Sub-Prime Credit Crisis of 07

Electronic copy available at: http://ssrn.
com/abstract=1112467

The Subprime Credit Crisis of 07
*

September 12, 2007
Revised July 9 2008

Michel G. Crouhy, Robert A. Jarrow and Stuart M. Turnbull

JEL Classification: G22, G30, G32, G38
Keywords:, ABS, CDOs, monolines, rating agencies, risk management, securitization, SIVs,
subprime mortgages, transparency, valuation.

Michel G. Crouhy: Natixis, Head oI Research & Development, Tel: 33 (0)1 58 55 20 58, email:
michel.crouhynatixis.com;
Robert A. Jarrow, Johnson Graduate School oI Management, Cornell University and Kamakura
Corporation, Tel: 607 255-4729, email raj15cornell.edu;
Stuart M. Turnbull, (contact author) Bauer College oI Business, University oI Houston, Tel: 713-
743-4767, email: sturnbulluh.edu

Electronic copy available at: http://ssrn.com/abstract=1112467
Credit Crisis Crouhy, Jarrow and Turnbull 2
Abstract

This paper examines the diIIerent Iactors that have contributed to the subprime mortgage credit
crisis: the search Ior yield enhancement, investment management, agency problems, lax
underwriting standards, rating agency incentive problems, poor risk management by Iinancial
institutions, the lack oI market transparency, the limitation oI extant valuation models, the
complexity oI Iinancial instruments, and the Iailure oI regulators to understand the implications oI
the changing environment Ior the Iinancial system. The paper sorts through these diIIerent issues
and oIIers recommendations to help avoid Iuture crises.

Introduction
The credit crisis oI 2007 started in the subprime
1
mortgage market in the U.S. It has
aIIected investors in North America, Europe, Australia and Asia and it is Ieared that write-oIIs oI
losses on securities linked to U.S. subprime mortgages and, by contagion, other segments oI the
credit markets, could reach a trillion US dollars.
2
It brought the asset backed commercial paper
market to a halt, hedge Iunds have halted redemptions or Iailed, CDOs have deIaulted, and
special investment vehicles have been liquidated. Banks have suIIered liquidity problems, with
losses since the start oI 2007 at leading banks and brokerage houses topping US$300 billion, as oI
June 2008.
3,4
Credit related problems have Iorced some banks in Germany to Iail or to be taken
over and Britain had its Iirst bank run in 140 years, resulting in the eIIective nationalization oI
Northern Rock, a troubled mortgage lender. The U.S. Treasury and Federal Reserve helped to
broker the rescue oI Bear Stearns, the IiIth largest U.S.Wall Street investment bank, by JP
Morgan Chase during the week-end oI March 17, 2008.
5
Banks, concerned about the magnitude
oI Iuture write-downs and counterparty risk, have been trying to keep as much cash as possible as
a cushion against potential losses. They have been wary oI lending to one another and,
consequently, have been charging each other much higher interest rates than normal in the inter
bank loan markets.
6

The severity oI the crisis on bank capital has been such that U.S. banks have had to cut
dividends and call global investors, such as sovereign Iunds, Ior capital inIusions oI more than
US$230 billion, as oI May 2008, based on data compiled by Bloomberg.
7
The credit crisis has
caused the risk premium Ior some Iinancial institutions to increase eightIold since last summer. It
has now become more expensive Ior Iinancial than Ior non-Iinancial Iirms, with the same credit
rating, to raise cash.
8

The crisis has aIIected the general economy. Credit conditions have tightened Ior all
types oI loans since the subprime crisis started nearly a year ago. The biggest danger to the
economy is that, to preserve their regulatory capital ratios, banks will cut oII the Ilow oI credit,
causing a decline in lending to companies and consumers. According to some economists, tighter
credit conditions could knock 1 / percentage point Irom Iirst-quarter growth in the U.S. and 2
points Irom the second-quarter growth oI 2008. The Fed lowered its benchmark interest rate 3.25
percentage points to 2 percent between August 2007 and May 2008 in order to address the risk oI
a deep recession. The Fed has also been oIIering ready sources oI liquidity Ior Iinancial
institutions, including investment banks and primary dealers, that are Iinding it progressively
harder to obtain Iunding, and has taken on mortgage debt as collateral Ior cash loans.
The deepening crisis in the subprime mortgage market has aIIected investor conIidence in
multiple segments oI the credit market, with problems Ior commercial mortgages unrelated to
subprime, corporate credit markets,
9
leverage buy-out loans (LBOs),
10
auction-rate securities, and
parts oI consumer credit, such as credit cards, student and car loans. In January 2008, the cost oI
insuring European speculative bonds against deIault rose by almost one-and-a-halI percentage
point over the previous month, Irom 340 bps to 490 bps
11
, while the U.S. high-yield bond spread
has reached 700 bps over Treasuries, Irom 600 bps at the start oI the year.
12

This paper examines the diIIerent Iactors that have contributed to this crisis and oIIers
recommendations Ior avoiding a repeat. In Section 2, we brieIly analyze the chain oI events and
major structural changes that aIIected both capital markets and Iinancial institutions that
contributed to this crisis. The players and issues at the heart oI the current subprime crisis are
analyzed in Section 3. In Section 4, we outline a number oI solutions that would reduce the
possibility oI a repeat, and a summary is given in Section 5.
Section 2: How It All Started
13

Interest rates were relatively low in the Iirst part oI the decade.
14
This low interest rate
environment has spurred increases in mortgage Iinancing and substantial increases in house
prices.
15
It encouraged investors (Iinancial institutions, such as pension Iunds, hedge Iunds,
investment banks) to seek instruments that oIIer yield enhancement. Subprime mortgages oIIer
higher yields than standard mortgages and consequently have been in demand Ior securitization.
Securitization oIIers the opportunity to transIorm below investment grade assets (the investment
or collateral pool) into AAA and investment grade liabilities. The demand Ior increasingly
complex structured products such as collateralized debt obligations (CDOs) which embed
leverage within their structure exposed investors to greater risk oI deIault, though with relatively
low interest rates, rising house prices, and the investment grade credit ratings (usually AAA)
given by the rating agencies, this risk was not viewed as excessive.
Prior to 2005, subprime mortgage loans accounted Ior approximately 10 oI outstanding
mortgage loans. By 2006, subprime mortgages represented 13 oI all outstanding mortgage loans
with origination oI subprime mortgages representing 20 oI new residential mortgages compared
to the historical average oI approximately 8.
16
Subprime borrowers typically pay 200 to 300
basis points above prevailing prime mortgage rates. Borrowers who have better credit scores than
subprime borrowers but Iail to provide suIIicient documentation with respect to all sources oI
income and/or assets are eligible Ior Alt-A loans. In terms oI credit risk, Alt-A borrowers Iall
between prime and subprime borrowers.
17

During the same period, Iinancial markets had been exceptionally liquid, which Iostered
higher leverage and greater risk-taking. Spurred by improved risk management techniques and a
shiIt by global banks towards the so-called 'originate-to-distribute business model, where banks
extend loans and then distribute much oI the underlying credit risk to end-investors, Iinancial
innovation led to a dramatic growth in the market Ior credit risk transIer (CRT) instruments.
18

Over the past Iour years, the global amount outstanding oI credit deIault swaps has multiplied
more than tenIold,
19
and investors now have a much wider range oI instruments at their disposal
to price, repackage, and disperse credit risk throughout the Iinancial system.
There were a number oI reasons Ior this growth in the origination oI subprime loans.
Borrowers paid low teaser rates over the Iirst Iew years, oIten paid no principal and could
reIinance with rising housing prices. There were two types oI borrowers, generally speaking: (i)
those borrowers who lived in the house and got a good deal, and (ii) those that speculated and did
not live in the house. When the teaser rate period ended, as long as housing prices rose, the
mortgage could be reIinanced into another teaser rate period loan. II reIinancing proved
impossible, the speculator could deIault on the mortgage and walk away. The losses arising Irom
delinquent loans were not borne by the originators, who had sold the loans to arrangers. The
arrangers securitized the loans and sold them to investors. The eventual owners oI these loans,
the ABS trusts, generated enough net present value Irom the repackaging oI the cash Ilows that
they could absorb these losses. In summary, the originators did not care about issuing below Iair
valued loans, because they passed on the loan losses to the ABS trusts and the originators held
none oI the deIault risk on their own books.
CDOs oI subprime mortgages are the CRT instruments at the heart oI the current credit
crisis, as a massive amount oI senior tranches oI these securitization products have been down-
graded Irom triple-A rating to non-investment grade. The reason Ior such an unprecedented drop
in the rating oI investment grade structured products was the signiIicant increase in delinquency
rates on subprime mortgages aIter mid-2005, especially on loans that were originated in 2005-
2006. In retrospect, it is very unlikely that the initial credit ratings on bonds were correct. II they
had been rated correctly, there would have been downgrades, but not on such massive scale.
The delinquency rate Ior conventional prime adjustable rate mortgages (ARMs) peaked
in 2001 to about 4 and then slowly decreased until the end oI 2004, when it started to increase
again. It was still below 4 at the end oI 2006. For conventional subprime ARMs, the peak
occurred during the middle oI 2002, reaching about 15. It decreased until the middle oI 2004
and then started to increase again to approximately 14 by the end oI 2006, according to the
Mortgage Bankers Association.
20
During 2006, 4.9 oI current home owners (2.45 million) had
subprime adjustable rate mortgages. For this group, 10.13 were classiIied as delinquent
21
; this
translates to a quarter oI a million home owners. At the end oI 2006, the delinquency rate Ior
prime Iixed rate mortgages was 2.27 and 10.09 Ior subprime.
22

There are Iour reasons why delinquencies on subprime loans rose signiIicantly aIter mid-
2005. First, subprime borrowers are typically not very creditworthy, oIten highly levered with
high debt-to-income ratios, and the mortgages extended to them have relatively large loan-to-
value ratios. Until recently, most borrowers were expected to make at least 20 down payment
on the purchase price oI their home. During 2005 and 2006 subprime borrowers were oIIered
'80/20 mortgage products to Iinance 100 oI their homes. This option allowed borrowers to
take out two mortgages on their homes. In addition to a Iirst mortgage Ior 80 oI the total
purchase price, a simultaneous second mortgage, or 'piggyback loan Ior the remaining 20
would be made to the borrower.
Second, in 2005 and 2006 the most common subprime loans were oI the 'short-reset
type. They were the '2/28or '3/27 hybrid ARMs subprime. These loans had a relatively low
Iixed teaser rate Ior the Iirst two or three years, and then reset semi-annually to a much higher
rate, i.e., an index plus a margin Ior the remaining period with a typical margin in the order oI
400 to 600 bps. Short-term interest rates began to increase in the U.S. Irom mid-2004 onwards.
However, resets did not begin to translate into higher mortgage rates until sometime later. Debt
service burdens Ior loans eventually increased, which led to Iinancial distress Ior some oI this
group oI borrowers. The distress will continue, as US$500 billion in mortgages will reset in 2008.
Third, many subprime borrowers had counted on being able to reIinance or repay
mortgages early through home sales and at the same time produce some equity cushion in a
market where home prices kept rising. As the rate oI U.S. house price appreciation began to
decline aIter April 2005, it became more diIIicult Ior subprime borrowers to reIinance and many
ended up incurring higher mortgage costs than they expected to bear at the time oI taking their
mortgage.
23

Fourth, a decline in credit standards by mortgage originators in underwriting over the last
three years, was a major Iactor behind the sharp increase in delinquency rates Ior mortgages
originated during 2005 and 2006.
24
The pressure to increase the supply oI subprime mortgages
arose because oI the demand by investors Ior higher yielding assets. A major contributor to the
crisis was the huge demand by CDOs Ior BBB mortgage-backed bonds that stimulated a
substantial growth in home equity loans. This CDO demand Ior BBB ABS bonds was due to the
Iact that the bonds had high yields, and the CDO trust could Iinance their purchase by issuing
AAA rated CDO bonds paying lower yields. This was because the rating agencies assigned AAA
ratings to the CDO`s senior bond tranches that did not reIlect the CDO bond`s true credit risk.
25

Because these tranches were mis-priced, the CDO equity holders generated a positive net present
value investment Irom just repackaging cash Ilows. This process boosted the demand by CDOs
Ior residential mortgage-backed securities (RMBS). Furthermore, this repackaging was so
lucrative, that it was repeated a second time Ior CDO squared trusts. A CDO squared trust
purchased high yield (low rated) bonds and equity issued by other CDOs. To Iinance the purchase
oI this collateral, they issued AAA rated CDO squared bonds with lower yields. This, in turn,
created demand Ior CDOs containing mortgage-backed securities (MBS) and CDO tranches.
This environment encouraged questionable practices by some lenders.
27
Some mortgage
borrowers have ended up with subprime mortgages, even though their credit worthiness qualiIies
them Ior lower risk types oI mortgages, others with mortgages that they were not qualiIied to
have.
28
Some borrowers and mortgage brokers took advantage oI the situation and Iraud
increased.
29

