Financial Crisis

Management of Risk
Course Information
Course Teachers Office Hours
Lecturer: Simone Varotto Monday 15:00 - 17:00

(s.varotto@icmacentre.ac.uk) Wednesday* 15:00 - 17:00
TA: Ludovico Rossi Monday 11:00 – 13:00

(l.rossi@pgr.reading.ac.uk) Tuesday 11:00 – 13:00
TA: Ana Sina Tuesday 11:00 – 13:00

a.sina@pgr.reading.ac.uk Thursday 11:00 – 13:00
TA: Ning Zhang Monday 13:00 – 15:00

N.Zhang3@pgr.icmacentre.ac.uk Tuesday 11:00 – 13:00
*Please note that Simone Varotto’s office hours on Wednesdays

10th and 17th October will be from 15:45-17:00.
1
Lectures/Seminars
Lecture/seminars dates/times/room may vary. Please

check your email regularly for updates.
o Last lecture on Friday 7th December.

o Additional lectures:
Friday 19th October, 16:00-18:00 Madejski
Theatre - Agriculture.
TBC: Tuesday 20th November, 16:00-18:00,
Online lecture via Blackboard
o First seminar on Monday 22nd October.
Reading Material
The recommended text for this course is:

Hull, J. C. (2018) “Risk Management and Financial Institutions,
5th ed.”, Wiley Finance. Free online copy available via our
library.
Additional references will be provided in lecture notes.
2
Module Assessment
Tests
1. Mid-term multiple choice test (30% of final mark), Friday
16th November, 16:00-17:00.
2. End of term multiple choice test (30% of final mark),
Tuesday 15th January, 11:30-13:00.
Note that both tests are paper based NOT computer based.
The tests will be based on the lecture notes (including

comments and examples), seminar exercises and relevant
chapters/sections in the textbook (Hull, 2018), which are
indicated in the reference section at the end of each part of
the lecture notes.
3
Group Project (40% of final mark)
Students will be asked to work in teams. Each team will do their
analysis in Excel and summarise the results in a report. Deadline:
April 2019 (date TBC).
Assessment
The assessment for this project will be based on the following
parameters:
o Technical proficiency: quality of analysis, clarity of Excel

spreadsheet, calculations and results in the spreadsheet
appropriately commented on, clarity and completeness of
summary report.
o Peer assessment. You will have the opportunity to grade one
another’s contribution to the project, which will affect
individual project scores as shown in the table below. A peer
assessment online form will be made available in due course.
Peer assessment criteria

The mark awarded for the project will be scaled according to a
peer assessment of your contribution to the group based on the
following questions:
Did X act compassionately* towards the other members of the

group? Yes/No
Did X attend regularly your meetings and was on time? Yes/No
Did X contribute ideas to the group? Yes/No
Did X produce the work they were assigned and give it to the
group on time? Yes/No
Did X read and comment on the draft report? Yes/No
4
*Compassion score. You should base your compassion score for
a group member on the extent to which that teammate is kind
and helpful towards other group members. Recent research
shows that compassion is a crucial feature of successful teams.
This video explains Google’s philosophy on compassion, which
you may find interesting.
Every “yes” answer translates to a score of 1, while every “no”

results in a mark of 0 for that criterion. I will then calculate an
average for each team member across all peer assessments for
that team member and use it to award a personal score for the
project.
Moderation: A peer assessor’s overall score for a student may be

overridden if the score deviates substantially from the average
score of the student across all peer assessments. Assessments
not submitted will be assumed to be top scores.
5
The table below assumes that the mark for the project is 60%.
Illustration of the impact of peer assessment on a student’s

project mark
Average peer score Proportion of Personal project
project score
score awarded
score>=4 100% 60
3<=score<4 90% 54
2<=score<3 80% 48
1<=score<2 70% 42
0<score<1 60% 36
0 0% 0
Misconduct
If the majority of the members of a group thinks that one or

more of their members are likely to receive a score below 1 they
should get in touch with me as soon as possible. Uncooperative
students may be asked to work alone on a new project.
Requirements for a pass

40%
6
Main Topics
2007-2012 Financial Crisis

e and Current Risk Management
Issues
Risk Management: An Overview. How to Measure Risk.

The Relationship between Capital and Risk. Bank Capital
Regulation.
Basic Statistics, Returns and Value at Risk. Arithmetic and

Geometric Returns. Time aggregation. Parametric and
non-parametric Value-at-Risk models. VaR Time Horizon
and Confidence Level. Expected Shortfall.
Market Risk and Liquidity Risk: Variance-Covariance

Approach, Simulations, Stress Testing, Risk Management
Tools: Component VaR and Best Hedge.
Back-Testing: Likelihood Ratio Test, Type 1 and 2 errors,

Regulatory Framework.
Credit Risk: Probability of Default estimation, Credit

Scoring, Credit Ratings, Credit Default Swaps, Credit Risk
Portfolio Models: JP Morgan’s CreditMetrics.
Risk Mitigation Techniques (TBC): Diversification,

Hedging, Collateral.
7
Part 1
The 2007-2012 Financial Crises and

Current Issues in Risk Management
Overview:
Financial risks in banks
Financial risks and the 2007-2012 Financial Crises

o Behavioural causes
o Timeline
o Credit boom
o Lax lending and housing bubble
o Leverage
o Securitizations
o Regulatory capital arbitrage
o Rating agencies
o Counterparty risk and clearing
o Implicit government guarantees
Lessons from the financial crises
8
1. Financial risks in banks
Liquidity Risk:
o Asset liquidity risk:
Uncertainty about how quickly an asset can be

sold or purchased (time dimension)
Uncertainty about transaction costs in relation
to trade size (volume dimension)
In a very liquid market, transactions can be

completed quickly, at low cost and (almost)
regardless of trade size.
Main Indicator: bid-ask spread
o Funding liquidity risk: uncertainty about availability

of funds at a reasonable cost to meet expected and
unexpected financial obligations.
Main indicators: liquid assets to total assets,

The higher these ratios,
the lower the funding current assets to current liabilities (current
liquidity risk
+ ratio).
Basel III has introduced a minimum global standard

for funding liquidity that has implication for the
asset liquidity in banks’ balance sheet (See LCR and
NSFR in Part 2 Notes).
9
o Consequences of funding liquidity risk for banks
during the sub-prime crisis.
Northern Rock: nationalised (February 2008)

Washington Mutual: defaulted - largest bank
failure ever in the US. (September 2008)
IndyMac: defaulted -4th largest bank failure in
the US (July 2008)
Wachovia: regulators forced its sale to Wells
Fargo (October 2008)
Top 5 US investment banks
Lehman Brothers: defaulted (September
2008)
Bear Stearns and Merrill Lynch: sold at
fire-sale prices to JP Morgan Chase
(March 2008) and Bank of America
respectively (September 2008).
Goldman Sachs and Morgan Stanley:
became commercial banks to be
protected by the government safety net
and reduce funding liquidity risk
(September 2008).
10
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Here is the big reason banks are safer than a decade ago https://www.ft.com/content/0271a93e-81ee-11e7-a4ce-15b2513cb3ff
The build-up to the financial crisis was marked by a rapid growth in wholesale
funding, where banks borrow from one another and other financial institutions,
rather than raising money through deposits from retail banking customers.
1 of 2 25/09/2017, 18:28
Here is the big reason banks are safer than a decade ago https://www.ft.com/content/0271a93e-81ee-11e7-a4ce-15b2513cb3ff
When the subprime mortgage meltdown began, banks lost faith in each other and
those wholesale funding markets seized up.
a.
While many western banks may have reduced their reliance on wholesale funding
since the crisis, Chinese banks have been heading in the opposite direction.
By tapping into the fast-growing market for wealth management products, which
offer savers higher yields than bank deposits, Chinese lenders have fuelled rapid
loan growth.
Wholesale funding now accounts for more than a third of many Chinese banks’ total
liabilities — three times as much as five years ago. Some analysts fear Chinese banks
may yet generate another “Lehman moment”.
Have banks and their regulators done enough to reduce risks in the system? Share
your thoughts in the comments below.
Is China heading for "Great recession" type of crisis?
2 of 2 25/09/2017, 18:28
Credit Risk: risk of portfolio losses due to
o Default risk
o Credit rating downgrade risk
o Recovery risk
An important aspect of credit risk, which played a major

role in the recent financial crisis, is counterparty risk.
This is defined as the risk of losses deriving from the
default of a counterparty in an over-the-counter (OTC)
derivative transaction or in a repo transaction. See Ch. 20
in Hull (2018) for more details.
Three types of credit risk:

o Retail
o Corporate
o Sovereign
Market Risk: risk of losses due to negative asset price

movements. Types of market risk
o Interest rate risk - BONDS

o Equity risk -
STOCKS
o Currency risk
o Commodity risk
… and,
o Asset liquidity risk

o Credit risk
11
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Jun-09 Dec-09
Dec-09 Jun-10
Jun-10 Dec-10
Dec-10 Jun-11
Jun-11 Dec-11
Dec-11 Jun-12
12
Jun-12 Dec-12
Example: corporate credit risk
Example: sovereign credit risk

