender originates a loan due to the risk of
the borrower to fail to pay. Reasons for this could arise be due to
credit events such as bankruptcy, default, debt restructuring or
delinquency. Traditionally, lenders have dealt with credit risk through
the use of financial guarantee agreements and/or collateral securities
(Kothari , 2002).
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There is no agreed single model that can provide a fair value for
these credit derivative instruments. In practice rating agencies
such as Standard & Poor, Moody’s or Fitch provide information
based on historical default probabilities. Also the mathematics
involved in the modellingmodeling the probability of default is
complex. In a practice many banks use in-house valuation
models but the wide range of differences in assumptions and
methodologies across models often lead to different results.
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Another key elementfactor behind the 2007 credit crunch is the conflict
of interest among credit-rating agencies. These agencies not only rate
debt packages but also offer the issuer assistancehelp in constructing
the product in order to obtain certain rating. This service has become a
lucrative business for the rating agencies, for instance, structured
finance deals accounted 40% of Moody’s total revenue in 2006 (Levitt,
2007). In addition, the rating agencies are paid by the issuers of the
securities, not by investors. Hence, they are always in the pressure to
providegive good rating unless absolutely unavoidable (Howley, 2006).
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In the early 1990s in the United States, the credit derivatives market
began to develop to meet large banks need to manage their risk
exposure to large lenders. The earliest credit derivative instrument,
the credit default swap (CDS) were invented in 1995 by Blythe
Masters who was then the head of JP Morgan’s Global Credit
Derivatives group (G.Tett 2006).
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5.0 Contagion Eeffect & of the credit crisis and impact on global
levelGlobal Impact
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Crisis The crisis has caused panic in financial markets and encouraged
investors to cut off their holding in take their money out of risky
mortgage bonds and shaky equities and divertedput it into
commodities as "stores of value". This has partly contributed to Most
3
of the recent increases in global food prices, as result of have been
the result of speculation and weakening of US dollarthe collapse in the
value of the US dollar. (MacWhirtler, 2008)4.
1
Subprime Effects Felt Worldwide, August 24th, 2007, downloaded at http://www.straightstocks.com/foriegn-markets/subprime-
effects/felt-worlwide
2
Arirang News, “Subprime Ripple Effect Sends Stocks Down Worldwide”, Jan.23, 2008, downloaded at
http://english.chosun.com/w21data/html/news/200801/200801230005.html
3
The cost of food: Facts and figures, May 29th, 2008 downloaded at http://news.bbc.co.uk/2/hi/7284196.stm
4
Mother of all bubbles prepares to burst, downloaded at
http://www.sundayherald.com/news/heraldnews/display.var.2104855.0.mother_of_all_bubbles_prepares_to_burst.php
5
Yalman Onaran. "Subprime Losses Top $379 Billion on Balance-Sheet Marks: Table", Bloomberg.com, Bloomberg L.P., 2008-05-
19. Retrieved on 2008-06-04.
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The credit crisis has also brought down share price of one of
largest US investment bank, Bear Sterns, from $169 to $ 2,
clearly due to the loss of confidence in credit markets. Bear
Sterns had been concentrated its main investments mainly on
sub-prime mortgage instruments, collateralized debt obligations
(CDOs) and other securities which are now seen as highly risky.
Bear Sterns then precipitatingIn the first stage of global credit
crunch when , two of its hedge funds, Bear Stearns High-Grade
Structured Credit Fund and Bear Stearns High-Grade Structured
Credit Enhanced Leveraged Fund, had lost nearly all of their
value amid a rapid decline in the market for subprime
mortgages. Following thatSubsequently, Bear Sterns then
pledged a collateralized loan of up to $3.2 billion to "bail out"
the Bear Stearns High-Grade Structured Credit Fund, while
negotiating with other banks to loan money against collateral to
another fund (Creswell et. al., 2007)6. Now However due to a
loss of confidence, other banks werhavee become unwilling to
invest money in Bear Stearns to keep its operations going and ,
leading Bear Sterns no longer has enough cash on hand, known
as liquidity, to fund its operationsto a liquidity crisis that quickly
escalated to a solvency crisis (BBC News, March 2008).7
The decision to stop was made before the 2007 crisis and
Northern Rock was struggling to raise money to fund its lending.
However, fFollowing the widespread losses made by investors in
loans to US homebuyers with poor credit history, investors have
become wary of buying all mortgage debt, including Northern
Rock's. The bank's assets were always sufficient to cover its
liabilities, but it had a liquidity problem because institutional
9
Sean Farrell, The Independent, February 12, 2008, "Northern Rock and Co-op cancel credit card tie-up", downloaded at
http://www.independent.co.uk/news/business/news/northern-rock-and-coop-cancel-credit-card-tieup-781102.html
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6.0
10
"Northern Rock gets bank bail out", September 13, 2007, downloaded at http://news.bbc.co.uk/2/hi/business/6994099.stm
11
Chris Giles, Jane Croft, Kate Burgess and Gillian Tett, "£3bn lent to Northern Rock", Septemnber 22, 2007, The Financial Times
Limited, downloaded at http://www.ft.com/cms/s/0/dbe3a046-68a4-11dc-b475-0000779fd2ac.html?nclick_check=1.