Section 3: Players and Issues at the Heart of the Crisis
The process oI securitization takes a portIolio oI illiquid assets with high yields and
places them into a trust. This is called the trust`s collateral pool. To Iinance the purchase oI the
collateral pool, the trust hopes to issue highly rated bonds paying lower yields. The trust issues
bonds that are partitioned into tranches with covenants structured to generate a desired credit
rating in order to meet investor demand Ior highly rated assets. The usual trust structure results in
a majority oI the bond tranches being rated investment grade. This is Iacilitated by running the
collateral`s cash Ilows through a 'waterIall payment structure. The cash Ilows are allocated to
the bond tranches Irom the top down: the senior bonds get paid Iirst, and then the junior bonds,
and then the equity. To ensure that a majority oI the bonds get rated AAA, the waterIall speciIies
that the senior bonds get accelerated payments (and the junior bonds get none), iI the collateral
pool appears stressed in certain ways.
30
Stress is usually measured by (collateral/liability) and
(cash-Ilow/bond-payment) ratios remaining above certain trigger levels. A surety wrap (insurance
purchased Irom a monoline) may also be used to ensure super senior AAA credit rating status. In
addition, the super senior tranches are oIten unIunded, making them more attractive to banks.
There are costs associated with securitization: managerial time, legal Iees and rating
agency Iees. The equity holders oI an asset-backed trust (ABS) would only perIorm
securitization iI the process generated a positive net present value. This could occur iI the other
tranches were mispriced. For example, iI an AAA rated tranche added a new security with
unique characteristics, this could generate demand and attract new sources oI Iunds. However,
asset securitization started in the mid 1980s, so it is diIIicult to attribute the demand that we have
witnessed over the last Iew years Ior AAA rated tranches to new sources oI Iunds. AIter this
length oI time, investors should have learnt to price tranches in a way that reIlects the inherent
risks. II ABS bond mispricing occurred, the question is why? The AAA rated liabilities could be
mispriced either because oI the mispricing oI liquidity or the rating oI the trust`s bonds were
inaccurate.
In this section, we identiIy the diIIerent players in the crisis, their economic motivation
and brieIly describe the events that have unIolded since 2005-2006. We start with the role oI the
rating agencies, as the issues oI timely and accurate credit ratings have been central to the crisis.
Then, we turn to the role oI the mortgage brokers and lenders. We then describe some oI the
institutions that have been at the center oI the storm. We also discuss how central banks reacted to
the current crisis. We then address the issues oI valuation and transparency that have been
catalysts Ior the crisis. We end this section explaining why systemic risk occurred.
3.1 Rating Agencies
31

In the summer oI 2006, it became clear that the subprime mortgage market was in stress.
At this time, the rating agencies issued warnings about the deteriorating state oI the subprime
market. Moody`s Iirst took rating action on 2006 vintage subprime loans in November 2006. In
February 2007, S&P took the unprecedented step oI placing on 'credit watch transactions that
had been closed as recently as the last year. From the Iirst quarter oI 2005 to the third quarter oI
2007, Standard and Poor`s (2008) reports Ior CDOs oI asset backed securities, 66 were
downgraded and 44 were downgraded Irom investment grade to speculative grade, including
deIault. For residential subprime mortgage backed securities, 17 were downgraded, and 9.8
were downgraded Irom investment grade to speculative grade, including deIault.
32
These changes
are large and naturally raise questions about the rating methodologies employed by the diIIerent
agencies.
Rating agencies are at the center oI the current crisis as many investors relied on their
ratings Ior many diverse products: mortgage bonds, asset back commercial paper (ABCP) issued
by the structured investment vehicles (SIVs), Derivative Product Companies (DPCs) and
monolines which insure municipal bonds and structured credit products such as tranches oI
CDOs. Money market Iunds are restricted to investing only in triple-A assets, pension Iunds and
municipalities are restricted to investing in investment grade assets and base their investment
decision on the rating attributed by the rating agencies.
33
Many oI these investors invested in
assets that were both complex and contained exposure to subprime assets. Investors in complex
credit products had considerably less inIormation at their disposal to assess the underlying credit
quality oI the assets they held in their portIolios than the originators. As a result, these end-
investors oIten came to rely heavily on the risk assessments oI rating agencies. Implicitly in the
investment decision is the assumption that ratings are timely and relatively stable. No one was
expecting, until recently, a triple-A asset to be downgraded to junk status within a Iew weeks or
even a Iew days. The argument could be made that as the yields on these instruments exceeded
those on equivalently rated corporations, the market knew they were not oI the same credit and/or
liquidity risk. But investors still mis-judged the risk.
The CDO rating process worked as Iollows. The CDO trust partners, the equity holders,
would work with a credit rating agency to get the CDO`s liabilities rated. They paid the rating
agency Ior this service. The rating agency told the CDO trust the procedure it would use to rate
the bonds the methods, the historical deIault rates, the prepayment rates, and the recovery rates.
The CDO trust structured the liabilities and waterIall to obtain a signiIicant percent oI AAA
bonds (with the assistance oI the rating agency). The rating process was a Iixed target. The CDO
equity holders designed the liability structure to reIlect the Iixed target. Note that given the use oI
historic data, the ratings did not reIlect current asset characteristics, such as the growing number
oI undocumented mortgages and large loan-to-value ratios Ior subprime mortgages.
From the CDO equity holders` perspective, iI not enough oI the CDO bonds are rated
AAA, it would not be economically proIitable to proceed with the CDO. Creation oI the CDO is
also in the interest oI the rating agencies, because the CDO trust requires continual monitoring by
the rating agency, with appropriate Iees paid.
34
This ongoing Iee payment structure created a
second incentive problem Ior the credit rating agency.
Rating agencies such as Moody`s, Standard and Poor`s and Fitch are Nationally
Recognized Statistical Rating Organizations, which provides a regulator barrier to entry. The
reputation oI rating agencies depends in part on their perIormance. However, there are
institutional and regulatory Ieatures that imply there is always demand Ior their services. Many
investors are restricted to invest in assets with certain ratings. For example, money market Iunds
can only invest in AAA rated assets, while many pension Iunds are restricted to investing in
investment grade assets. Basel II uses credit ratings to determine the amount oI regulator capital a
regulated Iinancial institution must hold. Reputation is oI course important. However, there is no
guarantee that the incentive structures oIIered to management that are essentially short term in
nature, will align management to act in the best long run interests oI the Iirm.
35
The European
Commission and Barney Frank, chair oI the House Financial Services Committee, have held
separate hearings on the agencies response to the subprime mortgage crisis, and possible conIlicts
oI interest arising Irom (a) rating agencies being paid by issuers and (b) rating agencies oIIering
advisory services to issuers.
Originators make loans and supposedly veriIy inIormation provided by the borrowers.
Issuers and arrangers oI mortgage backed securities bundle the mortgages and should perIorm
due diligence. The rating agencies receive data Irom the issuers and arrangers and assume that
appropriate due diligence has been perIormed. Rating agencies clearly state that they do not cross
check the quality oI borrowers` inIormation provided by the originators.
36
Normally mortgages
tend to have high recovery rates, but with the declining underwriting standards in the subprime
market and high debt to value ratios, this was no longer the case. Failure to check the data meant
that estimates oI the probability oI deIault and the loss given deIault did not reIlect reality. This
meant that the probability oI deIault and the loss given deIault were probably under estimated. It
also aIIected the ability to model deIault dependence amount the assets in the collateral pool.
The rating process proceeds in two phases. First, the estimation oI the loss distribution
over a speciIied horizon and, second, the simulation oI the cash Ilows. The simulations
incorporated the CDO waterIall triggers, designed to provide protection to the senior bond
tranches in case oI bad events, and were used to investigate extreme scenarios. The loss
distribution allows the determination oI the credit enhancement (CE), that is, the amount oI loss
on the underlying collateral that can be absorbed beIore the tranche absorbs any loss. II the credit
rating is associated with a probability oI deIault, the amount oI CE is simply the level oI loss such
that the probability that the loss is higher than CE is equal to the probability oI deIault. CE is thus
equivalent to a Value-at-Risk type oI risk measure. In a typical CDO, credit enhancement comes
Irom two sources: 'subordination, that is, the par value oI the tranches with junior claims to the
tranche being rated, and 'excess spread which is the diIIerence between the income and
expenses oI the credit structure. Over time, the CE, in percentage oI the principal outstanding,
will increase as prepayments occur and senior securities are paid out. The lower the credit quality
oI the underlying subprime mortgages in the ABS CDOs, the greater will be credit enhancement,
Ior a given credit rating. Deterioration oI credit quality, will lead to a downgrade oI the ABS
structured credits.
Rating agencies seek to make the rating oI subprime related structured credit stable
through the housing cycle, as with the rating oI corporate bonds. ThereIore, rating agencies must
respond to anticipated shiIts in the loss distribution during the housing cycle by increasing the
amount oI CE needed to keep the ratings constant as economic conditions deteriorate, or by
downgrading the structured credit. The contrary happens when the housing market improves.
37

Unanticipated changes may result in a rating agency changing a rating Ior a product. What was
not anticipated by some investors was the volatility oI the rating changes that Iollowed as the
housing market started to deteriorate.
38

For example, during the second week oI July 2007, S&P downgraded US$7.3 billion oI
securities sold in 2005 and 2006. A Iew weeks later, Moody`s Investor Service slashes ratings on
691 securities Irom 2006, originally worth US$19.4 billion. Some 78 oI the bonds had Moody`s
top rating oI Aaa. The securities were backed by second lien mortgages that included piggyback
mortgages. Moody`s stated that the cause Ior the downgrades was the dramatically poor overall
perIormance oI such loans and rising deIault rates. Fitch also downgraded subprime bonds sold
by Barclays, Merrill Lynch and Credit Suisse. In October, S&P lowered the ratings on residential
mortgaged backed securities with a par value oI US$22 billion. In November, Moody`s
downgraded 16 special investment vehicles with approximately US$33 billion in debt and in
December another US$14 billion was downgraded with US$105 billion under review.
3.2 Mortgage Brokers and Lenders
Originating brokers had little incentive to perIorm due diligence and monitor borrowers` credit
worthiness, as most oI the subprime loans originated by brokers were subsequently securitized.
This phenomenon was aggravated by the incentive compensation system Ior brokers, based on the
volume oI loans originated, with Iew negative consequences Ior the brokers iI the loan deIaulted
within a short period.
39

Distress among subprime mortgage lenders was visible during 2006. Problem started to
appear when the Fed started to raise interest rates. This raised the cost oI borrowing and made it
more expensive Ior people to meet their Iloating rate interest payments on their loans. At the end
oI the year, Ownit Mortgage Solutions Inc. ranked as the 11th largest issuer oI subprime
mortgages closed its doors. This was perhaps surprising, given that Merrill Lynch & Co had
purchased a minority stake in Ownit the previous year. In the Iirst quarter oI 2007, New Century,
ranked as the number two lender in the subprime market, also closed its doors. Others also Iailed
or leIt the business.
Problems with mortgage lenders spread Irom the subprime to other parts oI the mortgage
market, as concerns about collateral values increased. The share price oI Thornburg Mortgage
Inc., which specializes in large (jumbo) prime home loans, dropped 47 aIter it stated that it was
delaying its second quarter dividend and was receiving margin calls Irom creditors, due to the
declining value oI mortgages used as collateral. National City Home Equity Corp., the wholesale
broker equity lending unit oI National City Corp. announced that in response to market
conditions, it has suspended approvals oI new home equity loans and lines oI credit. Aegis
Mortgage Corp. (Houston) announced it is unable to meet current loan commitments and stopped
taking mortgage applications. Other institutions also withdrew Irom the subprime and Alt-A
markets. Alt-A originators, such as American Home Mortgage, Iiled Ior bankruptcy.
Small mortgage brokers were being hurt in a number oI diIIerent ways. GMAC LLC
announced that it was tightening its lending terms. It would not provide warehouse Iunding Ior
subprime loans and mortgages Ior borrowers who did not veriIy their income or assets. Many
small lenders use short-term warehouse loans that allow them to Iund mortgages until they can be
sold to investors. The inability to warehouse reduces the availability oI credit.
Originators also spent Iunds persuading legislators to reduce tough new laws restricting
lending to borrowers with spotty credits. Simpson (2007) reports that Ameriquest Mortgage Co.,
which was one oI the nation`s largest subprime lenders, spent over US$20 million in political
donations. Citigroup Inc., Wells Fargo & Co. Countrywide Financial Corp. and the Mortgage
Bankers Association also spent heavily on lobbying and political giving. These donations played
a major role in persuading legislators in New Jersey and Georgia to relax tough predatory-lending
laws passed earlier that might have contained some oI the damage.
40

3.3 Special Investment Vehicles
41

A special, or structured, investment vehicle (SIV) is a limited purpose, bankrupt remote,
company that purchases mainly highly rated medium and long term assets and Iunds these
purchases with short term asset backed commercial paper (ABCP), medium term notes (MTNs)
and capital. Capital is usually in the Iorm oI subordinated debt, sometimes tranched and oIten
rated. Some SIVs are sponsored by Iinancial institutions that have an incentive to create oII
balance sheet structures that Iacilitate the oII balance sheet transIer oI assets and generate
products that can be sold to investors. The aim is to generate a spread between the yield on the
asset portIolio and the cost oI Iunding by managing the credit, market and liquidity risks. Trading
the slope oI the yield curve would not have been proIitable enough to justiIy the capital allocated
to support most SIV iI they had to pay a credit spread Ior their borrowings. Hence, Ior almost all
SIVs, the AAA rating Ior their debt was essential. This is also partly due to the commercial paper
(CP) market, and how it operates. CP is held by money market Iunds, and most want only AAA
rated paper.
General descriptions oI the methodologies employed Ior SIVs by the agencies are
publicly available on their web sites. The basic approach is to determine whether the senior debt
oI the vehicle will retain the highest level oI credit worthiness, (Ior example, AAA/A-1 rating)
until the vehicle is wound-down Ior any reason. The level oI capital is set to achieve this AAA
type oI rating, with capital being used to make up possible short Ialls. The vehicle is designed
with the intent to repay senior liabilities, with at least an AAA level oI certainty, beIore the
vehicle ceases to exist. II a trigger event occurs and the SIV is wound-down by its manger
(deIeasance) or the trustee (enIorcement), the portIolio is gradually liquidated. Wind-down
occurs iI the resources are becoming insuIIicient to repay senior debt. No debt will be Iurther
rolled over or issued and the cash generated by the sale oI assets is used to payoII senior
liabilities.
The risks that a SIV has to manage to retain its AAA rating include credit, market,
liquidity, interest rate and Ioreign currency, and managerial and operational risk. Credit risk
addresses the credit worthiness oI each obligor and the risk during the wound-down period when
the SIV assets have suIIered credit deterioration. For market risk, the manager is required on a
regular basis to mark-to-market the liquid assets oI the portIolio and mark-to-model the illiquid
assets. When a SIV is Iorced to sell assets under unIavorable conditions, this will in general
aIIect the value oI all its assets. The manager`s ability to address this type oI situation is
assessed. Liquidity risk arises because oI (a) the need oI reIinancing due to the maturity
mismatch between assets and liabilities; and (b) some oI the portIolio`s assets will require due
diligence by potential investors and this will increase the length oI the sale period. The SIV must
demonstrate that apart Irom the vehicle`s cash Ilows that provide liquidity, it has backstop lines oI
credit Irom diIIerent institutions, and highly liquid assets that can be quickly sold, so that it is
able to deal with market disruptions. In a SIV, the liabilities are rolled over, provided that
deIeasance
42
has not occurred. In theory, a SIV could continue indeIinitely.
43