Dec-12 Jun-13
Jun-13 Dec-13
Dec-13 Jun-14
Jun-14 Dec-14
Dec-14 Jun-15
Jun-15
versus German Bond Yields
Dec-15
Dec-15 Jun-16
Jun-16 Dec-16
Dec-16
Jun-17
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Dec-17
Dec-17
Jun-18
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Jul-08 Dec-08
Jan-09 Jun-09
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Jul-09 Dec-09
Jan-10 Jun-10
Example: equity risk

Jul-10 Dec-10
Jan-11 Jun-11
Jul-11 Dec-11
FTSE100
13
Jan-12 Jun-12
Jul-12 Spain Dec-12
Jan-13 Jun-13
Jul-13 Dec-13
Jan-14 Jun-14
Jul-14 Dec-14
Jan-15 Jun-15
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Portugal
Jul-15 Dec-15
Jan-16 Jun-16
10 Year Government Bond Spreads
Jul-16 Dec-16
Jan-17 Jun-17
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Jan-18 Jun-18
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Jun-10 Jun-10
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Dec-10 Dec-10
Jun-11 Jun-11
Dec-11 Dec-11
Jun-12
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Jun-12
Dec-12
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Dec-12
Jun-13
Jun-13
France
Dec-13
Dec-13
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Jun-14
Dec-14
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Jun-15 Dec-15
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Mar-09 Mar-09
Oct-09 Oct-09
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May-10 May-10
Dec-10 Dec-10
Jul-11 Jul-11
Example: commodity risk
15
Feb-12 Feb-12
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Sep-12 Sep-12
Apr-13 Apr-13
Nov-13 Nov-13
Jun-14 Jun-14
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Jan-15 Jan-15
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Oct-16 Oct-16
May-17
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Jul-18
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Dec-13
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Jun-16
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Jun-18
Co-existence. The same asset can be subject to market,
credit and (asset) liquidity risk. For example, bonds,
stocks and derivatives.
o For instance, a change in the price of a stock

(market risk) can be due to a credit downgrade or
default (credit risk).
o The distinction was introduced for practical reasons.
Historically one could identify two types of

investors:
Investment bankers who have a short

term investment horizon and buy and sell
traded securities. As a result they are
mainly exposed to the risk of market
price fluctuations (i.e. market risk)
Commercial banks engaged in traditional

lending. Before securitizations, retail and
corporate lending was typically (and still
is to some degree) a buy-and-hold
investment activity mainly subject to
default risk.
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Regulators have also contributed to the

entrenchment of this artificial differentiation
with distinct bank capital regulations for
market risk and credit risk (though this is now
changing).
To address the co-existence of risk types in

different instruments and type of banking
activity, regulators have, for example,
introduced market risk regulation with credit
and liquidity elements. The Basel Committee
(2016) states that
“Varying liquidity horizons are

incorporated into the revised [rules] to
(
mitigate the risk of a sudden and severe
impairment of market liquidity across
asset markets. These replace the static
10-day horizon assumed for all traded
instruments under VaR in the current
c
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“Default Risk Charge (DRC) captures
default risk of credit and equity trading
book exposures”.
18
Basel Committee
on Banking Supervision
See Hull (2018) Chapter 18 for details
STANDARDS
Minimum capital
requirements for
market risk
January 2016
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Operational Risk:
Basel 2 definition: “Operational risk is defined as the risk

of loss resulting from inadequate or failed internal
processes, people and systems or from external events.
This definition includes legal risk, but excludes strategic
and reputational risk.”
Types of operational risk:
o Internal fraud: e.g. situations when traders

intentionally falsify information, i.e. rogue trading,
money laundering, Forex scandal, Libor scandal …
check Wikipedia for recent updates).
o External fraud: e.g. cybercrime: “Cybercrime is on

the rise, with attackers developing increasingly
sophisticated hacking methods to break through
banks’ defences. It is one of the biggest risks to
global banking, threatening to defraud customers
and cripple lenders.” (FT August 2017, Briton
extradited from Germany to face bank hacking
charges)
o See Hull 2018 Ch. 23 for further details.
19
US haul from credit crisis bank fines hits $150bn https://www.ft.com/content/71cee844-7863-11e7-a3e8-60495fe...
Financial institutions have paid more than $150bn in fines in the US

relating to the credit crisis, passing a significant milestone a decade after it
became clear American subprime woes had become a global problem.
Ten years ago this week, France’s BNP Paribas barred investors from
accessing money in funds with subprime mortgage exposure, citing a
“complete evaporation of liquidity”. The date — August 9 2007 — is pegged
by many as the moment the financial crisis began.
Financial institutions have largely recovered from the Great Recession that
followed, but the crisis profoundly reshaped economies and markets, and
1 of 5 25/09/2017, 16:12
the effects on politics and society are still being felt. Dealing with banks’
alleged misdeeds from the era also remains unfinished business.
The public outcry for accountability ushered in an era where the US

government was willing to penalise financial institutions sharply, yet most
crisis-related actions were civil rather than criminal. Much of the public
remained unsatisfied because few bankers went to prison.
A trio of multibillion-dollar settlements with European banks this year has

netted $19bn for the Department of Justice and regulators, including
$5.5bn paid by Royal Bank of Scotland of the UK last month — taking the
total over the landmark figure.
A single bank, Bank of America, has paid more than one-third of all
recoveries to US authorities, according to an analysis by the Financial
Times. Its $56bn in settlements with state and federal regulators and the
DoJ cover its own mortgage sales and actions by two companies it acquired
— subprime mortgage lender Countrywide and broker Merrill Lynch.
JPMorgan Chase, which acquired Bear Stearns and Washington Mutual,

has paid the second-largest amount, with $27bn in fines and relief.
The FT analysis of fines against banks, rating agencies and other
2 of 5 25/09/2017, 16:12
institutions covers conduct ranging from the faulty underwriting of

mortgages, improper foreclosure practices and discriminatory lending to
the mismarking of auction rate securities. The bulk of the $150.1bn total —
$89.1bn — was to settle allegations that institutions misled buyers of
securities backed by mortgages.
New cases related to the crisis are still being filed and investigations
continue, suggesting the $150bn total could grow. Barclays is fighting a
DoJ lawsuit alleging it misled buyers of mortgage-backed securities.
“You can argue that the fines are too high or too low. Nobody would argue
that the non-compliance behaviour needs to be addressed,” said Gerold
Grasshoff, a senior partner with Boston Consulting Group.
Prosecutors have demanded guilty pleas from banks for crimes ranging
from money laundering to violations of US sanctions law. Including those
3 of 5 25/09/2017, 16:12
settlements, financial institutions have paid more than $321bn worldwide

from 2007 until the end of 2016 for all types of misdeeds, according to a
report by Boston Consulting.
“We expect fines and penalties by regulators in Europe and Asia to rise in
coming years,” the report concluded.
Some authorities have said the lack of cases against top Wall Street
executives reflects the difficulty in proving criminal intent, since they were
often several levels removed from the fraud or insulated by lawyers. Others
suggest the DoJ was unwilling to pursue cases they might not win.
“Our nation cannot afford to take our eye off the ball when it comes to
crime or other illegal practices inside banks that require law enforcement
response,” said Christy Goldsmith Romero, the inspector-general of
Sigtarp, the federal agency overseeing government bailout funds.
“If a corporation is engaged in illegal practices they should not be able to

buy themselves out of accountability. The recoveries are important because
there must be a cost,” Ms Goldsmith Romero added. “DoJ has to be willing
to step outside of its comfort zone. They have to be willing to put the
evidence in the hands of the jury.”
4 of 5 25/09/2017, 16:12
Data analysis and graphics by Claire Manibog in New York
5 of 5 25/09/2017, 16:12
2. Financial Risks and the 2007-2012 Financial Crises
2.1. … but before we start let’s have a look at

“Non-Financial Risks”
Crises are cyclical because of persistent behavioural

biases (Economist.com “The Bias Curse” 9th May 2014),
e.g.
o Short memory. The past is past!

o Short termism. The future is now!
o Herding and greed
20
Richard Thaler wins Nobel Prize for Economics https://www.ft.com/content/aa08d810-acd8-11e7-aab9-abaa44b1e130
Richard Thaler has been awarded the Nobel Prize for Economics for his work on
incorporating insights from psychology into economic theory and policymaking.
The award, which is officially known as the Sveriges Riksbank Prize in memory of
Alfred Nobel, was awarded to Prof Thaler for his “contribution to behavioural
economics”, the prize committee said.
The US economist is currently professor of behavioural science and economics at the