12
"Northern Rock gets bank bail out", September 13, 2007, downloaded at http://news.bbc.co.uk/2/hi/business/6994099.stm
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. (wikipedia, 2008)
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8.0 Conclusion
A simple message from this current credit crunch should be clear to all
the key players (losers) within the financial marketplace starting from
institutions that originate or trade in credit derivative products to the
rating agencies who assess credit risk to government regulators who
establish and monitor the guidelines that shape the market to the
(largely) unassuming public investors:; “There is no such thing as a
free lunch.” Any investment scheme or businesses offering profit
margins significantly higher than the “risk-free” rate of return must be
subjected to the same scrutiny as investments that cause losses.
9.0 References
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Lim’s References
[1] Bernanke, Ben S., and Lown, Cara S, 1991, “‘The credit
crunch”’, Brooking Papers on Economic Activity , Issue 2, p.
205-247.
[2] Owens, Raymond E., and Schreft, Stacey L., 1992,
“‘Identifying credit crunches”’, Federal Reserve Bank of
Richmond Working Paper No. 92-1.
[3] Scott, David L., 2003, Wall Street Words: An A to Z Guide to
Investment Terms for Today’”s Investor, Boston: Houghton
Mifflin.
[4] Lee, Jong-Wha and Park, Cyn-Young, 2008, ‘“Global Financial
Turmoil: Impact and Challenges for Asia’”s Financial Systems,
ADB Working paper Series on Regional Economic Integrtaion
No. 18.
[5] Whalen, Charles J., 2007, ‘“The US Credit Crunch of 2007 – A
Minsky Moment’”, The Levy Economics Institute of Bard
College, Public Policy Brief No. 29.
[6] Ivry, B. and Shenn, J., 2008, ‘“Exploding ARMs Roil
Bernanke'’s Drive to Calm Markets’”. Retrieved 29th June, 2008
from http://www.bloomberg.com/apps/news?
pid=newsarchive&sid=akYNTEygRJH8.
[7] Howley, Kathleen M., 2007, ‘“Rating Subprime Investment
Grade Made `Joke'” of Credit Experts’”. Retrieved 29th June,
2008 from http://www.bloomberg.com/apps/news?
pid=newsarchive&sid=ajdL7eUHeUro.
[8] Levitt, Jr., 2007, ‘“Conflicts and the Credit Crunch’”, Wall
Street Journal (Eastern edition), 7th September.
[9] The Economist, 2008, ‘“Ruptured credit’”, 15th May.
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[7]
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[15] BBC News, 2008, “Q&A: Bear Stearns banking crisis”, 17th
March. Retrieved 4th July, 2008, from 17 March 2008,
downloaded at
http://news.bbc.co.uk/2/hi/business/7296827.stm.
[16] Associated Press, 2008 “JPMorgan Chase Funding Bear
Stearns”, March 14th March. Retrieved 4th July, 2008, from ,
2008, downloaded at
http://biz.yahoo.com/ap/080314/bear_stearns.html.
[17] Yorulmazer, T., 2008, “Liquidity, Bank Runs and Bailout:
Spillover Effects During the Northern Rock Episode”, Federal
Reserve Bank of New York. Retrieved 4th July, 2008, from
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1107570
[18] Castle, S., 2008, “Inquiry Opens Into Northern Rock Bailout”,
June 5, 2008, Retrieved 9th July, 2008, from
http://www.nytimes.com/2008/06/05/business/worldbusiness/
05rock.html?partner=rssnyt&emc=rss.
[19] Sean Farrell, The Independent, February 12, 2008, "Northern
Rock and Co-op cancel credit card tie-up", downloaded at
[20] Chris Giles, Jane Croft, Kate Burgess and Gillian Tett, 2007,
"£3bn lent to Northern Rock", The Financial Time, 22nd
September. Retrieved 4th July, 2008, from
http://www.ft.com/cms/s/0/dbe3a046-68a4-11dc-b475-
0000779fd2ac.html?nclick_check=1.
[21] Federal Deposit Insurance Cooperation (FDIC), 2007, Risk
Management and Allocation Conference, 25th June. Retrieved
4th July, 2008, from
http://www.fdic.gov/news/speeches/archives/2007/chairman/
spj 07.html.
[22] Obama, B., 2008, “Modernizing our regulation of financial
markets.” Retrieved 4th July, 2008, from
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http://www.barackobama.com/2008/03/27/in_major_speech_
obama_calls_fo.php.
[23] Reihl, H., 2008, Subprime Crisis Confirms: There”s No Free
Lunch”, Institute Bank-bank Malaysia (IBBM), Issue January-
February 2008, p.6-8.
[24] Thomson Reuters, 2008, “Islamic banks shielded from
subprime, Bahrain says”, 4th February. Retrieved 4th July,
2008, from
http://www.reuters.com/article/IslamicBankingandFinance08/i
dUSL0421657020080204?pageNumber=2.
[25]
Federal Deposit Insurance Corperation (FDIC), (2007). “ Remarks
By Sheila Bair Chairman, U.S. Federal Deposit Insurance
Corporation; 2007 Risk Management and Allocation Conference,
Paris, France”, Press Releases, 25th June. Downloaded from
http://www.fdic.gov/news/news/speeches/archives/2007/
chairman/spj 07.html
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Lim’s Bibliography
10.0 Bibliographies
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Albert’s Bibliography
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