According to Moody`s (September 5, 2007), there were some 30 SIVs and the total
volume under management oI SIVs and SIV-Lites
44
had nominal values oI approximately
US$400 billion and US$12 billion respectively at the end oI August 2007. The weighted average
liIe oI the asset portIolios in these vehicles is in the 3-4 year range.
The SIVs relied on being able to continuously roll over their short-term Iunding and,
even though they were 'bankruptcy remote Irom their sponsors, those that were unable to
achieve this were able to turn to their sponsoring banks that had undertaken to provide them with
backstop liquidity via credit lines in such situations. In Iact these SIVs, akin to 'unregulated
banks Iunding long-term assets with short-term Iunding resources, have been a contributor to the
current credit crisis.
As the credit crisis intensiIied and the mortgage-backed securities held by the SIVs
suddenly started to decline in value, some oI the ABCP were downgraded, sometimes all the way
to deIault within a Iew days. An increasing number oI SIVs became unable to roll their ABCP,
due to concerns about the value oI collateral, and turned to their sponsor banks Ior rescue. HSBC
was the Iirst bank (November 28, 2007) to transIer US$45 billion oI assets on to its balance sheet.
Other banks soon Iollowed: Standard Chartered took (December 5, 2007) US$1.7 billion,
Rabobank (December 6, 2007) took US$7.6 billion, and Citigroup (December 14, 2007) US$49
billion. This is not a complete listing. Societe Generale bailed out its investment vehicle with a
US$4.3 billion line oI credit (December 11, 2007).
The plight oI SIVs continues. In February 2008, Citigroup announced that it plans to
provide a US$3.5 billion Iacility to support six oI the seven SIVs it took onto its balance sheet to
shore up their debt rating and protect creditors. Also in February, Standard Chartered Iaced the
prospect oI a Iire sale at its US$7.1 billion Whistlejacket SIV. The value oI the assets had Iallen
to less than halI oI the amount oI start-up capital, which is a trigger Ior calling in receivers. More
recently (February 21, 2008) Dresdner Bank announced that it is providing a backstop Iacility oI
at least US$17 billion on senior debt Ior its US$19 billion K2 SIV, to avoid a Iorced sale oI its
assets.
45

3.4 Monolines
Monoline insurers provide insurance to investors that they will receive payment when
investing in diIIerent types oI assets. Given the low risk oI the bonds and the perceived low risk
oI the structured transactions insured by monolines, they have a very high leverage, with
outstanding guarantees amounting to close to 150 times capital.
46
Monolines carry enough capital
to earn a triple-A rating and this removes the need Ior them to post collateral.
47
(This triple-A
rating is essential to stay proIitable, as capital is costly and the spreads earned on insurance are
small.) The two largest monolines, MBIA and AMBAC, both started out in the 1970s as insurers
oI municipal bonds and debt issued by hospitals and nonproIit groups. The size oI the market is
approximately US$2.6 trillion, with more than halI oI municipal bonds being insured by
monolines. This insurance wrap guarantees a triple-A rating to the bonds issued by U.S.
municipalities.
In recent years, much oI their growth has come in structured products such as asset-
backed bonds and CDOs. The total outstanding amount oI bonds and structured Iinancing insured
by monolines is around US$2.5 trillion. According to S&P, monolines insured US$127 billion oI
CDOs that relied, at least partly, on repayments on subprime home loans and Iace potential losses
oI US$19 billion.
Since the end oI 2007 monolines have been struggling to keep their triple-A rating. Only
the two major ones, MBIA and AMBAC, and a Iew others less exposed to subprime mortgages
such as Financial Security Assurance (FSA) and Assured Guaranty, have been able to inject
enough new capital to keep their sterling credit rating.
48

The issue Irom a systemic point oI view is that when a monoline is downgraded, all oI the
paper it has insured must be downgraded too, including the bonds issued by municipalities. And
holders oI downgraded bonds under 'Iair value' accounting have to mark them down as well,
impairing their capital. Some institutional investors, such as pension Iunds and so-called
'dynamic or 'enhanced money market Iunds, may hold only triple-A securities, raising the
prospect oI Iorced sales. In addition, some issuers such as municipalities might lose their access
to bond markets, which may result in an increase in the cost oI borrowing money to Iund public
projects. Some municipalities and local agencies have issued tender option bonds, which are
auctioned weekly or monthly. The underlying collateral municipal bonds is insured by
monolines. Concern about the credit worthiness oI the monolines has caused disruptions to this
market. The loss oI the triple-A rating could cost investors up to US$200 billion according to
Bloomberg. Already, banks have had to write oII around US$10 billion oI the paper they insured
with ACA.
49

In response to this crisis, a group oI banks explored a bailout plan oI the largest
monolines with the New York`s insurance regulator, who was asking the banks to contribute as
much as US$15 billion to help MBIA and AMBAC preserve their ratings. The main
consideration was whether the cost oI participating in a bailout was greater than any loss oI value
in their holdings.
50
On Feb 14, 2008 Eliot Spitzer, New York governor, gave bond insurers three
to Iive business days to Iind Iresh capital, or Iace potential break-up by state regulators who want
to saIeguard the municipal bond markets.
51
Under a division oI the bond insurers into a 'good
bank/ bad bank structure, the insurers` municipal bond business would be separated Irom their
riskier activities, such as guaranteeing complex structured credit products. Warren BuIIet`s
Berkshire Hathaway Assurance Corp has already oIIered to take over the municipal bond
portIolios oI AMBAC, MBIA and FGIC.
52
While these plans would help to restore Iaith in the
municipal bond market, they would do little to help the structured products insured by the
monolines.
53
Monolines are counterparties to credit derivatives held by Iinancial institutions and
have sold surety wraps to Iinancial institutions. A break-up oI the bond insurers would have
grave implications Ior Iinancial institutions that Iace massive write-downs on these instruments.

3.5 ABS Trust, CDO and CDO Squared Equity Holders.

These equity holders made proIits by repackaging a pool oI mortgages` cash Ilows and
selling these new cash Ilows in the Iorm oI bond tranches. The repackaging oI a mortgage`s cash
Ilows only has a positive net present value iI the repackaged cash Ilows (the ABS bonds issued to
Iinance the purchase oI the mortgages) are over valued by the market.
Unsophisticated investors were less inIormed than sophisticated investors (deIined to be
those investors involved in the origination process in some manner). This asymmetric inIormation
was generated by two Iacts. First, the complexity oI the ABS trust waterIall. The waterIalls were
complex with various triggers (to divert cash Ilows to the more senior bonds in the case oI
Iinancial stress in the collateral pool). The complexity oI the waterIall made the ABS hard to
value. In addition, the waterIalls were unique to a particular trust, so each new ABS needed to be
programmed and modeled. Second, the scarcity oI generally available and timely data on the
collateral pool oI speciIic ABS trusts made the modeling (and simulation Ior scenario analysis) oI
the cash Ilows nearly impossible. Although data could have been purchased Irom Loan Pricing
Corporation, it was incomplete with respect to the current state oI the underlying mortgage loans.
Furthermore, alternative historical databases with histories oI mortgage loans were not
representative oI new risk trends because the new mortgage loans had teaser rates, no principal
payments in the beginning, and diIIerent loan standards (high loan to value ratios, and no
documentation).
The inIormation asymmetry in markets was even greater Ior CDOs than Ior ABS trusts,
because a typical CDO collateral pool depends on the ABS bonds oI many diIIerent ABS trusts
(approximately 100). Thus, to model the CDO collateral pool, one needs to model the diIIerent
ABS bonds - hence, the ABS collateral pool. This multiplier in terms oI modeling complexity,
and the absence oI readily available data on the collateral pools, made the accurate modeling oI
CDOs cash Ilows nearly impossible (even Ior sophisticated investors).
Also crucial in the creation oI CDOs was the existence oI credit deIault swaps on ABS
bonds (ABS CDS). This was essential Ior two reasons. First, there were not enough ABS bonds
trading to construct the underlying CDO collateral pools. CDOs were being constructed and
issued in great quantities in 2006 and 2007. Consequently, a majority oI the CDOs` collateral
pools were synthetic ABS bonds (ABS CDS). This leveraging oI the real ABS bonds multiplied
the eIIect oI deIaulting mortgage holders signiIicantly beyond the original notional values
increasing systemic risk. Second, the use oI ABS CDS meant that less capital was needed to
construct the collateral pool. This Iacilitated the rapid growth oI CDO issuance. In Iact, one
reason Ior the creation oI CDO squared trusts was the desire to Iinance the equity capital oI
CDOs by including CDO equity in a CDO squared`s collateral pool.

3.6 Financial Institutions
The change in the bank regulatory Iramework to Basel II has had perhaps unanticipated
consequences. The required regulatory capital requirement Ior holding AAA rated assets is 56
basis points (a 7 risk weighting and an 8 capital requirement). This provided banks with an
incentive to hold highly rated AAA rated assets. Thus, banks were willing customers Ior super
senior AAA rated tranches. Being this highly rated, it was thought that there was an insigniIicant
chance oI the assets being impaired due to deIaults in the collateral pool. With the tranches being
held in the trading book and marked-to-market, this did expose banks to risk oI write downs,
especially iI a surety wrap had been provided by a monoline insurance company. Banks and
regulators never anticipated these risks.
The credit rating oI AAA reduced, iI not removed, incentives Ior investors (pension
Iunds, insurance companies, mutual Iunds, hedge Iunds, regional banks) to perIorm their own due
diligence about the collateral pool. The short-term horizon oI management`s payment structure
(bonus) Iurther reduced their incentives to perIorm due diligence. II their investments soured,
managers might lose their jobs, but labor markets are imperIect. Failed money managers seem to
get new jobs even aIter horriIic losses. CDO bonds oIIered higher yields than corporate bonds
with the same credit rating. The managers working in these Iinancial institutions wanted AAA
bonds (or investment grade bonds) with higher yields (and rewards) Ior 'equivalent risk.
Although the risks were not really equivalent, the incentives were against doing due diligence.
3.7 The Economy and Central Banks
At the end oI spring 2007, Ben Bernanke, Chairman oI the Federal Reserve, stated (May
17, 2007), 'We do not expect signiIicant spillovers Irom the subprime market to the rest oI the
economy or the Iinancial system. It was vain hope, since at the start oI August the European
Central Bank injected 95 billion euro (US$131 billion) and inIormed banks that they could
borrow as much money as they wanted at the bank`s current 4 base rate without limit. The
Bank oI Canada issued a statement that it pledges to 'provide liquidity to support the Canadian
Iinancial system and the continued Iunctioning oI Iinancial markets. Exhibit 1 summarizes the
actions oI central banks.
In the second week oI August, the Fed reported that the total commercial paper (CP)
outstanding Iell more than US$90 billion to US$2.13 trillion over the previous week.
Traditionally, prime corporate names used the CP market to Iinance short term cash needs.
However, the low levels oI interest rates during the past Iew years has meant that many oI these
issuers moved away Irom the CP market and issued low cost debt with maturities ranging Irom 5
to 10 years. The current lack oI demand Ior CP made it very diIIicult Ior borrowers to rollover
debt. William Poole, President oI the St. Louis Federal Reserve publicly argued against a rate cut
(August 16). The Fed took the unusual step oI issuing a public statement that Mr. Poole`s
comments did not reIlect Fed policy.
During the same week, a Ilight to quality occurred, with investors buying Treasuries. The
yield on the three month T-bill Iell Irom approximately 4 to as low as 3.4. The FTSE 100
index declined by 4.1, with Iinancial companies being the hardest hit. Man Group Iell 8.3
and Standard Chartered Iell 7.6. The Chicago Board Options Exchange Vix index, an indicator
oI market volatility, jumped above 37, its highest level in Iive years. It did ease back to 31.
Unwinding oI carry trades caused a sudden 2 increase in the yen/dollar exchange rate. Further
unwinding occurred two days later, with hedge Iunds and institutional investors reversing carry
trades, causing the yen to increase 4 against the dollar, 5.3 against the euro, 5.8 against the
pound, 10.3 against the New Zealand dollar and 11.5 against the Australian dollar.
Also during this period, the Fed injected US$5 billion into the money market through 14-
day repurchase agreements and another US$12 billion through one-day repurchase agreements.
54

The Russian Central Bank injected Rbs 43.1 billion (US$1.7 billion) into the banking system.
Foreign investors had started to Ilee the ruble debt market, causing a liquidity squeeze. The
European Central Bank pumped money into Europe`s overnight money markets. The Fed took
similar actions in the US.
Four banks, Citigroup, JP Morgan, Bank oI America and Wachovia, each borrowed
US$500 million Irom the Fed. In a statement, JP Morgan, Bank oI America and Wachovia, stated
that they had substantial liquidity and had the capacity to borrow money elsewhere on more
Iavorable terms. They were trying to encourage other banks to take advantage oI the lower
discount rate at the Fed window.
During the third week oI August, the Ilight to quality continued. At the start oI trading in
New York, the yield on the 3 month T-bill was 3.90, during the day, it Iell to 2.51, and by the
end oI day, it closed at 3.04. However, other parts oI the Iixed income markets continued to
Iunction, with investment grade companies issuing debt: Comcast Corp sold US$3 billion in
notes; Bank oI America sold US$1.5 billion in notes and Citigroup US$1 billion in notes. There
was a rare high yield issuing by SABIC Innovative Plastics. It sold US$1.5 billion in senior
unsecured notes.
The volatility in the Ioreign exchange market caused some hedge Iunds to close their yen
carry trade positions. Between August 16-22, investors poured US$42 billion into money market
Iunds. Institutional investors switched Irom commercial paper to Treasuries.
In April 2008, the Fed took the unprecedented measure oI introducing a new lending
Iacility, called the Primary Dealer Credit Facility (PDCF), Ior investment banks and securities
dealers that allows them to use a wide range oI securities as collateral Ior cash loans Irom the
Fed. Among other things the securities pledged by dealers must have market prices and
'investment grade credit ratings.
55