University of Chicago. He is the 79th recipient of the Nobel, which was announced
by the Royal Swedish Academy of Sciences in Stockholm today. He will receive a
prize of 9m Swedish krona ($1.1m).
Economists have traditionally assumed that individuals behave rationally, making

decisions on the basis of all information that is readily available to them and not
1 of 3 09/10/2017, 12:45
Richard Thaler wins Nobel Prize for Economics https://www.ft.com/content/aa08d810-acd8-11e7-aab9-abaa44b1e130
making decisions that they regret in hindsight.
Prof Thaler’s work has focused on incorporating insights from psychology to help
explain why in practice individuals behave in ways that are not fully rational — for
example, struggling to save for retirement and placing a higher value on items or
money they already have than on those they might buy or win.
After the prize was announced, Prof Thaler, who is a keen golfer, said he would try
to spend the money “as irrationally as possible”.
The insights from his work were summarised in the global bestseller Nudge, which
was co-authored with Cass Sunstein, a professor at Harvard. Prof Sunstein quipped
on Twitter that the decision to award the prize to Prof Thaler was “an unboundedly
rational choice for the Nobel”.
The prize committee said Prof Thaler’s work had inspired many other researchers
and transformed the field of behavioural economics, which his work spawned, from
being “a fringe and controversial” field to a “mainstream area”.
Prof Thaler’s work has shown how nudging people can help them exercise greater
self-control. These conclusions have been influential in shaping economic policies in
recent years.
He served as an adviser to the behavioural insights team, which advised the UK

government on incorporating ideas from behavioural economics into policy design.
He has also advised the Swedish government on improving the design of their
pension system.
Prof Thaler made a cameo appearance in the 2015 film The Big Short, in which he
appeared alongside Selena Gomez to explain how synthetic collateralised debt
obligations proliferated in the run-up to the financial crisis of 2007-2008.
2 of 3 09/10/2017, 12:45
Memory bias. Placing more weight on recent events than on
past ones. Interestingly, some volatility prediction models are
based on this idea (EWMA).
Haldane (2009): “Back in August 2007, the Chief Financial

Officer of Goldman Sachs, David Viniar, commented to the
Financial Times:
“We are seeing things that were 25-standard deviation moves,

several days in a row” To provide some context, assuming a
normal distribution, a 7.26-sigma daily loss would be
expected to occur once every 13.7 billion or so years. That is
roughly the estimated age of the universe.
A 25-sigma event would be expected to occur once every 6 x

10124 lives of the universe. That is quite a lot of human
histories.
When I tried to calculate the probability of a 25-sigma event

occurring on several successive days … the computer said
“No”. [Clearly] the model was wrong.”
21
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Hyperbolic discounting. It is the “memory bias” applied to the
future. People value short term cash flows (a bonus or short
term sales) much more than long term cash flows.
Source: www.farnamstreetblog.com
Implication: short termism.
Compensation and short termism
Long-term compensation and claw-backs: In 2009, the

Financial Stability Board (FSB) introduced principles of
sound compensation practices that are “aligned with
long-term value creation and prudent risk-taking”. The
principles state that “[f]or senior executives as well as
other employees whose actions have a material impact on
the risk exposure of the firm:
... a substantial portion of variable compensation (i.e.

bonuses), such as 40 to 60 percent, should be payable
under deferral arrangements over a period of years;
22
Subdued or negative financial performance of the firm
should generally lead to a considerable contraction of the
firm’s total variable compensation, taking into account
both current compensation and reductions in payouts of
amounts previously earned, including through malus (i.e.
negative bonus) or clawback arrangements.”
The implementation of these principles has been

undertaken by the Basel Committee on Banking
Supervision, the International Association of Insurance
Supervisors (IAIS) and the International Organization of
Securities Commissions (IOSCO). Similar principles have
been embedded in the Dodd-Frank Act that was signed
into law in the United States in 2010.
Greed and Herding:
One well acquainted with these risks is Warren Buffett who is

reported to have said:
“When everyone is greedy, it is time to be fearful

When everyone is fearful, it is time to be greedy”
23
Bank of England tightens bonus rules https://www.ft.com/content/709cab9e-b9e4-11e5-bf7e-8a339b6f2164
1 of 4 11/10/2016 11:03
2 of 4 11/10/2016 11:03
3 of 4 11/10/2016 11:03
Rigid structures may no longer

serve clients’ best interests But some managers say a ranking
system provided by Morningstar is
unfair
4 of 4 11/10/2016 11:03
2.2. Highlights of the Crises: What happened?
2007-2009 Subprime Crisis

22 Apr 2007 Second-largest US subprime lender, New
Century Financial, declares bankruptcy
25 Jul 2007 Carry trade experiences a 6 standard
deviation move
9 Aug 2007 BNP Paribas halts redemption from three
money market funds exposed to subprime
14 Sep 2007 Run of Northern Rock deposits
17 Feb 2008 Northern Rock is nationalized
16 Mar 2008 JPMorgan buys Bear Stearns following
liquidity shortage at the latter
June 2008 MBIA and Ambac lose their AAA ratings
11 Jul 2008 IndyMac closes down
7 Sep 2008 Fannie Mae and Freddie Mac are taken into
conservatorship (i.e. “mild nationalization”)
15 Sep 2008 Lehman Brothers files for bankruptcy, BoA
announces purchase of Merrill Lynch
16 Sep 2008 US government provides emergency loan to
AIG
16 Sep 2008 Reserve Primary Fund “breaks the buck”
due to its holdings of Lehman Brothers
debt
25 Sep 2008 Washington Mutual goes bankrupt, assets
sold to JPMorgan
29 Sep 2008 Bradford and Bingley is nationalized by the
UK government
3 Oct 2008 Wells Fargo merges with Wachovia
24
12 Dec 2008 Bernard Madoff is arrested for allegedly
carrying out a Ponzi scheme.
19 Dec 2008 The Bush administration agrees to lend
$13.4 billion to GM and Crysler
2007-2009 Several anti-crisis measures by
governments and central banks around the
world: Troubled Asset Relief Program TARP,
Commercial Paper Funding Facility, Money
Market Investor Funding Facility, Term
Asset-Backed Securities Loan Facility
(TALF), interest rate cuts, Quantitative
easing, …
2010-2012 Sovereign Crisis

May 2010 Greece is bailed out by the EU and the IMF
(Euro 110bn)
Nov 2010 Ireland is bailed out by the EU and the IMF
(Euro 85bn)
May 2011 Portugal is bailed out by the EU and the IMF
(Euro 78bn)
Feb 2012 Greece is a bailed out for the second time
(Euro130bn)
Mar 2012 Greece restructures its debt (i.e. defaults)
Jul 2015 Greece is bailed out by the EU (Euro 86bn)
Source: Acharya and Richardson (2009), p. 51-56 and press
articles.
25
2.3 The causes of the 2007-2009 crisis
2.3.1. Credit boom: low interest rates and easy access to credit
o Low interest rates:

The Fed, the Bank of England and other central
banks kept interest rates low even though the
property market was booming. Mr Greenspan,
the former chairman of the Fed, was of the
opinion that it was not a good idea to burst
bubbles, but to wait until they burst naturally
and then intervene with corrective monetary
policy.
Inflation measured without taking into account
property prices.
o Easy access to credit:

Partly justified by low interest rates
Excess liquidity: emerging markets had a
surplus of savings and developed economies
were ready to borrow (especially retail
customers, i.e. mortgages and consumer loans)
Low risk premia: Excess liquidity drove down
the cost of borrowing, i.e. risk premia, giving
the false impression that loans were less risky
than they actually were
Excess supply of liquidity created incentives for
banks to lend to non-prime customers beyond
prudent levels.
26
two with
Monetary policy
:
hitting pigeons
st
one
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inner
9
%
µ House Prices
Prices
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-
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me
Could the FED raise rates? See The potential canary in the U.K. debt
market - FT 2017 (non conforming mortgages) - a rate rise could trigger a
wave of defaults as weak borrowers become unable to repay their
mortgages
o Have we seen this before?
“The probable causes of the Great Depression
include the loose money policies of the Federal
Reserve and the misallocation of capital based
on easy and inexpensive credit.” (Wikipedia:
Depression)
2.3.2. Housing Bubble:
o US housing market started to decline in 2006.
27
Martin Wolf: Nothing like this has happened in 323 years https://www.ft.com/content/5e5b2fca-7ed0-11e7-ab01-a13271d...
The Bank of England was founded just over 323 years ago, in July 1694, at
the instigation of King William III. It is the second oldest continuously-
functioning central bank in the world, after Sweden’s Sveriges Riksbank,
founded in 1668.
The Bank of England supported the UK’s public finances and stabilised the
British financial system through the wars with Revolutionary and
Napoleonic France, two world wars and the Great Depression. Throughout
that period, the Bank has made secured overnight loans to commercial
banks (under different names).
1 of 2 02/10/2017, 14:26
Martin Wolf: Nothing like this has happened in 323 years https://www.ft.com/content/5e5b2fca-7ed0-11e7-ab01-a13271d...
Prior to January 2009, the Bank had never lowered its lending rate below
2 per cent. But it was then lowered to 1.5 per cent, on its way to 0.5 per
⇒
cent in March 2009 and 0.25 per cent in August 2016. This ultra-easy
policy was further buttressed by a huge expansion of the Bank’s balance
sheet, which now contains £435bn in UK government “gilt-edged”
securities and £10bn in corporate bonds.
Currently at 0.75%
Throughout this prolonged recent period of ultra-easy monetary policy, the
concern has never been one of runaway inflation, but rather of the
opposite. This time really has been different. What does it mean for the
future? Nobody knows.
2 of 2 02/10/2017, 14:26
2.3.3. Ill-conceived mortgage products:
o Several mortgages were Adjustable Rate Mortgages

(ARMs) with teaser rates, i.e. low rates that were
bound to increase at predefined “reset” dates.
2/28 and 3/27 ARMs (i.e. 2-3 years fixed and 28-
27 years floating) were in essence designed to be
refinanced under the assumption that house prices
would grow. After the first short period of low and
fixed interest, the rate and, consequently, the
monthly mortgage payments, jump upward
dramatically (e.g. LIBOR + 6%)
o Others where mortgages with balloon payment, i.e.

short term with monthly instalments designed to
cover only interest not the principal which is paid as
a lump sum at maturity. With these mortgages one
does not build equity. At maturity (5-7 years) if the
price of the house has fallen the borrower will have
negative equity on the property.
o Result: non-prime mortgage holder will have only

two options when the rate becomes variable:
Refinance: this is a possibility if house prices
have gone up since the mortgage was taken
out
Default
28
If the
only way
is up!
+
a
⇐
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-
.
th
NINJAS priceat
House t : los
105 ( keep 5 to
Mortgage interest )
pay
At tti : REMORTGAGE
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*
15 in
year pocket !
Even Gu efford I !
2.3.4. Lax lending practices:
o These were especially widespread in the US (with the

UK possibly following closely behind).
NINJA mortgages granted to borrowers with no
income, no job, no assets
Agency problem in the originate-to-distribute
model.
o Regulators failed to impose limits on underwriting

standards. Faith in the efficiency of the market.
o Was it all madness?
“In 1999, under pressure from the Clinton

administration, Fannie Mae, the nation's largest
home mortgage underwriter, relaxed credit
requirements on the loans it would purchase
from other banks and lenders, hoping that
easing these restrictions would result in
increased loan availability for minority and
low-income buyers.”
29
FT Article
FT.com: A decade on from the financial crisis, what

have we learnt? As cheap money floods global economy,
Patrick Jenkins asks if a similar mess looms
by Patrick Jenkins
August 31, 2017
A well meaning political decision

It is hard to pinpoint when the financial crash of 2007 began. Its
roots arguably trace back a good 12 years. It was in 1995 that Bill
Clinton’s administration delivered a laudable affordable-housing
agenda through amendments to the Community Reinvestment
Act.
Subprime and Securitizations

Not by chance, it was in 1995, too, that a trio of ambitious young
financiers founded New Century Financial in Irvine, California.
Brad Morrice, Edward Gotschall and Robert Cole reckoned the new
rules Clinton had ushered in would help them make a killing
among people whose poor credit records had previously barred
them from buying a home. They were right. Soon a rampant new
“subprime” market was granting mortgages to many people who
couldn’t really afford them.
New Century was America’s biggest independent subprime

mortgage lender, granting tens of billions of dollars of mortgages
a year. To fuel its rapid growth it spurned the traditional, hard-
grind funding method of gathering deposits, relying instead on
fashionable new “securitisation” structures, which wrapped up
parcels of mortgages for resale to Wall Street investment banks
and, in turn, to investors around the world. The market for
FT Article
mortgage-backed securities (MBS) and even more complex

“collateralised debt obligations” (CDOs) boomed.
Underwriting standards
So great was investors’ appetite for these high-yielding MBSs and
CDOs that mortgage companies lowered their underwriting
standards to feed the securitisation sausage machine. Fatally, as
loan quality was deteriorating, the Federal Reserve was
simultaneously raising interest rates amid concern about
consumer inflation. Soon subprime borrowers were defaulting en
masse. And mortgage lenders like New Century Financial quickly
found themselves in trouble. Their reliance on the whizz-kids of
Wall Street backfired spectacularly. Not only did the appetite for
new mortgage-backed securities dry up. Small-print clauses
obliged the group to buy back the defaulting loans in earlier
securitisations. At the same time, investment banks and hedge
funds were pushing down the value of the securitisations still
further through “short-selling” strategies.
Funding liquidity risk

If there was one moment when Wall Street knew that a crisis was
looming, it was on April 2 2007, when New Century filed for
bankruptcy. Over the months that followed, a wildfire spread
around the world. Funds set up to invest in the securitisations —
so-called structured investment vehicles, or Sivs — had to be
bailed out by the banks that had created them. Some banks
managed to absorb the hit. Others, such as Germany’s IKB,
collapsed. In early August, France’s BNP Paribas decided to freeze
withdrawals from a trio of funds linked to subprime mortgages.
Market nervousness turned to panic. Banks stopped their usual
practice of lending to each other overnight, unsure of who held
what on their balance sheets. They found themselves unable to
FT Article
issue new securitisations or even mainstream bonds. And with

that, the fate of Northern Rock, which relied for an unprecedented
70 per cent of its funding on these “wholesale markets”, much of
it very short-term money, was sealed.
If the 2007 leg of the crisis felt scary, 2008 would prove far more
systemic, as panic spread and a string of big name financial
institutions were felled, either by their investment in mortgage-
backed securities or the related seizure of funding markets.
The financial crisis: a decade of debt
Would another major crisis happen again?

Given the progress, could it all still happen again? There is
certainly mounting concern about a subprime car-loan crash. The
US car finance market has expanded 70 per cent over the past
seven years, and loan defaults are running at six-year highs — for
some, an uncanny echo of the mortgage crisis of 2007. Many
bankers and regulators are sanguine, nonetheless, and point to
higher regulatory capital requirements as evidence of a stronger
banking system. In June, Janet Yellen, the Federal Reserve chair,
declared that another financial crisis was unlikely “in our lifetime”.
But other policymakers are on edge. In its recent financial stability

report, the Bank of England highlighted Brexit, excessive
consumer debt and China as risks to beware. Governor Mark
Carney sees China, where the total debt-to-GDP ratio has soared
above 300 per cent, as a serious danger. “It is the biggest risk to
financial stability,” says one person close to the governor,
pointing out that many of the pre-crisis practices in the west,
such as the creation of Sivs to invest in high-risk assets, are
FT Article
commonplace in China today. “If you want to find a Siv, go to

China,” the person says.
Chinese banks are now the biggest in the world. Both Industrial
Commercial Bank of China and China Construction Bank are more
than triple the size they were a decade ago.
Mark Carney sees China, where the total debt-to-GDP ratio has
soared above 300 per cent, as a serious danger to financial
stability
Western finance, despite all the regulatory reforms, is hardly

failsafe, either. If banks were deemed too big to fail a decade ago,
many are even bigger today, thanks to mergers and ongoing
growth. Bank of America’s balance sheet has ballooned by 50 per
cent, JPMorgan’s is two-thirds bigger and BNP has expanded by
15 per cent. “We haven’t had the test of a downturn,” warns the
FDIC’s Hoenig.
Risks from Non-banks

But for some, it is the expansion of “non-bank” financial groups
like asset managers that poses more worrying risks. BlackRock,
the world’s biggest fund management group, now has $5.7tn of
assets under management, four times as much as it had a decade
ago. And close to half of US equity funds are now run as “passive”
investments that have to track an index, rather than being
“actively” chosen by a fund manager. “The worry is that fewer HERDING
bigger clients all go the same way,” says the markets boss of one
big European bank. “Volatility is super low until it’s super high.”
History repeating itself

FT Article
One of the inescapable truths of the past 10 years is that the

central bank policies introduced to mitigate the crisis may be
sowing the seeds of another one. As in the run-up to 2007, ultra-
low interest rates have been distorting the world’s finances. In
addition, an abundance of cheap money flowing into the markets
thanks to quantitative easing has also pushed up the world’s debt
burden. The Institute of International Finance said in June that
global debt hit a record $217tn, up by $70tn in a decade, with
much of the growth centred on China and other emerging
markets. At the same time, investors are seeking “yield” wherever
they can find it, pushing up the value of a range of investments.
So-called asset bubbles are everywhere as a result.
The UK’s housing market, particularly in the south-east of

England, is one of the most obvious. With London house prices
=
now at 14 times average earnings, up from a long-term norm of
eight times, experts say the only question is when and how the
bubble bursts, not if. “As real interest rates return to normal,
asset prices are bound to fall relative to incomes,” says Lord King.
“In the UK, we have to see a sharp slowing of consumption and a
switch to exports and investment. That has to happen either
through higher taxes or higher interest rates. But something will
have to happen in order to encourage us to spend less. Asset
prices will deflate one way or another.”
Martin Sandbu’s Free Lunch Email, premium, daily
When the 2007 crisis broke, fingers of blame were pointed in all
directions. At subprime mortgage companies for selling loans
inappropriately. At borrowers for taking on too much debt. At
investment bankers for creating and marketing irresponsible
products. And at policy makers for presiding over an environment
of low interest rates and lax regulation that allowed a crisis to
FT Article
ferment. But some bankers are more self-critical. “At the end of
the day, the crisis was the banks’ fault,” says one former Lehman
Brothers executive who still works on Wall Street. “You can’t
blame the regulator — just because a gun is left sitting on the
counter, it doesn’t mean you have to pick it up and shoot
someone.” The financial industry should remember that next
time.
Patrick Jenkins is the FT’s financial editor

FT Article
‘Nonprime has a nice ring to it’: the return of the

high-risk mortgage
Subprime loans were one of the main causes of the financial
crisis. So why is lending to high-risk borrowers making a
comeback?
August 31, 2017

by Ben McLannahan
[…]
Underwriting standards
Under President Donald Trump, for example, agencies are under
orders to review just about every financial rule that emerged
under Barack Obama. In June, the Treasury department put out a
report saying that tight underwriting standards were partly to
blame for “anaemic” growth in housing, which accounts for
almost one-fifth of GDP.
Subprime market is back