3.8 Valuation Uncertainty
One oI the critical issues driving the crisis has been the diIIiculty oI valuing structured
credit products.
56
In a Iair value accounting Iramework
57
and with liquid markets, it is
straightIorward to value standardized instruments, though there are issues with non-standard
instruments. In this Iramework, there are three levels used Ior classiIying the type oI Iair
valuation employed: Level 1 clear market prices;
58
Level 2 valuation using prices oI related
instruments; and Level 3 prices cannot be observed and model prices need to be used. For
example, valuation under Level 1 can be achieved Ior standard instruments such as credit deIault
swaps Ior well known obligors. For a credit deIault swap with a non-standard maturity, direct
market prices cannot be observed. Prices oI credit swaps Ior the same obligor with standard
maturities can be used to calibrate a valuation model to price the non-standard maturity. This
would Iall under Level 2 classiIication. There are many instruments that are non-standard and are
illiquid, making valuation diIIicult. For such instruments, model valuation must be employed.
This situation would Iall under Level 3 classiIication. Faith in the reliability oI these values is
highest Ior Level 1 and lowest Ior Level 3, which is more subjective. There are numerous
diIIiculties associated with implementing Iair value accounting, even in liquid markets.
59
In the
Iirst quarter oI 2008, level 3 assets have increased in U.S. banks. Goldman Sachs reported an
increase oI 40 oI these assets to reach a total oI US$96.4 billion oI which US$25 billion are
ABS. Level 3 assets are US$78.2 billion and US$42.5 billion Ior Morgan Stanley and Lehman
Brothers, respectively.
Model prices are used Ior marking-to-model illiquid assets. For model estimation, prices
oI other assets and time series data may be used. InIerring the parameters necessary to use the
model becomes problematic in turbulent markets. This increases the uncertainty associated with
the model prices. II markets are in turmoil, the number oI instruments that can be valued under
Level 1 decreases and the diIIiculties associated with implementation greatly increase. This
increases the uncertainty associated with the valuation oI instruments held in portIolios and this
uncertainty Ieeds back into the market turmoil. Lenders want collateral Ior their loans, but
turbulence in the markets increases the potential Ior disagreement between borrowers and lenders
over the valuation oI collateral. This can place borrowers in the position oI being Iorced to sell
assets, and in some cases cause Iunds to close, adding to the market turmoil.
One oI the major issues in an illiquid market and one that has been repeatedly raised in
the current crisis, is that due to the high degree oI uncertainty, current prices Ior certain
instruments are well below their true` values. Pricing assumptions that were reasonable a Iew
weeks ago must be re-evaluated. In Iair value accounting, the price oI an instrument is what you
would receive iI sold. This implies that many institutions and Iunds have been Iorced to mark
down their portIolios. For some Iunds, this has triggered automatic shut down clauses. In the
case oI the asset backed commercial paper market, it has brought the market to a close. Hedge
Iunds borrow in the commercial paper market, pledging assets as collateral. Lenders look at the
value oI the pledged assets, which in many cases were related to the subprime market. Given the
increasing levels oI uncertainty associated with the valuation oI assets, lenders reIused to extend
credit. This caused a major disruption to the asset backed commercial paper market and was one
oI the critical events in the crisis.
When Iinancial institutions report their quarterly earnings, Ior Level 3 assets their
valuation methodologies and associated inputs will in general diIIer. This is unavoidable given
the use oI models. Institutions know this and have incentives to pick their inputs to ensure that
their results are 'reasonable. Investors know that this game is going on, so even when quarterly
results are published, uncertainty remains about the value oI Level 3 assets.
The problems arising Irom the valuation oI collateralized mortgage obligations
containing subprime, and the rolling over oI asset backed commercial paper came to a head
during the summer. At the beginning oI summer, two oI Bear Stearns hedge Iunds, High Grade
Structured Credit Strategies Master Fund and the High Grade Structured Credit Strategies
Enhanced Leverage Master Fund, ran into collateral trouble aIter substantial losses in April.
Merrill Lynch seized US$800 million in collateral assets and planned to sell these assets on June
18. Bear Stearns had negotiations with JP Morgan, Chase, Merrill Lynch, Citigroup and other
investors over the state oI the two hedge Iunds. However, these negotiations did not stop Merrill
Lynch Irom selling the assets. Bear Stearns disclosed that the hedge Iunds were Iacing a sudden
wave oI withdrawals by investors and by July, it closed the two hedge Iunds, wiping out virtually
all invested capital.
The widespread gravity oI the valuation problems were highlighted when at the
beginning oI August, BNP Paribas Iroze three hedge Iunds, stating that it is impossible to value
the assets due to a lack oI liquidity in certain parts oI the securitization market. The asset values
are reported to have Iallen Irom US$3.47 billion to US$1.6 billion. Paribas stated that the Iunds
were invested in AAA and AA rated structures.
60
In the third week oI August, BNP Paribas
announced that it has Iound a way to value the assets oI three oI its Iunds and it allowed investors
to buy and sell assets. In the same week, the Carlyle Group put up US$100 million to meet
margin calls on a European mortgage investment aIIiliate, with US$22.7 billion in assets. The
group issued a statement, explaining that while 95 oI the aIIiliates assets are AAA mortgage
backed securities with implicit U. S. government guarantees, the value oI the assets has declined
due to diminished demand Ior the securities.
During this period, money market Iunds that normally purchase asset backed commercial
paper (ABCP) adopted a policy oI buying only Treasuries. The yields on Treasury bills Iell, as a
result oI this Ilight to quality. This action by money market Iunds and other investors helped to
trigger a corporate Iunding crisis, with many special investment vehicles unable to roll over their
ABCP. This Iorced vehicles to seek Iunding Irom other sources and to sell assets. The problems
were not restricted to the U. S. ABCP market.
61

The diIIiculty underlying the valuation oI collateral and the resulting liquidity and
Iunding problems, aIIected many special investment vehicles and hedge Iunds. In the middle oI
August, the Goldman Sachs Iund, Global Equities Opportunities, lost over 30 oI its value over
several days. Investors injected US$1 billion and Goldman injected US$2 billion oI its own
money into the Iund.
62
Funds in the U. S., Canada, Europe, Australia have experienced Iunding
diIIiculties, some being Iorced into bankruptcy. The need to generate cash Iorced the sale oI
assets. This aIIected many quantitative hedge Iunds, such as Renaissance Technologies, which
Iell 8.7. Exchanges rates were aIIected, as Iunds reduced their leverage. Selling by hedge
Iunds and nervous investors also Iorced muni bond prices down.
Other players were aIIected. Real estate Iunds were hard hit due to both Ialling real
estate prices and the tumult in the credit markets. The average Iund investing primarily in the
U.S. lost 17.2 over the Iirst three months oI the summer and were down 16.5 on the year
(Morningstar Inc). Fund redemptions have Iorced managers to sell assets in Ialling markets.
KKR Financial Holdings LLC, a real estate Iirm, 12 owned by Kohlberg, Kravis Roberts & Co.
reported in the middle oI August that losses threaten its ability to repay US$5 billion in short term
debt. It announced plans to raise US$500 million by selling shares to Morgan Stanley and
Farallon Capital.
Merger arbitragers were also hit, with many being Iorced to unwind positions to oIIset
losses. The gap between a target`s stock price and the price the buyer has agreed to pay widened
to 68 in August, compared to a spread oI 11 at the end oI June (reported by a Goldman Sachs
analysis). Sowood Capital Management liquidated positions in a number oI pending mergers and
went into deIault.
63
In the Iight to gain deals, banks had waived such provisions as the 'market
out clause, which allows banks to re-negotiate an underwriting deal iI market conditions have
deteriorated. Banks are now having to re-negotiate deals without this weapon in their arsenal.
Home Depot delayed and re-negotiated a US$10.3 billion deal to sell its construction supply
business to private equity Iirms.
Asset backed structured products are diIIicult to value Ior many reasons. First, is the
general complexity oI the liability structure, the cash Ilow waterIalls, and the diIIerent types oI
collateral/interest rate triggers. Each structure is unique and computer programs used to simulate
the cash Ilows to the diIIerent bonds must be tailored made to each trust. Second, is the valuation
oI the assets in the collateral pool. For subprime ABS trusts, this typically implies valuing a pool
oI several thousand subprime mortgages with diIIerent terms and a wide diversity in the
characteristics oI the borrowers. For CDOs, this implies valuation oI the bonds issued by ABS
trusts; and Ior CDO squared structures, this implies the valuation oI bonds issued by CDOs.
Compounding these diIIiculties, many oI the asset pools are synthetic credit deIault swaps on
ABS, which need to be valued. Third, cash Ilows to trusts oIten depend on Iuture values oI the
collateral or the Iuture ratings oI the collateral by the credit rating agencies. This creates an
additional layer oI complexity: to estimate the value today, it is necessary to estimate values in
the Iuture or predict Iuture credit ratings oI the collateral. Fourth, is the scarcity oI data about the
nature oI the diIIerent asset pools. Data on the asset pools is usually not readily available and not
updated on a regular basis.
3.9 Transparency
There are a number oI diIIerent dimensions associated with the general issue oI
transparency in credit markets. First, is the complex nature oI the products and how this aIIects
both pricing and risk assessment. Many unsophisticated investors have used credit ratings as a
suIIicient metric Ior risk assessment. Buyers oI these products, such as pension Iunds, university
endowment Iunds, local counties and small regional banks do not have the in-house technical
sophistication to understand the true nature oI these products, the Irailty oI the underlying
assumptions used in their pricing and credit rating and how they might behave in diIIicult
economic conditions. For risk measurement, they have relied oI the rating agencies and took
comIort in the protection that a rating might give.
64
The rating agencies have been unclear as to
the precise meaning oI a rating Ior structured product bonds and the robustness oI their
methodologies Ior such products.
Second is the lack oI transparency with respect to the valuation oI illiquid assets. This
lack oI transparency has generated investor concerns about the robustness oI posted prices in
assessing the credit worthiness oI counterparties. For some Iunds, this is a substantial issue. For
example, in Bears Stearns High Grade Structured Credit Strategies Enhanced Leveraged Iund,
over 63 percent oI its assets were illiquid and valued using models see Goldstein and Henry
(2007). This was one oI the causes oI the collapse oI Bears Stearns.
Third, is the type oI assets within a vehicle, such as the percentage oI CDOs, CDOs
squared, prime, Alt-A and subprime mortgages. This basic type oI inIormation is rarely available
and has produced a market Ior lemons (unsophisticated) investors are unable to observe or
unwilling to believe that Iunds have no exposure to the subprime market. Synapse closed one oI
its high grade Iunds on September 3, 2007, citing 'severe illiquidity in the market. The
company stated that the Iund had no exposure to the U. S. subprime market.
65