The market for securitising subprime loans is picking up, too,
spreading the risk of default in much the same way as before.
Fitch, the credit rating agency, expects $3bn of issuance of
nonprime mortgage-backed securities (MBS) this year, up from
about $1bn over the previous 18 months. (Back in January, it was
predicting $2bn for the year.)
This time is different

This time it’s different, say the lenders. Thanks to the Dodd-
Frank Act of 2010, the nonprime loans being written now bear
little relation to the sludge that stunk up the system a decade
ago.
FT Article
Perl and Gunderlock say they spent weeks going through the 800
pages of Dodd-Frank that was relevant to mortgages, as they
looked to crank up the machine again. There were all kinds of
proscriptions on funding and closing and servicing a loan, says
Perl, but in the end it came down to this: “People have to be
relatively reasonable about how they treat borrowers. You can’t
lie, you can’t cheat, you can’t steal.”
Gone, as a result, are some dubious features that caused trouble

last time round, such as zero deposits or low teaser rates that
adjusted sharply higher in two or three years. Gone, too, are the
negative amortisation loans that allowed borrowers to pay less
!
than the interest due, so that the loan balance actually grew.
There’s no more “stated income” either: whatever the borrower

declares, the lender has to check by looking at pay stubs and tax
returns, rather than assuming it’s the truth.
Granted, standards in nonprime are generally looser than those

that apply to mortgages eligible to be bought by government
agencies such as Fannie Mae. Such loans are known as “qualified
mortgages”, or QM, and they account for the vast majority of
America’s home-loan market.
But today every mortgage has to conform to an overarching

standard known as ATR, or “ability to repay”. Unless a lender can
be convinced in eight separate ways that the borrower has the
means to pay the thing back, it can be sued down the track if the
loan goes bad.
[…]
FT Article
Perl and others note that investors in these new classes of

nonprime MBS have extra degrees of comfort. Under Dodd-Frank
reforms that took effect in 2015, sponsors of a deal need to
retain an interest of at least 5 per cent of the aggregate credit risk
of the assets they’re turning into securities. It’s known as “skin in
the game”: if originators are on the hook for losses, the theory
goes, they’ll take a lot more care over what they’re producing.
Before the crisis, there was no minimum ownership, resulting in

mortgage firms simply flipping all kinds of dross at Goldman or
Merrill or Bear Stearns. “This is not an originate-to-sell model; it’s
an originate-to-own model,” says Fierman of Angel Oak. His firm,
which buys nonprime loans from other brokers as well as
originating its own, has been the most active of MBS issuers,
completing four deals since 2015 worth a total of $630m. He says
that Angel Oak has gone well beyond the basic 5 per cent
threshold, owning as much as 10 per cent of its MBS deals at
various points. “Trust has to be built with investors,” he says.
“They’re watching us closely.”
Some of the big names on Wall Street have already tiptoed back
in. Pimco, the world’s biggest bond house, has 25 per cent of the
equity in Perl’s Citadel, according to a person familiar with the
ownership structure. Blackstone, the private equity giant, has a
cluster of nonprime investments, including a stake in Bayview
Asset Management, a firm which buys mortgages from Coral
Gables, in Florida.
Will the big US banks get back into subprime? Inevitably, says Guy
Cecala, CEO and publisher of Inside Mortgage Finance, the
industry bible. He notes that overall mortgage originations in the
FT Article
US have slipped about one-fifth this year, mostly because a rise in

interest rates has caused refinancing business to drop.
“At the end of the day, every lender out there, unless they want to
see their business decline, has to look at alternative products,” he
says.
In the meantime, other banks are taking supporting roles. Credit

Suisse and Nomura, for example, are supplying lines of credit to
originators and underwriting securitisations of subprime
mortgages. Fitch, DBRS and Kroll, the credit rating agencies, have
given their stamps of approval to a succession of securitisation
deals.
Even Standard & Poor’s, which paid $1.4bn in 2015 to the US

Department of Justice to resolve a probe into ratings inflation, is
back on the scene, rating five deals this year. (Moody’s, which
settled with the government in January this year, has yet to re-
appear.)
[…]
One regret? Not trademarking “nonprime”, which [Dan Perl] thinks

he coined five years ago.
As for “subprime”, he never liked it.
“It sounds kind of Neanderthal, doesn’t it? It sounds almost like

you’re a monkey and humans are better. But nonprime has a nice
ring to it.”
Ben McLannahan is the FT’s US banking editor

o Mortgage default: a type of retail credit risk.
Mortgage default is crucially linked to house prices.

Below is a figure reporting the relationship between
house prices and mortgage default risk in the US:
state/origination year and national/origination year,
1985-1995 cohort for a 80% loan-to-value ratio,
and 30-year fixed rate home-purchase mortgages
(Van Order, 2008)1.
1
Van Order, Robert (2008) “Modeling and Evaluating the Credit Risk of Mortgage Loans: A Primer”, The
Journal of Risk Model Validation, Vol. 2, No. 2, pp. 63-82.
30
Interaction among retail, corporate and sovereign credit risks
o Retail Credit Risk generates Corporate Credit Risk.
Sequence of events:
House prices start to decline. Sub-prime

market crisis beings.
Banks make large losses on mortgage related
products.
Interbank market freezes.
Banks need to raise capital and reduce risky
exposures in their portfolios in order to:
Meet capital requirements
Meet investors’ expectations.
Failure to do so convincingly resulted in a large

fall in bank stocks (see Figure below)
Bank Stocks, 1st June 2007 = 100

120
100
80
60
40
20
0
Jun-13
Jun-07
Jun-08
Jun-09
Jun-10
Jun-11
Jun-12
Jun-14
Jun-15
Jun-16
Jun-17
Jun-18
Dec-14
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-15
Dec-16
Dec-17
Citigroup BoA HSBC RBS
31
Fewer funding sources for banks and capital
constraints cause bank lending to decline
Lower lending and lower consumer confidence

increase corporate defaults.
;
.
10 Year Greek Government Bond Spreads
50
40
Percent
30
20
10
0
Jun-17
Jun-07
Dec-07
Jun-08
Jun-09
Jun-10
Jun-11
Jun-12
Jun-13
Jun-14
Jun-15
Jun-16
Jun-18
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15
Dec-16
Dec-17
Conclusion: retail credit risk (mortgage default)
leads to corporate credit risk (corporate
default).
However, corporate credit risk can also be

exacerbated by sovereign credit risk (more on
this below). Indeed sovereign credit risk is
likely to be one of the main factors behind the
increases in the price of corporate default
insurance between 2010 and 2012, which can
be clearly seen in the graph above.
32
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2
2.3.5. Leverage: Why playing the leverage game?
A simplified example: Interaction of leverage and funding

liquidity risk.
Commercial Bank Commercial Bank getting

Bigger
Balance Sheet (by increasing leverage)
Balance Sheet
M=100 D=90 M=200 D=90
K=10 IM+MM=100
K=10
Profit and Loss Summary Profit and Loss Summary
Interest on D, 5% 4.5 Interest on D, 5%

Interest on IM+MM, 5% )
-
9.5
Interest on M, 6% + 6
Interest on M, 6% + 12
Pre-tax Profit, 1.5 i.e. 15% Pre-tax Profit, 2.5 i.e. 25% of
of K K
o M: Mortgages in the form of CDOs, MBS and direct

mortgage lending, D: deposits, K: equity capital, IM:
interbank market, MM: money market beyond the
interbank market.
o Banks through leverage and greater exposure to the

interbank market increase profit by 10%.
31
o However, if IM and MM become illiquid, cost of
funding (and funding liquidity risk) rises and profits
may turn into losses.
“With market risk and credit risk you could lose

a fortune. With [funding] liquidity risk you
could lose the bank!” Bruce McLean, UBS Group
Treasury.
32
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: return on ants is
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items ⇐ 'm%÷
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SURVIVES ✓
BANK BANK DEFAULTS X
The credit crisis did not lead to deleveraging https://www.ft.com/content/8bdb3458-7dff-11e7-9108-edda0bc...
. .
FLAT
INCREASING
The financial crisis that began to wash over the world 10 years ago was the
result of an enormous accumulation of debt in rich countries — the bulk of
which was owed by households and financial institutions. It was the
realisation that many of these claims may not be honoured that triggered
the credit crunch and ensuing financial market freeze.
Since then, the debt-to-GDP ratio in mature economies has remained

roughly constant. But debt has continued to play an important role in post-
crisis developments, in two ways.
The first is that the composition of indebtedness has changed markedly.
1 of 2 02/10/2017, 14:31
The credit crisis did not lead to deleveraging https://www.ft.com/content/8bdb3458-7dff-11e7-9108-edda0bc...
Public debt increased sharply as governments tried to cushion the shock to

aggregate demand as the private sector tightened its belt and tried to
“deleverage” or reduce its debts.
And just as the rich world reined in credit growth, the emerging world —
led by China — opened the stimulus spigot. As a result, the world is today
more awash in debt than ever. How that debt accumulation can possibly
end is one of the big questions hovering over the global economy today.
Should we be worried about the amount of leverage in the world — or

where it lies? Share your thoughts in the comments below.
2 of 2 02/10/2017, 14:31
Helps to solve maturity mismatch
-
2.3.6. Securitization: a good tool that was misused.
o What is it?
Banks securitize loans in their balance sheet
and sell the newly created asset-backed
securities to investors
o Why so popular?
Securitizations are an effective way to match
demand and supply of credit. Through
securitizations, countries with a surplus of
savings (emerging markets) could buy asset-
backed securities issued by banks in countries
with a saving deficit (i.e. with a high demand of
consumer loans).
o Why is securitization useful? Through securitizations

banks can
Transfer default risk to outside investors,
Gain from the difference between the interest
paid to investors and the interest received from
borrowers.
Immediately recover the principal for other
investments
o Why can they be dangerous?