Fourth, is not knowing the total magnitude oI the commitments a Iinancial institution has
given, whether it be to back stop lines oI credit or loan commitments to private equity buyouts. A
vehicle that relies upon Iunding Irom, say, the commercial paper market, will buy a commitment
Irom a Iinancial institution to provide Iunding in the event oI a market disruption. Financial
institutions also oIIer lines oI credit to Iirms, which can be drawn down and repaid at the Iirm`s
discretion. FulIilling all such commitments could have serious impact on an institution`s
liquidity. The level oI such commitments is not known to outside investors.
66
To avoid holding
all the committed capital, the institution will purchase a contract Irom another institution to
provide additional capital iI needed. This type oI contract is oI questionable value iI there is a
major market disruption, as the institution selling the contract will also have its own liquidity
problems.
FiIth, money market Iunds provide a saIe haven Ior investors to park their money.
67
In
order to retain their AAA level rating, they are generally restricted Irom investing in low credit
grade securities. II any oI their holdings are down-graded, the Iund is under pressure to sell these
holdings, incurring losses. Unless the Iund has suIIicient liquidity, it risks its net asset value per
share Ialling below one dollar, resulting in a 'breaking the buck, which could trigger investors to
exit the Iund, due to concerns about the saIety oI their investments. It would also harm the
reputation oI the Iund manager. Some oI the money market Iunds have invested in SIVs. A Iew
oI these SIVs have been downgraded, and others are Iacing downgrading. Many banks have very
proIitable money market Iranchises and have implicit commitments to these Iunds. It is in a
bank`s own interests to buy the Iallen assets and to take the loss, rather than risk a run on their
money market Iunds.
68
This is another Iorm oI commitment that is not reported.
Finally, many banks hold similar assets to those held by SIVs. In the arrangement
process, a bank may hold or warehouse assets until they can be securitized and sold. The extent
oI these holdings is oIten unknown to investors, though the amount oI Level 3 assets might be a
guide. II SIVs are Iorced to sell assets, this will drive the prices down and banks will be Iorced to
mark-to-market similar assets at the lower prices. Investors are uncertain as the magnitude oI
potential losses the banks might be Iacing and this is one oI the Iactors contributing to increased
volatility in the share prices oI banks. It could cause a credit crunch and aIIect the whole
economy. In an attempt to avoid this type oI scenario, Bank oI America, Citigroup Inc. and JP
Morgan Chase & Co. held talks with the U. S. Treasury to establish a new super conduit to buy
up to US$100 billion in assets Irom SIVs.
69
Because the conduit would be backed by a group oI
banks, it was hoped that investors would have conIidence in buying the Iund`s commercial paper
and this could re-start the ABCP market.
3.10 Systemic Risk
Systemic risk arises iI events in one market aIIect other markets. Many money market
managers that normally purchase ABCP abandoned the market and Iled to the Treasury bill
market, causing a major increase in prices and lowering oI yields. The ABCP market relies on
the quality oI the collateral to minimize the risk oI non-perIormance by borrowers. Lenders need
assurance as to the nature oI the assets and their values. In the breakdown oI the ABCP market,
there have been reservations about both dimensions. Some lenders have been concerned that the
collateral contains subprime mortgages. This lack oI transparency has meant that some borrowers
were unable to rollover their debt, even though they had no exposure to the subprime market.
There has also been uncertainty with respect to the value oI collateral. The lack oI transparency
with respect to the holdings oI structured products by monolines and the associated valuation
concerns, has adversely aIIected many markets, such as bond auction markets and tender option
bonds, which use monolines to provide an insurance wrap.
Even under normal market conditions, many instruments are illiquid and it is diIIicult to
estimate a price. In the turmoil oI summer, these problems became insurmountable. These
problems were illustrated by BNP Paribas decision to Ireeze withdrawals Irom three hedge Iunds
in the beginning oI August, stating that it is impossible to value the assets due to a lack oI
liquidity in certain parts oI the securitization market
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.
The eIIective closure oI the ABCP market had many repercussions. For many hedge
Iunds, the inability to rollover debt, has Iorced them to sell assets and this has aIIected many
diverse markets. First, the collateralized debt obligation market has come under a lot oI pressure
Irom this selling to the extent that many Iunds have Iound prices to be artiIicially low and some
have resorted to selling other assets. Some Iunds have closed trading positions by selling 'good
assets and buying 'bad assets that were shorted. This has caused prices oI good assets to
decrease and oI bad assets to increase. This type oI price reversal has adversely aIIected some
'quant hedge Iunds that trade based on price patterns. Hedge Iunds and institutional investors
reduced their leverage by unwinding carry trades.
Many SIVs have backstop lines oI credit Irom banks. The uncertainty oI the magnitude
oI these possible demands has Iorced banks to hoard cash, making them reluctant to lend to other
banks. The three month London inter bank oIIered rate (LIBOR) increased by over 30 bps during
the Iirst part oI August. Compounding the banks` Iunds concerns, are the commitments to
underwrite levered buyouts. The reluctance to lend and the tightening oI credit standards has
aIIected hedge Iunds, availability oI residential and commercial mortgages, bond auction markets
and lending to businesses.
3.11 Summary
Here we summarize in point Iorm the Iactors that have contributed to the credit crisis.
1. A low interest rate environment that generated a search Ior yield enhancement.
2. The demand Ior high yielding assets to put into the collateral pools in order to increase
the proIitability oI securitization. Subprime mortgages were an ideal choice, along with
auto loans and credit cards.
3. Mortgage originators did not assume deIault risk oI risky mortgage loans. They had little
incentive to perIorm due diligence. There was Iraud and lax regulatory oversight.
4. To reduce capital requirements, banks employed an originate to distribute` mode oI
operation. They had little incentive to perIorm due diligence.
5. The equity holders oI CDOs, CDO squared, SIVs, DPCs sold many derivative claims. In
many cases the underlying collateral were credit deIault swaps written on asset backed
bonds. This implied that credit deIault swaps written on the same asset could appear in
many diIIerent structures. This increased the systemic risk.
6. The rating agencies did no monitoring oI the raw data, even though it was common
knowledge that lending standards were declining and Iraud increasing. This implied that
assumptions used to estimate the probability oI deIault, recovery rates and deIault
dependence did not reIlect current conditions.
7. Rating agencies were tardy in recognizing the implications oI the declining state oI the
subprime market Ior the ratings oI monolines.
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8. Rating agency incentive problem they are paid by clients and there is limited
competition (by regulation). The rating oI structured products has been very proIitable
business Ior the agencies.
9. Monoline accepted at Iace value the ratings Ior senior tranches Irom the agencies and
sold insurance wraps.
10. Management oI Iinancial institutions are given bonuses based on short run perIormance.
They have little incentive to care about the long run consequences oI their actions
(agency-shareholder problem). Labor markets are not perIect: Iailure, even spectacular
Iailure is rarely a barrier to getting a job at another institution.
11. The new Basle II capital requirements made it attractive Ior banks to invest in super
senior tranches. Money markets Iunds are required only to invest in AAA rated assets.
Other Iinancial institutions are regulated only to invest in investment grade assets. These
investors provided a receptive market Ior the AAA rated asset backed bonds.
12. The absence oI complete data on the collateral pools Ior many structures made valuation
impossible even Ior sophisticated investors. It also made independent analysis oI credit
ratings impossible. To an unsophisticated investor, the ratings process was not
transparent. They had to rely on the rating agencies. Regulators ignored this problem.
13. The absence oI complete and timely data and concern about valuation methodologies
made investors uncertain about valuations posted by banks in their trading books.
14. The implicit commitments oI banks to their SIVs and money market Iunds were not
reported to investors.

4 Steps to Prevent a Repeat
We have identiIied the major issues that have contributed to the credit crisis. In this
section we make recommendations about the steps necessary to avoid a repeat. The rating
agencies have received considerable attention, though they are only one part oI the story. Other
issues have played an important role in the crisis: incentive structures, diIIiculties in valuing
illiquid assets, lack oI transparency, lack oI data, the underlying design oI SIVs and structured
credit products, inadequate risk management and the Iailure oI state and Federal regulators.
4.1 Rating Agencies
In the current crisis, we have witnessed relatively newly rated Iacilities having their credit
ratings changed Irom AAA to junk, and the tardy response oI agencies to recognize the risk
arising Irom the holding oI subprime mortgages by monolines. These observations raise the
question oI the eIIectiveness oI the methodologies used by the agencies to model loss
distributions Ior portIolios oI assets and the Iailure oI the agencies to recognize the limitations oI
their models in a timely manner.
Rating agencies have a long history oI estimating the probability oI deIault and the loss
given deIault Ior individual obligations. This is not the case Ior structured products, where there
are many additional diIIicult issues. As discussed by AschcraIt and Schermann (2007) subprime
ABS ratings diIIer Irom corporate debt rating in a number oI diIIerent dimensions. Corporate
bond ratings are largely based on Iirm-speciIic risk, while CDO tranches represent claims on cash
Ilows Irom a portIolio oI correlated assets. Thus, the rating oI CDO tranches relies heavily on
quantitative models while corporate debt ratings rely essentially on the analyst judgment. While
the rating oI a CDO tranche should have the same expected loss as a corporate bond Ior a given
rating, the volatility oI loss, that is, the unexpected loss, is quite diIIerent and strongly depends on
the correlation structure oI the underlying assets in the pool oI the CDO.
For structured products, such as ABS collateralized debt obligations, it is necessary to
model the cash Ilows and the loss distribution generated by the asset portIolio over the liIe oI the
CDO, implying that it is necessary to model prepayments
72
and default dependence (correlation)
among the assets in the CDO and to estimate the parameters describing the dependence.
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Over
the liIe oI a CDO, individual deIaults may occur at any time, implying that it is necessary to
model the loss distribution over time. This necessitates modeling the evolution oI the diIIerent
Iactors that aIIect the deIault process and how these Iactors evolve together.
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This requires
assumptions about the stochastic processes that describe the evolution oI the diIIerent Iactors,
such as interest rates and prepayment behavior, and the estimation oI the parameters describing
these processes, which usually requires the use oI time series data. II there are major changes in
the economy, then these parameters may change, implying that it is necessary to examine the
sensitivity oI a rating methodology to parameter changes.
It is critical to assess the sensitivity oI tranche ratings to a signiIicant deterioration in
credit conditions aIIecting credit worthiness and deIault clustering. As shown in Fender, Tarashev
and Zhu (2008) the impact oI shocks aIIecting credit worthiness on CDO tranche ratings is very
diIIerent than Ior a corporate bond. It depends critically on the magnitude and the clustering oI
the shocks and it tends to be non-linear.
II deIault occurs, it is necessary to estimate the resulting loss. We know Irom the work oI
Acharya et al (2003) and Altman et al (2005) that recovery rates depend on the state oI the
economy, the condition oI the obligor and the value oI its assets. Loss rates and the Irequency oI
deIaults are dependent (correlated): iI the economy goes into recession, the Irequency oI deIaults
and loss rates increase. It is necessary to model the Iactors that aIIect the loss and the joint
dependence between the Irequency oI deIault and loss. The level oI dependence will vary, in
general, with the state oI the economy.
To have conIidence in a model, it is necessary to have a clear deIinition oI what a rating
means Ior a particular type oI instrument, the Iactors that an agency considers when assigning a
rating and the how well a rating model perIorms in diIIerent economic environments. There is a
lack oI clarity about what does a rating actually measure.
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Is it a measure oI the probability oI
deIault or the expected loss over some speciIied horizon? What is the length oI the horizon? Does
a rating, say BBB, have the same meaning Ior asset backed securities as Ior corporate bonds?
To test model predictions against actual outcomes requires data.
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UnIortunately, Ior
many types oI collateralized products, data availability is limited across instruments and does not
extend over long periods. Consequently, there is little inIormation about the accuracy and
robustness oI models over diIIerent parts oI the credit cycle. To assess the credit risk oI
structures such as SIVs, it is necessary to consider other risk dimensions, such as market liquidity
and valuation oI collateral. These Iactors have been overlooked, though they aIIect the credit
worthiness.
The rating agencies clearly state that they do not perIorm due diligence on the raw data.
The current situation is analogous to accountants accepting at Iace value the Iigures given to them
by Iirms. There is no auditing Iunction. The current situation is problematic. In moving
Iorward, iI data auditing are required, then the issue oI compensation both Ior rating and Ior
auditing needs to be addressed. It is not clear that regulating the originators will solve the
problem oI Iaulty data unless there is adequate enIorcement. Continuing the analogy, Iirms are
required to Iollow generally accepted accounting principles, though accounting Iraud still occurs.
For the last Iew years, the characteristics oI subprime mortgage borrowers were
undergoing major changes due to declining underwriting standards and Iraud. The Iailure to
explicitly recognize the changing nature oI the underlying data used in model estimation implied
that the probabilities oI deIault, recovery rates, deIault dependence and the dependence between
deIault and recovery rates were poorly estimated. Models need to capture deIault contagion that
exists in local housing markets. There exist statistical techniques, such as data sampling,
introducing unobservable heterogeneity and diIIerent prior distributions, which have the potential
to ameliorate some oI these problems.
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For collateralized structures, there is the need Ior more
transparency about (a) the types oI models used by the agencies; (b) the assumptions about the
data used to rate a particular structure; and (c) the accuracy and robustness oI the rating
methodologies to the underlying assumptions. Current methodologies Iailed due to the use oI
inappropriate assumptions derived Irom historic data Ior corporate CDOs with tranches much
wider than Ior ABS CDOs. They also Iailed to appropriately model both deIault and recovery
dependences.
To rate the commercial paper oI a SIV, there are additional Iactors to consider. First is an
assessment oI the backstop lines oI support and other contingent Iunding in the case oI market
disruptions. The rating agencies rate the contingent sources oI Iunding available to a vehicle.
Second, Ior an investor to buy asset backed commercial paper (ABCP), they need to know the
nature oI the assets supporting the paper and the value oI the collateral. The agencies are clear
that they make no statement about valuation. Yet iI the value oI the collateral deteriorates, this
adversely aIIects the credit worthiness oI the commercial paper. Thus logically, one must address
the issue oI the valuation oI the collateral, iI one is to assess the credit worthiness oI the vehicle.
There is the need to be more transparent with respect to the meaning oI a rating Ior
commercial paper or medium term notes Ior structured products and investment vehicles.
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What
does a rating actually consider and what assumptions are made in reaching a rating decision? At
present the onus is on the investor in an ABCP to understand exactly what a rating means, the
underlying assumptions and data used to derive such a rating and the limitations oI the rating
methodology. This is demanding a lot Irom investors, given the lack oI transparency. Again,
there is also the need Ior more transparency about the methodologies used to assess the diIIerent
Iactors and how these considerations are incorporated to reach a Iinal decision. There is a long
list oI uninIormed investors who naively interpreted an ABCP credit rating as measure oI the
underlying credit worthiness, being unaware oI the limitations oI the methodologies.
Recommendations
1. The meaning oI a rating needs to be clearly stated. For example, is a rating a measure oI
the probability oI timely payment? Is it a measure oI the expected loss averaged over the
liIe oI the instrument or some other horizon? II a rating is through-the-cycle, what is the
length oI the cycle? How do the agencies actually calculate their numbers? To avoid
conIusion, the agencies need to be explicit and attach actual numbers to their Iorecasts.
2. For any particular type oI instrument that is being rated, there is the need Ior a clear
statement about the methodology used to derive a given rating and the underlying
assumptions. These have to be generally available, so that in principle the rating could be
reproduced by an independent party. At present, the inIormation agencies make available
to non clients is quite limited. Rating agencies oIten state that a rating depends both on
quantitative and qualitative Iactors. The quantitative part oI the rating should be
reproducible by an independent party.
The ability to independently validate a rating would go a long way to reduce the eIIects oI
conIlicts oI interest. Independent validation requires that data be available. We address this issue
in the next recommendation.
3. For asset backed securities, the government should sponsor an agency that collects
inIormation on a timely basis about the collateral pools and make it available to market
participants. This will Iacilitate an independent party`s ability to reproduce the credit
ratings.
4. Clarity is required about the data sources used to reach a rating. Is the agency accepting
data Irom a third party and has the agency done anything to check iI there have been
structural changes in the data sources? Has it checked the data to justiIy the validity oI
its distributional assumptions?
4.2 Valuation
In the current crisis, one oI the Iundamental problems is the valuation oI the securitized
tranches Ior mortgage assets. To value a simple credit deIault swap requires speciIication oI the
probability oI deIault oI the obligor over the liIe oI the swap and the loss iI deIault occurs. These
probabilities and loss rates are not those estimated by rating agencies. For pricing purposes, we
need the price of risk Ior each Iactor that aIIects the loss distribution. The price oI risk Ior a
Iactor relates the risk oI loss to value. Market prices Ior swaps with standardized maturities oI
one, three, Iive, seven and ten years now exist Ior a large number oI obligors, though the market
Ior non-standardized maturities is still illiquid. The existence oI market prices means that models
can be calibrated to match current prices. Once we can inIer prices oI risk Ior a particular obligor,
we can price non-standard swaps written on the same obligor.
For synthetic CDOs,
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valuation becomes more complicated, as it is necessary to model
deIault and recovery dependences among the obligors in the CDO. For each credit deIault swap
within the structure, the probabilities oI deIault over the liIe oI the CDO are inIerred using the
current market prices Ior all the swaps on the particular obligor. It is necessary to patch together
the individual credit swaps to produce a price Ior the whole structure. The typical types oI
models used by Iinancial institutions are relatively simple and static in nature,
80
and do a
relatively poor job oI pricing all oI the diIIerent tranches. Transparency in pricing and the
liquidity oI the market has greatly increased Iollowing the introduction oI credit indices and the
trading oI tranches written on the indices. This has also Iacilitated models to be calibrated to the
prices oI the individual tranches oI an index. However, Ior synthetic CDOs that do not contain
the same obligors as in an index, additional assumptions are required Ior pricing.
For pricing assets such as mortgages, auto-loans or credit cards, the diIIiculties associated
with valuation greatly increase, as there are Iew prices that can be used Ior calibration. Even
under normal conditions, markets are illiquid. The types oI models used to estimate the credit
ratings oI CMOs could be extended to pricing. This can be achieved by estimating the prices oI
risk associated with each Iactor that aIIects deIault and the resulting loss. However, this requires
market prices. Mortgage related credit indices now exist, allowing the prices oI risk to be
estimated. UnIortunately, mortgage portIolios may diIIer substantially Irom the characteristics
oI the index, as there is wide heterogeneity across diIIerent types oI mortgages. Standardization
oI structures will help to improve liquidity and pricing, as recently suggested by Lagarde
(2007),
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though there are many practical diIIiculties with this type oI suggestion. II prices oI risk
cannot be estimated, another approach is to use the credit rating Ior the mortgage structure and
then make some heroic assumption about what yield an asset with a given rating commands. The
use oI this type oI model has meant that in the current crisis, as rating agencies have down-graded
assets, there have been automatic write-downs. There are two diIIiculties with this approach. It
assumes that ratings are both accurate and timely. The second diIIiculty is the nature oI the
required heroic assumptions. Apart Irom pragmatism, there is little justiIication
Recommendations
1. There is a need Ior the simpliIication and standardization oI instruments. Many
instruments have become too complicated, making reliable pricing or risk management
problematic.
2. For many diIIerent asset classes, the industry needs to develop markets Ior indices
written on standardized assets. This will help in price discovery and Ior pricing related
assets.
4.3 Transparency
The lack oI transparency has aIIected Iinancial institutions in a number oI diIIerent ways.
First, banks hold or are warehousing mortgages beIore securitization, as well as tranches oI
structural products that they are in the process oI selling to investors. In the credit crisis, as the
value oI credit sensitive instruments has declined, Iinancial institutions have been Iorced to write
down the value oI these assets. In many cases, investors have been surprised by the magnitude oI
the write-downs.
Second, is the level and diversity oI commitments, both explicit and implicit, given by
banks. The Iirst explicit type oI commitment is that to underwrite levered buyouts. For the Iirst
part oI 2007, the competition was such that many banks oIIered to provide Iinancing, without the
protection oI an adverse market clause that gives them an escape route. The total magnitude oI
these commitments was oIten not disclosed on a timely basis. The second type oI explicit
commitment occurred when banks gave backstop lines oI credit to their sponsored SIVs. A bank
will oIten provide a backstop line oI credit, usually Ior a Iraction oI the total amount the vehicle
needs. There is a lack oI clarity as to the total level oI these commitments and a bank`s ability to
honor such commitments.
The Iirst type oI implicit commitment arose because oI reputation concerns. Bank
sponsored SIVs are oII balance sheet vehicles, created and managed by banks, who earn revenue
Irom the generous management Iees. To qualiIy Ior oII-balance sheet treatment, a bank should
not be exposed to risk. This test is usually satisIied, given the typical SIV structure. Yet in a
number oI cases, banks to protect their reputation have brought vehicle assets onto their balance
sheets. The second type oI implicit commitment arose because a number oI banks run enhanced
money market Iunds that invested in subprime assets. The banks have stepped in to support the
Iunds in order to avoid breaking the buck, as the value oI the subprime assets declined. During
2007 bank shareholders have had a series oI negative surprises due to the lack oI inIormation
about the diIIerent types and magnitude oI implicit commitments.
For banks, 10K statements oIIer little inIormation about actual holdings oI assets being
warehoused and there is a lack oI clarity with respect to the total level oI bank commitments.
Regulators could request that this inIormation be reported on a regular basis. This would provide
investors with inIormation about a bank`s exposure and the eIIects on valuation iI downgrades
occur. A similar requirement is also needed Ior monolines. The recent Senior Supervisors Group,
(April 11, 2008) report surveys twenty Iinancial Iirms. It Iound that in some cases the level oI
disclosure was extensive. However, even in these cases, the level oI disclosure was at such an
aggregated level, that many important details were hidden about the true nature oI an institutions
exposure.
The lack oI transparency in the pricing oI subprime structures has been a major issue.
Illiquid assets are diIIicult to value even in normal markets. One way to improve pricing
transparency and liquidity is to encourage the trading oI indices based on standardized baskets oI
the assets. Trading in these indices would improve transparency and provide guidance Ior
calibrating models used Ior non-standard baskets oI assets. The last Iew years have seen the
development oI such indices,
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though in some cases, the asset structures used to deIine the
underlying assets in the index lack transparency. There is a need Ior more simplicity and
transparency in design.
Recommendations
1. For banks there is the need Ior transparency as to the magnitude oI explicit commitments
arising Irom lines oI credit, backstop supports, and Iunding Ior levered buyouts.
2. For banks there is the need Ior transparency as to the magnitude oI implicit commitments
that arise Irom reputation concerns. Examples are the implicit commitments to oII
balance sheet vehicles and enhanced money market Iunds. A bank should state in its
annual report the consequences oI bring back onto its balance sheet its oII-balance
vehicles. This would help reduce the inIormation asymmetry.
3. There is the need Ior greater transparency with respect to the nature oI assets held by
Iinancial institutions, especially assets that are diIIicult to value (level three assets).

4.4 Instrument Design
The lack oI transparency and liquidity Ior many asset backed securities such as subprime
mortgages, auto-loans and more exotic CDO squared securities have been a major issue in the
current crisis. In the near Iuture, we can expect investors to Iocus on relatively simple and liquid
products that can be easily standardized and valued.
The introduction oI credit deIault swap indices in late 2002 enhanced the development oI
the credit swap market by improving the transparency. Investors could observe bid/ask spreads
Ior the diIIerent tranches on the index. Indices, such as the ABX, have been introduced Ior the
mortgage market. However, the heterogeneity oI the mortgage market means the prices oI the
sub-indices are oI limited help Ior calibrating particular mortgage structures. To improve the
pricing transparency, more sub-indices are required. For more exotic instruments, such as CDO
squared, there are two issues. First, is the identiIication oI obligors in each oI the underlying
CDOs, and second, the modeling oI deIault dependence. Given the limited success oI models Ior
simple CDOs, modeling a CDO squared is problematic.
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The data Ior all structured products
should be collected by a regulator and made available Ior analysis. This would be a Iirst step to
improve the pricing transparency oI such complex instruments.
New products exposed to 'gap risk have been introduced such as Constant Proportion
PortIolio Insurance (CPPI) and Constant Proportion Debt Obligation (CPDO). Both products are
leveraged investments whose return depends on the perIormance oI an underlying trading
strategy. Quite oIten positions are taken into the available credit indices such as iTraxx and CDX.
Typically, the perIormance oI these trading strategies is exposed to 'gap risk that is not captured
with traditional option pricing models because oI the continuous paths oI the Brownian motion
assumed by these models. The rating oI these products was initially based on Ilawed models, with
most oI the CPDOs being subsequently downgraded with huge losses. For example, Moody`s on
November 26, 2007 announced that Tyger Notes, a CPDO based on Iinancial credits Irom UBS
lost 90 percent oI its value aIter its net asset value Iell below the level that triggered its unwind.
Moody`s later on cut the rating oI the other CPDOs.
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SIVs were Iunding medium-term and hard-to-value assets with short-term money market
securities exposing the vehicle to the risk oI a market disruption.
85
When banks were unable to
roll the ABCP Iunding these SIVs, and market liquidity had totally evaporated Ior subprime
related assets, banks to preserve their reputation had no other alternative, but to take back the
assets on their balance sheet. The design oI the SIVs can be altered to make them less sensitive to
market disruptions. There are a number oI ways to achieve this. Currently, some oI the extant
short-term commercial paper gives the vehicle the option to extend the maturity oI the debt.
Usage oI this option could be expanded. Another type oI option would be to allow the vehicle to
convert the paper into one or two year Iloating rate debt. The option could be contingent on the
event oI a market disruption. The cost oI the option would be relatively small, given that the
probability oI a market disruption is small. The cost oI these modiIications would be to decrease
expected proIits.
Recommendations
1. There is the need to demonstrate that valuation methodologies can be validated with
respect to external prices and risk management is Ieasible, especially Ior complex
instruments.
2. There is the need to design instruments that allow Ior market disruptions.
4.5 Regulatory Issues
The Basel based Financial Stability Forum (FSF) whose membership consist oI central
bankers, regulators and Iinance ministers Irom many countries, presented to the G-7 Ministers
and Central Bank Governors at their meeting in Washington in April 2008 a set oI 67
recommendations Ior increasing the resilience oI markets and institutions going Iorward. Many oI
these recommendations aim at improving transparency in Iinancial markets, regulatory oversight
and coordination across regulatory bodies at the national and international levels. Among the
proposals are increased capital requirements Ior structured credit products and the trading book to
explicitly capture deIault and event risk oI credit exposures held in the trading book, Iaster
disclosure oI losses by banks and increased cross-border monitoring oI banks by regulators.
However, there are a number oI issues at the heart oI the current credit crisis that need an urgent
regulatory response.
First, the lax lending standards over the last Iew years have been a major contributor to
the current crisis. Both regulators and risk managers ignored the implications. A decline in
underwriting standards Ior subprime mortgages (and also auto-loans and credit cards) implied that
the probability oI deIault Ior subprime borrowers and that the deIault dependence increased,
while recovery rates decreased. This, in turn, lowered the value oI structures containing subprime
mortgages. There needs to be regulatory requirements Ior the random sampling oI the raw
mortgage data and the methodologies used to generate the multi-period loss distributions need to
be Ilexible enough to incorporate the changing regime nature oI the data.
In response to the credit crisis, there has been a rush to introduce new laws regulating
lending standards. However, without eIIective enIorcement mechanisms such eIIorts will be oI
little value. The responsibility Ior enIorcement needs to be clearly deIined, especially given state
and Iragmented Iederal divisions. To motivate Iinancial institutions that sell structured products
to undertake the appropriate due diligence, they could be required to hold a speciIied percentage
oI the equity portion oI the structures they sell to investors. This way they bear the direct costs
Irom mispricing due to inappropriate assumptions about the nature oI the loss distribution. For
example, iI a bank sets up a special purpose vehicle, it is required to purchase and hold a
speciIied percentage oI the equity.
Second, the issue oI counterparty risk has arisen at two levels. Many banks had put
options that allowed them to put back mortgages to originators in the case oI delinquency. In a
number oI cases when banks attempted to exercise this option, the originators did not have the
assets to reimburse the banks. The credit derivative market is an over-the-counter market,
implying that there is always counterparty risk. In the current credit crisis, the ability oI some
counterparties to honor their commitments has been called into question.
While banks keep track oI their counterparty exposures, the determination oI the value oI
the total exposure (aIter netting) to a counterparty and the posting oI collateral has been based on
relatively simple Iorms oI rules. The reliance both on credit ratings as a measure oI the risk oI a
counterparty and the valuation oI illiquid assets have been contributing Iactors to the crisis. The
rating agencies have done a poor job in assessing on a timely basis the credit worthiness oI many
oI the counterparties and the valuation oI illiquid assets is diIIicult even in normal times. Both
banks and regulators have Iailed to recognize that a credit event that adversely aIIects a bank may
also adversely aIIect both the credit worthiness oI a counterparty and the value oI the bank`s
collateral. Moving Iorward, there is a need to understand and model the dependence between the
valuation oI the cash Ilows Irom a counterparty and its ability to pay, what is known as 'wrong-
way counterparty credit exposure. Regulators should ensure that methodologies adequately
account Ior this type oI dependence.
Centralized clearing houses (CCHs) oIIer a potential way to localize counterparty risk.
All over-the-counter trades would be cleared through a CCH. The CCH must have suIIicient
capital, monitor its exposure to each customer and request the posting oI collateral. II a party
Iails, such as Bears Stearns, the CCH bears the counterparty risk Ior all the OTC contracts.
Third, banks have many implicit commitments that do not appear on the balance sheets.
For example, some banks have received managerial Iees Irom hedge Iunds and SIVs and
provided lines oI credit. Some banks have used their name to market enhanced money Iunds. In
these cases, it was known that the bank had implicit commitments. It is not surprising, and should
have been expected, that many banks to protect their reputations brought assets on to their
balance sheets, adversely aIIecting their capital and Iorcing some banks to raise additional capital.
Regulators should request that these implicit commitments be recognized Ior capital calculations
and that these contingencies given explicit recognition in Value-at-Risk measurements. For
practical implementation, regulators should be ready to speciIy some minimum probability oI
occurrence. Whether it is desirable to hold capital against these commitments is another issue.
There are two types oI contingencies. The Iirst type oI contingency is the case oI a vehicle
having reIinancing problems that are isolated to the particular vehicle and the bank transIerring
assets onto its balance sheet. The second type oI contingency is the case oI a general market
disruption. To hold capital against this type oI event could be prohibitive. Explicit and implicit
commitments should also be reported in the bank`s accounts, so investors know oI potential
Iuture liabilities.
Fourth, the requirement that assets in the trading book be marked-to-market (or model)
has come under attack Irom some bankers.
86
The central issue is the belieI that in the current
crisis, market or model prices do not reIlect the true value oI an asset and consequently
companies are being Iorced to recognize losses on assets they had no intention oI selling. In the
current crisis, companies have recognized huge write-downs, causing investors to become
increasingly concerned about the credit worthiness oI Iinancial institutions, which have been
Iorced to raise capital at unIavorable prices.
87