Lack of transparency about the original pool of
assets. Possible consequences
Panic among investors
Higher than expected default risk
33
Securitisation can be a sturdy ally for investors https://www.ft.com/content/0089dd70-7cef-11e7-9108-edda0bc...
The first tremors of the global financial crisis were felt 10 years ago this
month when the short-term credit markets froze after BNP Paribas
suspended three investment funds. The crisis had many consequences —
not least to create a thriving industry involved in providing commentary
on the cause and effects. Among the most severely affected was European
securitisation, which is regarded by some as a significant contributor to the
crisis.
Owing to its sheer underlying size, the securitisation market represents the
sturdy elephant of the financial world. However, in the years leading to
1 of 4 02/10/2017, 14:30
August 2007 when the credit markets froze, the mammal was allowed to
balance on the tightrope of leverage. It duly fell off with an almighty thud.
Investors in securities issued by the UK’s Northern Rock or a number of

structured investment vehicles were left nursing heavy losses. However,
stringent criticism of securitisation is wide of the mark. Admittedly, in the
wrong hands — of the greedy or reckless — it can be positively dangerous.
However, used responsibly, it can be a powerful tool to give investors an
exposure to risk and return profiles that suits their objectives.
One of the most appealing features of securitisation as a technology is its

flexibility. It can be used on granular assets such as residential mortgages
where many thousands of individual mortgages can sit within a deal. It can
also be used to finance non-granular assets such as commercial real estate,
where deals might only be underpinned by 10 loans or fewer.
The risks can be overblown. Taking European rated-structured finance as a

whole between 2000 and 2016, credit losses amounted to just 0.25 per
cent of the €3.2tn total universe rated by Fitch. These losses were
distributed unevenly among the different asset classes that make up the
market. European RMBS (residential mortgages) have not generated any
losses to rated bonds, nor have ABS (primarily credit cards and auto
loans). The bulk of the losses have come from CDOs of structured finance
and CMBS, which were typically backed with a small pool of property
loans.
So, with a couple of notable exceptions, the evidence suggests that

European structured finance caused limited actual credit losses and has
been a relatively safe asset class. The market started to stabilise three years
after the crisis started, after which pricing has recovered strongly. Many of
2 of 4 02/10/2017, 14:30
the banks that had stood behind SIVs or held ABS on-balance sheet moved
their investments into workout units or bad banks, allowing them to
manage their assets in a more disciplined way.
At the same time, mainstream investors recognised that the dislocation in

pricing had more to do with technical effects than fundamentals and
gradually returned to the game. For some years, investors were able to
capitalise on the stressed sellers and, in effect, buy dollar bills for 90 cents
(or less).
One of the most enduring consequences of the crisis for the securitisation
market in Europe has been the regulatory response. The capital that banks
are required to hold against investing in securitisation has increased
significantly, to a multiple of the capital required for other comparably
rated assets such as covered bonds. Likewise, insurance regulators,
through Solvency II, make securitisation assets hard and costly to own.
Regulators have also forced a greater disclosure in the asset class and
reduced complexity. Originators of assets are being forced, rightly, to
retain capital at risk in deals in order to co-align their interests with those
of external investors. This “skin in the game” concept gives us a degree of
comfort, though we remain vigilant.
Rating agencies have also come under much greater regulatory scrutiny
and their output is now significantly more conservative and transparent.
Finally, regulation is forcing investors to demonstrate clearly that they are
undertaking a full and detailed analysis of their securitisation exposures —
only those with expertise can participate.
The elephant, today, has all four feet firmly planted on the ground. Pricing
of securitisation assets remains generally attractive alongside comparable
3 of 4 02/10/2017, 14:30
assets in the fixed income world. A narrower investor base, in which asset
managers are the key group, dominate the space. We believe strongly that
securitisation assets have an important part to play in fixed income
portfolios — the credit is robust but diligent and insightful analysis is
crucial.
The technology also has much to offer in deploying capital to invest in the
real economy. The temptation for regulators, as the asset class
rehabilitates further, is to lower the hurdles for banks and insurers. But we
need to remain vigilant lest the elephant mounts the tightrope again.
Andrew Dennis is fixed income investment manager, Aberdeen Standard

Investments
4 of 4 02/10/2017, 14:30
o Credit risk becomes market risk through
securitizations
o Types of securitizations
Mortgage Backed Securities (MBSs): mortgages
US government agencies Fannie Mae,
Freddie Mac and Ginnie Mae pool and sell
large portions of bank mortgages.
ABS: credit card loans, auto loans, home equity

loans, leasing receivables
Pass-through vs tranched securitizations
In pass-through securitizations the cash

flows of the underlying assets are simply
transferred from the originator to the
investor.
In tranched securitizations the underlying

assets are pooled and prioritised into
senior, mezzanine and junior (or equity)
tranches.
34
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EXHIBIT 30
Annual Issuer-Weighted Corporate Default Rates by Letter Rating, 1920-2015
Year Aaa Aa A Baa Ba B Caa-C Inv Grade Spec Grade All rated
2000 0.000% 0.000% 0.000% 0.350% 1.111% 5.744% 17.492% 0.127% 5.971% 2.416%
2001 0.000% 0.000% 0.156% 0.180% 1.159% 9.232% 29.022% 0.124% 9.484% 3.624%
2002 0.000% 0.000% 0.161% 1.015% 1.215% 4.567% 26.708% 0.432% 7.533% 2.884%
2003 0.000% 0.000% 0.000% 0.000% 0.877% 2.450% 19.894% 0.000% 5.092% 1.768%
2004 0.000% 0.000% 0.000% 0.000% 0.378% 0.797% 11.773% 0.000% 2.418% 0.835%
2005 0.000% 0.000% 0.000% 0.163% 0.000% 0.815% 7.272% 0.061% 1.719% 0.647%
2006 0.000% 0.000% 0.000% 0.000% 0.193% 1.067% 5.910% 0.000% 1.666% 0.594%
2007 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 4.645% 0.000% 0.896% 0.331%
2008 0.000% 0.508% 0.406% 1.025% 2.339% 4.002% 10.591% 0.628% 5.416% 2.508%
2009 0.000% 0.000% 0.240% 0.930% 1.771% 6.983% 26.176% 0.429% 12.097% 5.015%
2010 0.000% 0.000% 0.170% 0.075% 0.000% 0.387% 8.682% 0.096% 3.100% 1.269%
2011 0.000% 0.193% 0.000% 0.428% 0.157% 0.349% 5.594% 0.218% 1.926% 0.904%
2012 0.000% 0.000% 0.000% 0.072% 0.142% 0.550% 7.678% 0.033% 2.750% 1.231%
2013 0.000% 0.000% 0.090% 0.121% 0.579% 0.808% 6.282% 0.096% 2.617% 1.235%
2014 0.000% 0.000% 0.088% 0.060% 0.142% 0.401% 4.468% 0.064% 1.872% 0.911%
2015 0.000% 0.000% 0.000% 0.000% 0.293% 2.285% 6.272% 0.000% 3.474% 1.662%
Mean 0.000% 0.059% 0.093% 0.273% 1.032% 3.197% 10.450% 0.149% 2.778% 1.137%
Median 0.000% 0.000% 0.000% 0.000% 0.561% 2.101% 7.699% 0.000% 1.827% 0.786%
St Dev 0.000% 0.176% 0.264% 0.458% 1.609% 3.819% 11.233% 0.274% 2.971% 1.365%
Min 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.000%
Max 0.000% 0.855% 1.639% 1.990% 11.550% 19.444% 50.000% 1.550% 15.709% 8.489%
39 FEBRUARY 29, 2016 SPECIAL COMMENT: CORPORATE DEFAULT AND RECOVERY RATES, 1920-2015
In case of default the equity tranche is
used to cover the losses. When the value
of that tranche has been wiped out,
further defaults will be charged against
the mezzanine tranche and finally against
the senior one.
Tranching allows for the senior (and often

the mezzanine) tranche to obtain
investment grade status
RBS
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.
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35
Wikipedia (2012): Credit Rating Agencies
Inflated ratings. Credit Rating Agencies have made errors of judgment in rating
:
structured products, particularly in assigning AAA ratings to structured debt,
which in a large number of cases has subsequently been downgraded or defaulted.
Reliance on rating agencies […] For a number of reasons (frequently having to

do with inadequate staff expertise and the costs that risk management programs
entail), many institutional investors relied solely on the ratings agencies rather than
conducting their own analysis of the risks these instruments posed.
Complexity. As an example of the complexity involved in analyzing some CDOs,

the Aquarius CDO structure has 51 issues behind the cash CDO component of the
structure and another 129 issues that serve as reference entities for $1.4 billion in
✓
CDS contracts for a total of 180. In a sample of just 40 of these, they had on
average 6500 loans at origination. Projecting that number to all 180 issues implies
that the Aquarius CDO has exposure to about 1.2 million loans.
Questionable assumptions. Credit rating agencies only accounted for a ~5%
:
decline in national housing prices at worst, allowing for a confidence in rating the
many of these CDOs that had poor underlying loan qualities as AAA.
Conflict of interest. It did not help that an incestuous relationship between

financial institutions and the credit agencies developed such that, banks began to
leverage the credit ratings off one another and 'shop' around amongst the three big
credit agencies until they found the best ratings for their CDOs. Often they would
add and remove loans of various quality until they met the minimum standards for
a desired rating, usually, AAA rating. Often the fees on such ratings were $300,000
- $500,000, but ran up to $1 million.
U.S. Subprime Origination and Securitization, 2001-2006
($ Amounts in Billions)
Total Subprime Share % Subprime %