The valuation oI illiquid assets is diIIicult under normal markets conditions and
problematic when markets are in turmoil. In the current crisis, there was a Iailure to adjust
distributional assumptions due to misrepresentation oI the underlying risk associated with
subprime borrowers. For assets recorded in the banking book, a loss reserve is required. The
magnitude oI the reserve is usually based on the expected loss over the next year. In general, in
the current crisis this has been under estimated, given the inappropriate distributional
assumptions. II markets are mispricing assets in the current crisis, it is probably due to the lack oI
transparency with respect to the nature oI the assets. Investors need to assess the value oI an
institution`s assets. The Iocus oI the debate should be on the issues oI transparency oI the assets
held by institutions and the valuation oI these assets.
FiIth, the systemic nature oI the crisis has arisen because oI widespread ownership oI
structures containing subprime and the circular dependence between reIinancing and collateral
valuation. Regulators Iailed to recognize the existence oI positive Ieedback mechanisms and to
understand their implications Ior the Iinancial system.
88
II asset values decline, ability to
reIinance declines, valuation oI counterparty collateral declines, the value oI monoline assets
declines and the value oI the guarantees given by monolines declines. Regulators were blind to
the impending crisis. To avoid a repeat, there needs to be more transparency as to the nature oI
assets held by diIIerent institutions. To achieve this will require increased cooperation oI
regulators across national boundaries. There is also the need to recognize Ieedback mechanisms
explicitly and understand their implications Ior the Iinancial system.
Many Iinancial institutions Iailed to anticipate the liquidity risks associated with some oI
their businesses. Regulators need to understand the risks that can be caused by liquidity and
require that these risks be Iormally recognized in measuring the risk oI an institution.
Rating agencies Iailed to understand the risks arising Irom structured products. Given the
regulatory importance attached to ratings, the onus is on regulators to monitor the rating agencies
with respect to data quality, methodologies and rating designations.

Recommendations
1. Minimal Federal lending standards are required across all states in order to avoid the
problems arising Irom lobbyist pressuring state lawmakers to have state laws relaxed.
2. There is the need Ior compulsory random sampling oI mortgage lending practices and
mortgage delinquency rates, especially in major states. The responsibility Ior such duties
must Iall to an independent body.
3. Originators should be required to hold a randomly selected number oI mortgages Irom
each mortgage class. Arrangers should be required to hold a speciIied percentage the
equity tranche oI any structure that they sell.
4. In cases where a counterparty posts collateral, regulators need to consider the eIIects oI
'wrong-way counterparty credit exposure in determining capital requirements. They
also need to recognize the eIIects oI pro-cyclicality in stress testing and scenario analysis.
5. Fair value accounting has come in Ior criticism due to its pro-cyclical nature. A possible
solution is to allow investment banks to place an asset either in the trading book or the
bank book. This decision is made at the time the bank buys the asset. There is the need
Ior some rules to avoid cherry picking by banks that is banks cannot keep on switching
an asset back and Iorth as market conditions change.
6. For Iinancial institutions that are oI a size or importance such that their Iailure threatens
the stability oI the Iinancial system, there is the need Ior consistent regulation across such
institutions.
89

7. The Iragmented regulator system both at the Federal level and at the state level needs to
be improved.
90

8. Regulators need to monitor the rating agencies with respect to data quality,
methodologies, and the eIIicacy oI their prediction. The inherent conIlicts oI interest
between the rating agencies and their clients needs to be addressed.
91
The ability to
perIorm independent validation oI ratings would go a long way to reduce the eIIects oI
possible conIlicts oI interest, which are impossible to eliminate.
9. Centralized clearing houses (CCHs) should be used to reduce and localize counterparty
risk.
4.6 Risk Management Issues
The Senior Supervisors Group issued a report in March 2008 that identiIies risk
management practices that diIIerentiate Iinancial institutions that have been able to weather
relatively well the Iinancial market turmoil, Irom those that did not perIorm well and have been
exposed to large credit write-oIIs. Firms that perIormed relatively well:
- adopted a comprehensive view oI their exposures: they shared quantitative and
qualitative inIormation more eIIectively across the organization so that they were able to identiIy
very early the sources oI signiIicant risk and had more time to evaluate the appropriate actions to
be taken; these Iirms have risk management committees that meet on a weekly basis to discuss all
signiIicant risk exposure across the Iirm, and include senior management (CEO, CFO, CRO,
COO,..) and the heads oI business lines as well as legal and compliance oIIicers, all as equal
partners;
- had in place rigorous internal processes to value complex and potentially illiquid
securities: they had independent in-house expertise to assess the credit quality oI structured credit
assets and were not relying only on the assessment oI credit rating agencies;
- enIorced active controls over the consolidated organization`s balance sheet, liquidity
and capital positions: they aligned the treasury Iunctions more closely with risk management
processes, incorporating inIormation Irom all businesses in global liquidity planning, including
actual and contingent liquidity risk; these Iirms had in place internal pricing mechanisms that
provide incentives Ior the business units to better control balance sheet growth and ensure that
contingent liquidity risk does not outweigh expected returns;
- relied on a wide range oI risk measures: they had adaptive risk measurement processes
and systems that could rapidly alter underlying assumptions in risk measures to reIlect current
circumstances; in particular, they complemented VaR measures with Iorward-looking stress
testing;
92
stress tests specially designed to allow Iirms to estimate the economic beneIits oI
diversiIication and the impact oI correlation risk in stressed markets. Exhibit 2 discusses 'cliII
eIIects or strong non-linearities that characterizes the risk oI subprime CDO tranches, and limit
the useIulness oI VaR measures under some circumstances.
The report also emphasizes the role oI senior management to articulate the strategy oI the
Iirm that will increase its Iranchise value. Imbedded within this responsibility is the task oI
Iinding the right balance between the desire to develop new businesses and the risk appetite oI the
Iirm. In particular, senior management plays a critical role in identiIying and understanding
material risks and acting on that understanding to mitigate excessive risks. Internal
communication across the Iirm is also critical to perIormance in stressed market conditions. The
existence oI organizational silos in the structures oI some Iirms appeared to be detrimental to the
Iirms` perIormance during the turmoil. Firms that avoided signiIicant losses cited a degree oI
integration among the liquidity, credit, market and Iinance control structures. Firm-wide risk
management has become a necessity to keep pace with the growth oI risk taking.
Finally, compensation has been cited as a major issue in the current credit crisis. In
particular, the incentive structure tied loan originator revenues to loan volume, rather than to the
quality oI the loans to be securitized. There is a need to better align compensation and other
incentives with the interests oI the investors and oI the shareholders oI the Iirm, and to Iind the
appropriate balance between short-run and long-run perIormance, and between individual
business unit goals and the Iirm-wide objectives. The originate-to-distribute business model has
created incentives Ior both Iirms and individuals that have conIlicted with sound underwriting
practices, risk management best practices and the interest oI investors and shareholders.
Recommendations
1. Firms should adopt a comprehensive Iirm-wide risk management and share quantitative
and qualitative inIormation in risk management committees that meet Irequently and
include senior management as well as heads oI business lines, legal and compliance
oIIicers, all as equal partners.
2. Rigorous internal processes should be put in place to value complex and illiquid
securities and internal credit quality assessment should complement external ratings.
3. The treasury Iunctions should be closely aligned with risk management to plan and
control balance sheet, liquidity and capital positions.
4. Traditional Value-at-Risk measures should be complemented by Iorward-looking stress
testing to capture the impact oI severe market shocks.
5. The incentive and compensation system should be reviewed to better align the interests oI
all the participants in the securitization chain with the interests oI the investors and
shareholders oI the Iirm. The incentive compensation scheme should be closely related to
long-term, Iirm-wide proIitability.
5 Summary
Securitization allows banks to move assets oII their balance sheets, Ireeing up capital and
spreading the risk among many diIIerent players. These are real beneIits. Federal Reserve
Chairman Ben Bernanke said at the opening meeting in April 2008 oI the G-7 in Washington that
Iailures in the so-called 'originate-to-distribute model oI credit extension were the root oI the
current crisis. It broke down at a number oI key points, including at the stages oI underwriting,
credit rating and investor due diligence. Financial institutions that had bought structured credit
products coming Irom the securitization oI subprime loans did not have adequate risk
management or liquidity plans in place. Chairman Ben Bernanke also said 'these problems
notwithstanding, the originate-to-distribute model has proven eIIective in the past and with
adequate repairs could be so again in the Iuture.
In this paper, we have identiIied many oI the Iactors that have contributed to the crisis,
Irom the search Ior yield, Iraud, agency problems resulting in lax underwriting standards,
incentive issues, Iailure to identiIy a changing environment, poor risk management by Iinancial
institutions, lack oI transparency, the limitation oI extant valuation models and the Iailure oI
regulators to understand the implications oI the changing environment Ior the Iinancial system.
The paper addresses the diIIerent issues and oIIers suggestions on how to move Iorward.
Appendix A
Biggest losses/write-downs since the beginning of 2007, in billions of US$ as of April 2008
(Source: Bloomberg)

Citigroup $40.9
UBS $38
Merrill Lynch $31.7
Bank oI America $14.9
Morgan Stanley $12.6
HSBC $12.4
JP Morgan Chase $9.7
IKB Deutsche $9.1
Washington Mutual $8.3
Deutsche Bank $7.5
Wachovia $7.3
Credit Agricole $6.6
Credit Suisse $6.3
RBS $5.6
Mizuho Financial Group $5.5
Canadian Imperial Bank oI Commerce $4.1
Societe Generale $3.9

Exhibit 1
Central Banks Interventions
European Central Bank August 9, Euro 95 billion (US$130 billion)
August 10, Euro 61 billion (US$84 billion)
U. S. Federal Reserve August 9, US$24 billion
August 10, US$38 billion
Bank oI Canada August 10, C$1.64 billion (US$1.55 billion)
Bank oI Japan August 10, Y100 billion (US$8.39 billion)
Swiss National Bank August 10, SF 2 -3 billion (US$1.68 -2.51 billion)
Reserve Bank oI Australia August 10, A$4.95 billion (US$4.18 billion)
Monetary Authority oI Singapore August 10, S$1.5 billion (US$0.98 billion)

Exhibit 2: Cliff effects or non-linearities in the risk of subprime CDO tranches
Banks and rating agencies have based their risk assessments on market assumptions
which didn`t reIlect the severity oI the current environment aIter the housing market started to
deteriorate and market liquidity evaporated. It has long been suggested to complement standard
risk analyses based on 'normal market conditions
1
by 'stress-testing methods and 'scenario
analysis which take into account liquidity risk and other complexities in order to ensure that
banks are aware oI the potential losses they might incur in highly unlikely but plausible
scenarios.
2
It is well known that Value-at-Risk (VaR) models do not accurately capture 'gap
risk, i.e., extreme market events. It is clear that iI the term structures oI deIault probabilities, the
losses given deIault and the deIault correlations oI the mortgage bonds in the pool oI the
subprime CDOs, had been reasonably stressed we would have known the extent oI the potential
losses. Traditional Value-at-Risk risk measurement models are static in nature and do not capture
the impact on potential losses oI limited liquidity and complex non-linearities embedded in
structured credit products.
In particular, the nature oI the risks involved in holding a triple-A rated super-senior
tranche oI a subprime CDO was completely missed by all the players: rating agencies, regulators,
Iinancial institutions and investors. Subprime CDOs are in Iact CDO squared as the underlying
pool oI assets oI the CDO is composed oI subprime MBS bonds that are themselves tranches oI
individual subprime mortgages. A typical subprime trust is composed oI several thousand
individual mortgages, typically around 3 to 5,000 mortgages Ior a total amount oI approximately
a billion dollars. The distribution oI losses oI the mortgage pool is tranched into diIIerent classes
oI MBS bonds Irom the equity tranche, typically created through over-collateralization, to the
most senior tranche rated triple-A. A typical subprime CDO has a pool oI assets composed oI
MBS bonds rated double-B to double-A, with an average rating oI triple-B. The problem is that
the initial level oI subordination Ior a triple-B bond is relatively small, between 3 and 5 percent
and the width oI the tranche is very thin 2.5 to 4 percent maximum. As prepayments occur the
level oI subordination oI the lower tranches increase, in relative terms, and can reach 10 percent
over time. Assuming a recovery oI 50 percent on the Ioreclosed homes, means that a deIault rate
oI 20 percent on subprime mortgages, which is realistic in the current environment, will most
likely hit most oI the triple-B tranches. Moreover, it is also most likely that in the current
downturn in the housing market and recessionary economic environment, the loss correlations

2
See, Ior example, Crouhy, Galai and Mark (2006).
across all the triple-B tranches will be close to one. As a consequence, iI one triple-B tranche is
hit, it is most likely that most oI the triple-B tranches will be hit as well during the same period.
And, given the thin width oI the tranches, it is most likely that iI one MBS bond is wiped out,
they all will be wiped out at the same time, wiping out the super-senior tranche oI the subprime
CDO. In other word, we are in a binary situation where either the cumulative deIault rate oI the
subprime mortgages remains below the threshold that keeps the underlying MBS bonds
untouched and the super-senior tranches oI subprime CDOs won`t incur any loss, or the
cumulative deIault rate breaches this threshold and the super-senior tranches oI subprime CDOs
could all be wiped out.
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*
We grateIully acknowledge comments Irom Steve Arbogast, William Dellal, Darrell
DuIIie, Paul Embrechts, Tom George, Rajna Gibson, Dan Jones, Arthur Maghakian and Lee
Wakeman. We would like also to thank Stephen Figlewski, the editor, Ior constructive and
helpIul comments.