MBS Securitized
2001 $2,215 $190 8.6% $ 95 50.4%

2002 2,885 231 8.0 121 52.7
2003 3,945 335 8.5 202 60.5
2004 2,920 540 18.5 401 74.3
2005 3,120 625 20.0 507 81.2
2006 2,980 600 20.1 483 80.5
Source: Acharya and Richardson (2009), p. 68.
o What went wrong in securitization?
Complexity – lack of transparency. The

purpose of the securitization structure
described in Figure 3.1 above was to generate
as many AAA tranches as possible. From the
original RMBS the proportion of AAA was 81%
which is then taken to 92% with the CDO and
CDO^2 products. Can the market price
correctly a AAA CDO^2?
Pricing problems and lack of knowledge of who

holds what led to complete lack of trust in the
market place and consequent widespread
illiquidity.
36
Risk partly not transferred. Although MBSs and
CDOs were designed to transfer (and spread
the) risk from the banks to investors, this is
not quite what happened.
Between prime and subprime
e
The market of subprime and Alt-A mortgages
was around $2 trillion. This is large, but had it
been distributed outside the banking sector we
would probably have not seen such dramatic
market crash (led by banks’ losses).
However, banks, investment banks and GSEs

had a total of $2.644 trillion of securitized
loans of which about $1trillion were non-
prime. Of the AAA CDO tranches (backed by
nonprime loans) the majority was held by
banks, GSEs and investment banks ($791
billion, 48%).
But surprisingly, the majority of the

subordinated tranches was also held by those
financial institutions ($320billion, 67%).
37
o Why did banks take the gamble?
Profit: Tranches of subprime MBSs yielded

more than equivalently rated cash instruments
(i.e. bonds). “At the peak of the housing bubble
in June 2006, … the spreads from the tranches
of subprime MBSs to similarly rated debt of the
average US firm … [were] 18 basis points (bps)
versus 11 bps for AAA-rated securities, 32 bps
versus 16 bps for AA-rated, 54 bps versus 24
bps for A-rated, and 154 bps versus 48
. bps for
BBB-rated.”. (Acharya and Richardson p. 21).
o Why were regulated banks allowed to take the

gamble?
A regulatory loophole allowed banks to reduce

regulatory capital by switching from loans to
AAA-rated tranches of CDOs and CLOs. This is
C.
an example of regulatory capital arbitrage (we
will discuss this in detail in future lectures).
This type of regulatory capital arbitrage is achieved by

shifting assets from the banking book to the trading
book.
38
their and
By securitizing buying
banks
MBS
,
were
essentially shifting
CTB÷
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trading
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2.3.7. Rating agencies: accountability, dominance and
conflicts of interest.
Rating definition (Moody’s):

o “An opinion on the future ability and legal
obligation of an issuer to make timely payments
of principal and interest on a specific fixed
income security”.
o Opinion NOT investment recommendation. As

such ratings are protected by the freedom of
speech clause in 1st Amendment to the US
Constitution. This prevents or severely limits
rating agencies’ legal accountability for the
ratings they issue.
Dominance: near monopoly of Nationally Recognised

Statistical Rating Organizations (NRSROs) following
their formal recognition by the SEC ( w THE Us ) ]
Corporations are "forced" to use the major rating
Conflicts of interest: agencies as there are no other viable alternatives
or that do
o Agencies are paid by the companies they rate securitizations
o Other services may be sold to these companies:
e.g. how to achieve a certain rating in a CDO
transaction …
Independent ratings: Wikiratings,

www.wikirating.org/wiki/Main_Page
For more information on the above, see the topic

“Credit Rating Agencies” in Wikipedia.
32
2.3.9. OTC derivatives and counterparty risk:
Lack of a clearing house for CDS contracts and other OTC

derivatives caused widespread exposure to counterparty
risk, which contributed to severe illiquidity (due to lack of
confidence).
The over-the-counter derivatives market is becoming

more regulated and transparent under pressure from
regulators and governments. A list of central
counterparties authorised to clear market exchanged and
OTC derivative contracts in the European Union is
provided by ESMA (2018).
Bilateral vs Central Clearing + CCPs. See Hull (2018),

Chapter 15 pp. 354-356 and Chapter 17, excluding
Section 17.2.2.
42
Reducing Counterparty risk :
bilateral end multilateral ( Ccp )

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traded with one
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getting .
18/10/2018 How clearing houses aim to avert market disasters | Financial Times
Clearing and settlement

How clearing houses aim to avert market disasters
In the past decade global authorities have elevated the role and importance of CCPs
Members of Nasdaq Clearing want to know how private trader Einar Aas managed to inﬂict such huge losses on them ©
Reuters
Philip Staﬀord SEPTEMBER 14, 2018 o

Clearing houses have been cast into the spotlight after soured bets from
Norwegian trader Einar Aas blew a €114m hole in the buffers that are designed to
stem systemic losses from trading derivative contracts in the European power
markets.
In the past decade global authorities have elevated clearing houses as central
pillars of market stability. This in turn has raised concerns that these utilities are
the new “too big to fail” institutions.
For some the episode is a perfect example of a system working as intended after
the financial crisis. For others, it is a sober warning of what could go wrong in
stressed markets.
“The reserves clearing houses put in place are calculated according to the
probability of trades like this happening,” said Stephen Connelly, an associate law
professor at the University of Warwick. “In this case the clearing house has taken
a huge hit from Mr Aas’s trades and may not be able to take another such hit if a
similar event asks tomorrow.”
https://www.ft.com/content/01596fde-b805-11e8-b3ef-799c8613f4a1 1/6
How clearing houses aim to avert disaster

A clearing house stands between two parties in a trade and helps manage the
credit risk to the counterparty if one side defaults on payments. Any position it
takes on with one party is offset by an opposite position taken with a second party.
In normal circumstances the clearer avoids taking on the risk when there is a
change in the market value of the trades they enter into.
But when a counterparty can no longer support its trades, the clearing house is
exposed on those outstanding contracts.
The first layer of defence — its so-called default waterfall — begins before it is too
late. The clearing house demands more margin, or insurance, from the struggling
party or the market, to cover any potential losses. This happened in the eurozone
debt crisis when London’s LCH raised the margin on trading several European
sovereign bonds.
This is the biggest shield and usually suffices in most cases. The margin of the
defaulter covers any losses caused by the clearing house closing out the positions.
Defaulted positions can also be transferred or auctioned off to other solvent
members of the clearing house.
But the size of Mr Aas’s position on the European power markets meant there was
not enough margin at Nasdaq Clearing. Even a late transfer of $36m from Mr Aas
was not enough to cover the widening losses.
For a clearing house, this is a rare occurrence. By comparison LCH used around a
third of the $2bn of initial margin it had called from Lehman Brothers in 2008 to
close its positions.
Layers of protection
If margin calls fail to cover the losses from the defaulter, there are broadly three
resolutions on offer:
• Capital from the clearing house

• A mutual default fund made up of contributions from clearing
members
• Other resources from the clearing house, such as capital from its
parent company
Mr Aas’s positions burnt through Nasdaq’s own capital of €7m, which is likely to
reignite a debate between clearing houses and its biggest members, the banks,
over a clearing house’s “skin in the game”. Banks such as JPMorgan have long
called for clearing houses to include more of their resources as a backstop.
After that, the Nasdaq turned to the default fund consisting of contributions from
all clearing members to share extreme losses. It acts like insurance for unforeseen
market events. Nasdaq allows institutions and traders to become a clearing
member if they have at least €1m in equity to support themselves.
Shared losses
It was this layer that cushioned the impact from Mr Aas’s trades, although the
losses used up two-thirds of the default fund.
After the financial crisis regulators toughened the rules over how much resources
clearing houses should hold. They demanded the biggest and most systemically
important clearing houses in Europe should hold enough resources to meet the
losses that could arise from the default of their two largest clearing members in
extreme but plausible market conditions.
However most of Lehman’s exposures were not centrally cleared.
F
The pre-funded financial resources at UK clearing houses totalled around £120bn
on average in 2016, according to the Bank of England.
In the case of Lehman Brothers, the default fund was not required and so all the
counterparties to Lehman’s trades did not incur a loss. Not so with the members
of Nasdaq Clearing. For example Fortum, a Finnish energy company, said on
Friday it had lost around two-third of its €30m contribution to the fund.
As clearing houses are required to replenish the fund as soon as possible, its
members have to pay up before Monday morning. Members like Fortum will have
to find €20m while others will demand to know how a single private trader
managed to inflict a loss on them.
Last update 9 August 2018
List of Central Counterparties authorised to offer services and activities in the Union
The Central Counterparties (CCPs) listed below have been authorised to offer services and activities in the Union in
accordance with Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC
derivatives, central counterparties and trade repositories (EMIR).
The tables below are published by ESMA in accordance with Article 88(1) of EMIR.
Table 1: List of CCPs that have been authorised to offer services and activities in the Union
Established in the Competent authority (if

Identification Code Country of Date of initial
No Name of the CCP Union or in a established in the
of CCP (LEI) establishment authorisation
Third Country Union)
54930002A8LR1AA
1 Nasdaq OMX Clearing AB In the Union Sweden Finansinspektionen 18 March 2014
UCU78
European Central 724500937F740MH De Nederlandsche

2 In the Union Netherlands 1 April 2014
Counterparty N.V. CX307 Bank (DNB)
2594000K576D5CQ Komisja Nadzoru

3 KDPW_CCP In the Union Poland 8 April 2014
XI987 Finansowego (KNF)
529900LN3S50JPU Bundesanstalt für

4 Eurex Clearing AG 47S06 In the Union Germany Finanzdienstleistungs 10 April 2014
aufsicht (Bafin)
Cassa di Compensazione e 8156006407E264D2

5 C725 In the Union Italy Banca d’Italia 20 May 2014
Garanzia S.p.A. (CCG)
R1IO4YJ0O79SMW Autorité de Contrôle

6 LCH SA VCHB58 In the Union France Prudentiel et de 22 May 2014
Résolution (ACPR)
529900M6JY6PUZ9 Bundesanstalt für

European Commodity
7 NTA71 In the Union Germany Finanzdienstleistungs 11 June 2014
Clearing
aufsicht (Bafin)
F226TOH6YD6XJB United
8 LCH Ltd 17KS62 In the Union Bank of England 12 June 2014
Kingdom
Create an incentive for banks to take on more risk
M
2.3.10. Guarantees to Financial institutions: These guarantees
allowed banks to keep the cost of funding low, even though
they were increasing the risk in their balance sheets through
risky investments and leveraging.
o Explicit guarantees:
Deposit insurance,
Government Sponsored Enterprises (GSEs, such
as Fannie Mae and Freddie Mac).
o Implicit guarantees:
Too Big to Fail (TBTF). When is a bank too big
to fail?
43
TBTF European banks
Country Bank Name Total Assets Total Assets to

2007 (Bn Euro) GDP, %
Iceland Kaupthing 53 623

Switzerland UBS 1,426 484
Iceland Landsbanki 32 374
Switzerland Credit Swiss 854 290
Netherlands ING 1,370 290
Belgium & Lux. Fortis 886 254
Belgium and Lux. Dexia 605 173
Spain Santander 913 132
UK RBS 2,079 126
Netherlands Rabobank 571 121
France BNP Paribas 1,694 104
Ireland Bank of Ireland 183 102
Ireland Allied Irish 178 99
UK HSBC 1,608 98
UK Barclays 1,542 94
France Credit Agricole 1,414 87
Germany Deutsche Bank 1,917 86
UK HBOS 838 51
UK Lloyds 444 27
44
What happened to the ‘too big to fail’ banks? https://www.ft.com/content/0bd8f4d4-76de-11e7-a3e8-60495fe...
1 of 5 02/10/2017, 14:16
What happened to the ‘too big to fail’ banks? https://www.ft.com/content/0bd8f4d4-76de-11e7-a3e8-60495fe...
Are the largest banks still “too big to fail” after the regulatory reforms of the past
decade? Share your thoughts in the comments below.
4 of 5 02/10/2017, 14:16
Required level of additional capital for Global Systemically
Important Banks (G-SIBs) as of November 2017
Additional Capital G-SIBs
3.5% (Empty)
2.5% JP Morgan Chase
2.0% Bank of America, Citigroup, Deutsche

Bank, HSBC
1.5% Bank of China, Barclays, BNP Paribas,

China Construction Bank, Goldman
Sachs, Industrial and Commercial Bank
of China Limited, Mitsubishi UFJ FG,
Wells Fargo
1.0% Agricultural Bank of China, Bank of New

York Mellon, Credit Suisse, Groupe
Crédit Agricole, ING Bank, Mizuho FG,
Morgan Stanley, Nordea, Royal Bank of
Canada, Royal Bank of Scotland,
Santander, Société Générale, Standard
Chartered, State Street, Sumitomo
Mitsui FG, UBS, Unicredit Group
Source: Financial Stability Board (2017)
45
Systemic risk: Risk arising from TBTF institutions, or
TMTF (Too Many To Fail) scenarios.
o See Vlab for current and historical systemic risk

rankings for countries and financial institutions,
vlab.stern.nyu.edu/welcome/risk/
46
47
3. Lessons for Risk Managers from the Crisis
Liquidity risk, counterparty risk and sovereign risk should

be looked at very closely.
Do not be over-reliant on the interbank market (if this is

an option)
Deal only on financial instruments you understand
Do not trust models blindly
Scenario analysis, stress testing beyond historical

simulation may be vital.
Other risk measures beyond VaR? Expected shortfall.
Be assertive when dealing with pure profit maximising

portfolio managers. Risk and return, two sides of the
same coin. See CAPM.
See also Hull (2018), Chapter 29.
Main Conclusion
Lots of work for Risk Managers!!!
Exercise: do practice questions at the end of Chapter 6 in Hull

(2018).
48
References
1) Acharya, V. V. and Richardson, M. (2009) “Restoring

Financial Stability” Wiley Finance.
2) Basel Committee on Banking Supervision (2016) “Minimum

capital requirements for market risk”
www.bis.org/bcbs/publ/d352.pdf
3) Financial Stability Board (2017) “2017 List of Global

Systemically Important Banks (G-SIBs)”
4) Haldane, A. G. (2009) “Why Bank Failed the Stress Test”

Speech given at the Marcus - Evans Conference on Stress-
Testing 13 February 2009.
http://www.bankofengland.co.uk/archive/documents/histor
icpubs/speeches/2009/speech374.pdf
5) Hull, J. C. (2018) “Risk Management and Financial

Institutions, 5th ed.”, Wiley Finance. Chapters 6,
17(excluding Section 17.2.2), 23 (pp. 515-520) and 29.
49

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Management of Risk

Course Teachers Office Hours

Lecturer: Simone Varotto Monday 15:00 - 17:00

TA: Ludovico Rossi Monday 11:00 – 13:00

TA: Ana Sina Tuesday 11:00 – 13:00

TA: Ning Zhang Monday 13:00 – 15:00

*Please note that Simone Varotto’s office hours on Wednesdays

Lecture/seminars dates/times/room may vary. Please

o Last lecture on Friday 7th December.

The recommended text for this course is:

Additional references will be provided in lecture notes.

The tests will be based on the lecture notes (including

o Technical proficiency: quality of analysis, clarity of Excel

Peer assessment criteria

Did X act compassionately* towards the other members of the

Every “yes” answer translates to a score of 1, while every “no”

Moderation: A peer assessor’s overall score for a student may be

Illustration of the impact of peer assessment on a student’s

If the majority of the members of a group thinks that one or

Requirements for a pass

2007-2012 Financial Crisis

Risk Management: An Overview. How to Measure Risk.

Basic Statistics, Returns and Value at Risk. Arithmetic and

Market Risk and Liquidity Risk: Variance-Covariance

Back-Testing: Likelihood Ratio Test, Type 1 and 2 errors,

Credit Risk: Probability of Default estimation, Credit

Risk Mitigation Techniques (TBC): Diversification,

The 2007-2012 Financial Crises and

Financial risks in banks

Financial risks and the 2007-2012 Financial Crises

Lessons from the financial crises

o Asset liquidity risk:

Uncertainty about how quickly an asset can be

In a very liquid market, transactions can be

Main Indicator: bid-ask spread

o Funding liquidity risk: uncertainty about availability

Main indicators: liquid assets to total assets,

Basel III has introduced a minimum global standard

Northern Rock: nationalised (February 2008)

Market of MBS becomes illiquid

Risk Is meosred with

BID ) or BID - Ash spread

with MBS market frozen ,

then hour con the bonk survive ?

efv 'D injection

Is China heading for "Great recession" type of crisis?

An important aspect of credit risk, which played a major

Three types of credit risk:

Market Risk: risk of losses due to negative asset price

o Interest rate risk - BONDS

o Asset liquidity risk

GAN WILL DEPEND ON

THESE TWO SEENARIO ) :

DEFAULT 607 x 100 = GO ZY

Tesco 's default

does not abut risks

Example: sovereign credit risk

Example: equity risk

1st June 2007 = 100

EU Members' Equity Indices,

Example: commodity risk

Aug-15 Commodities, 1st June 2007 = 100 Aug-15

o For instance, a change in the price of a stock