1
The term 'subprime reIers to mortgagees who are unable to qualiIy Ior prime mortgage rates. Reasons
Ior this include poor credit histories (payment delinquencies, charge oIIs, bankruptcies, low credit scores,
large existing liabilities, high loan to value ratios).
2
In April 2008, the International Monetary Fund (IMF) said that total Iinancial losses stemming Irom the
housing turmoil and the global credit crunch, including the securities tied to commercial real estate and
loans to consumers and corporates, may reach US$945 billion over the next two years, with US$565 billion
directly related to the subprime crisis. And losses at Iinancial institutions are likely to be saddled with halI
the potential losses, or about US$440 to US$510 billion.
3
The US$300 billion in losses related to the subprime crisis compares to about US$170 billion in losses Ior
the savings and loan crisis in the 1980s and early 1990s.
4
Appendix 1 shows the credit losses and subprime related write-downs since the beginning oI 2007 at
major banks worldwide, based on data compiled by Bloomberg. Early 2008, AIG`s auditors Iorced the
insurer to lower the value oI credit-deIault swaps it holds by an estimated amount oI US$4.88 billion.
Credit Suisse also announced in February that it had to write-down US$2.85 billion oI previously mis-
marked structured credit products.
5
To smooth the deal, the Fed has taken the unprecedented step oI providing US$30 billion in Iinancing Ior
Bear`s less liquid assets. The Fed is assuming responsibility Ior managing the assets and assumes the risk
oI those assets declining in value, except Ior the Iirst billion which will have to be absorbed by JP Morgan
Chase, and the proIit iI they rise in value.
6
These rates, in turn, aIIect monthly payments on millions oI credit cards and mortgages in Europe and the
U.S.

7
As an alternative to raise more capital banks are trying to shrink their balance sheet by selling loans at a
discount. Citigroup negotiated (April 18, 2008) with a group oI leading private equity Iirms (Apollo,
Blackstone and TPG) the sale oI US$12 billion in leverage loans at a discount that could come in at about
90 cents on the dollar.
Anxiety is such that even some dedicated Iree-market spirits, such as Nobel laureate Myron Scholes,
declared to the French newspaper, La Tribune (January 24
th
, 2008) that a concerted political eIIort has
become necessary. In addition to sovereign Iunds, the U.S. government may have to step in to recapitalize
some oI the large Iinancial institutions subject to large losses to ensure that they can keep Iinancing the
economy.
8
For example, Iunding Ior Citigroup, one oI the hardest hit by the credit crisis, has risen Irom 12 bps to 1
percentage point over Libor, while the cost oI borrowing Ior Merrill Lynch has climbed Irom to 1.50
percentage point over Libor Irom 20 bps. Investors believe there is an increasing probability oI deIault Ior
banks. The iTraxx Senior Financial Index that tracks the cost oI insuring the senior debt oI a portIolio oI 25
European banks and insurers has increased Irom 8 bps to 57 bps.
9
The credit crisis has caused credits spreads to increase, especially Ior junk bonds. Some highly levered
companies have been Iorced to postpone new debt issues.
10
The leverage loan market in February 2008 is starting to show signs oI weakness as UBS and Credit
Suisse announced the write down oI a combined US$400 million in the value oI leveraged loans as part oI
their Iourth-quarter 2007 earnings report. Some analysts expect as much as US$15 billion in leveraged-loan
related write-downs at commercial and investment banks in the Iirst quarter oI 2008.

11
CI. iTraxx Europ e crossover index. It closed at 510 bps on February 6, which means that the annual cost
oI insuring 10 million euros worth oI high-yield debt against deIault over 5 years is 510,000 euros. In the
U.S., the HiVol index oI the 30 riskier investment grade credits oI the 125 names composing the CDX
index reached almost its peak on February 6, at 271 bps.
12
According to a recent report by Altman and Karlin (2008) deIault rates were near-record low and
recovery rates were near record high in 2007 Ior high-yield bonds. DeIault rates Iell to just 51 bps, the
lowest since 1981. According to S&P the deIault rate on leveraged loans decreased again in 2007 to just 26
bps, down Irom 1.1 in 2006 and 3 in 2005. DeIault losses on high yield bonds were just 20 bps in 2007
based on an average recovery rate oI 67. One measure oI the potential increase in deIaults going Iorward
is the distress ratio, i.e., bonds yielding more than 10 above Treasuries. This ratio increased dramatically
to 10.4 as oI year-end 2007 Irom record low levels just six months earlier, and Irom 1.7 at the end oI
2006. Altman Iorecast a deIault rate Ior high yield bonds oI 4.6 in 2008 and 5 in 2009, a signiIicant
increase Irom the current deIault rate oI 51 bps.
13
Items have been drawn Irom many diIIerent sources: Business Week, Financial Times (London), New
York Times, Wall Street Journal, Bloomberg and the Federal Reserve.
14
The Fed Iunds rate was 1 in June 2003. It started to slowly increase in June 2004, and was 5.25 by
June 2006. It was reduced to 4.75, September 18, 2007.
15
In the U. S. 50 million, or two-thirds oI homeowners currently have mortgages, with 75.2 being
Iinanced with Iixed rate mortgages and the remaining 24.8 with adjustable rate mortgages (ARMs).
These Iigures come Irom the Mortgage Bankers Association, August 15, 2007.
16
Subprime loans grew Irom US$160 billion in 2001 (or 7.2 oI new mortgages) to US$600 billion in
2006 (or 20.6 oI new mortgages).
17
For a comparison oI prime and subprime mortgages, see Agarwal (2007)
18
See DuIIie (2007) Ior a discussion about credit risk transIer innovations.
19
According to Bank Ior International Settlements (BIS) the notional amount outstanding oI CDSs (Credit
DeIault Swaps) was US$58 trillion end oI December 2007 while it was only US$14 trillion at the end oI
2005. However, according to ISDA, the net exposure to the banking system is 'only US$1 trillion aIter
netting.
20
Doms, Furlong and Krainer (2007) Iind a negative correlation between house prices appreciation and
subprime delinquency rates. They also show that the rate oI change in the price appreciation aIIects the
delinquency rate.
21
The Mortgage Bankers Association deIines delinquent as having one or more payments over due.
22
These Iigures are given in the press release oI the Mortgage Bankers Association (March 13, 2007).
23
The economy started to change during 2004. First, mortgage rates started to increase, as the Federal
Reserve increased the Fed Funds rate and second, house price appreciation decelerated. There are many
Iactors that cause delinquency in the mortgage markets, major candidates being: job loss, unanticipated
medical expenses, divorce and rising mortgage expenses. House prices can also aIIect the deIault decision.
II house prices are Ialling, this can aIIect this decision in two ways. First, it limits the ability to re-Iinance
and second, it can cause the home owner`s equity to become negative iI the initial equity stake was small,
as is oIten the case Ior subprime mortgages. Since the middle oI 2005, the rate oI house price appreciation
has been continuously decreasing. There has been wide variation across the country, with CaliIornia,
Florida Michigan, Massachusetts and Rhode Island having price depreciation. Consequently, there has been
wide variation in subprime delinquency rate across diIIerent metropolitan areas. (See the report Irom the
OIIice oI Federal Housing Enterprise Oversight August 30, 2007)
24
This phenomenon was exacerbated by the decline in subprime mortgage rates starting in 2004 due to
increase price competition. This, along with the Federal Reserve increasing interest rates, reduced the
proIitability oI lending. To oIIset this decrease, some originators reduced standards see Coy (2007).

Evidence oI loosening underwriting standards was Iirst noted in 2005 in the OIIice oI the Comptroller oI
the Currency`s annual survey oI underwriting practices at national chartered banks.
25
We will subsequently discuss why the CDO bonds were mis-rated. BrieIly, the rating methodology did
not reIlect current market conditions, and there was an incentive problem in the way rating companies were
compensated Ior rating assignments.
27
See Morgenson (2007).
28
Lenders were Iar too willing to lend as evidenced by the creation oI new types oI mortgages, known as
'aIIordability products that required little or no down payment, and little or no documentation oI a
borrower`s income, the last ones being known as 'liar loans. Liar loans accounted Ior 40 percent oI the
subprime mortgage issuance in 2006, up Irom 25 percent in 2001. The Federal Reserve issued three cease
and desist orders due to mortgage related issues in the last Iour years: Citigroup Inc. and CitiFinancial
Credit Company (May 27, 2004); Doral Financial Corporation (June 16, 2006); R&G Financial
Corporation (June 16, 2006). Ameriquest Mortgage Company (Aegis Mortgage Corporate and associated
companies) set up a US$295 million Settlement Fund to compensate borrowers Ior unlawIul mortgage
lending practices.
The state oI the subprime market also attracted attention to industry practices in mortgage origination. The
declining underlying standards and Iraud is noted by Cole (2007) and Bernanke (May 17, 2007).
Morgenson (2007) identiIied some oI the techniques used by lenders to increase subprime mortgages
originations. These were oIten not in the best interest oI the borrower.
29
In 2007, the Federal Bureau oI Investigation was looking at over 1,200 Iraud cases compared to 818
cases in 2006. In 2006, they obtained over 204 mortgage Iraud convictions, generating US$388 million in
restitution and US$231 million in Iines see Davies (2007).
30
Consequently, these waterIall payment structures are oIten complex and diIIicult to model Ior risk
management purposes.
31
Some oI the material in this section draws Irom the publicly available inIormation supplied by Moody`s,
S&P and the testimonies given by Michael KaneI, Managing Director, Moody`s Investors Services (2007)
and Vickie Tillman, Executive Vice President oI S&P (2007).
32
Fitch (2008) reports numbers Ior the year 2007. Transitions Irom investment to speculative grade,
including deIault, Ior U.S. structured Iinance show a dramatic increase.
33
Most oI the US$2.5 trillion sitting in the money market Iunds is invested in such assets as U.S. Treasury
bills, certiIicates oI deposit and short-term commercial debt. In the recent low interest rate environment
these Iunds have also invested in triple-A super-senior tranches oI CDOs and triple-A rated ABCP, in order
to increase the yield generated by these Iunds.
34
Rating agencies earn heIty Iees Ior rating structured credit securities. In 2006, Moody`s reported that 43
percent oI total revenues came Irom rating structured notes.
35
See Partnoy (2006). The conIlict between incentives and reputation is illustrated by the recent disclosure
by Moody`s (July2, 2008), that management Iailed to inIorm investors on a timely basis that a computer
program used to rate constant proportional debt obligations contained an error. Consequently, a number oI
credit ratings were over estimated by several notches.
36
In testimony to Committee on Banking and Urban AIIairs, both agencies stated that they accepted the
raw data without any Iorm oI checking- Ior Moody`s see KaneI (Iootnote 3, 2007) and Ior S&P see Tillman
(P7, 2007).
37
This pro-cyclicality in CE has the potential to ampliIy the housing cycle. See AshcraIt and Schuermann
(2007). A rating that is 'through the cycle means that it under estimates the true probability oI deIault in a
recession and over estimates it in an expansion.
38
Some hedge Iunds aware oI the problems in the subprime markets (these were public knowledge) and the
Iailure oI rating agencies to incorporate such inIormation into their ratings, anticipated signiIicant
downgrades and declining prices.
39
To some extent this should have been mitigated by originators having to repurchase delinquent loans
within a Iew months oI origination ('early payment deIault clause). However, as some oI the brokers were
experiencing Iinancial diIIiculties and even in some cases Iiled Ior bankruptcy, this did not occur, leading
to even greater losses on the underlying asset pools. For example, Merrill Lynch demanded in December

2006 that ResMae mortgage Corp. which sold it US$3.5 billion in subprime mortgages, buy back US$308
million oI loans where the borrowers had deIaulted. ResMae said that those demands 'crippled its
operations, in its Iiling Ior bankruptcy protection in February 2007. Accredited Home Lenders Holding
reported a loss oI US$37.8 million due to repurchase oI bad loans (February, 2007).
40
In June 2004, New Jersey`s Assembly and Senate passed bills that rolled back parts oI the earlier law,
including the 'tangible-net-beneIit rule that required lenders to prove that a reIinancing oI any home loan
less than Iive years old would provide a 'tangible-net-beneIit to the borrower. Thousand oI New Jersey
homeowners subsequently reIinanced existing mortgages or took new loans with Ameriquest beIore the
subprime market tanked. Many oI these loans are now in Ioreclosure.
41
This section draws on material given in Polizu (2006).
42
The deIeasance mode is the orderly wind-down by the manager oI the portIolio. The enIorcement mode
occurs iI the trustee undertakes the wind-down.
43
Capital notes are subordinated to senior creditors and rank pari passu with all other capital notes
outstanding. Capital notes typically have a Iixed maturity date. Each year the maturity is automatically
extended Ior a Iurther year, unless the investor stops the automatic extension. This mechanism is termed
the 'rolling capital notes. Capital notes usually receive some minimum rate, payable at pre-speciIied
dates. The intention oI the manager is to create excess spread above this minimum rate. ProIits are shared
between the manager (perIormance Iees) and the investor (known as an additional interest amount).
Leverage Ior a SIV is deIined as the ratio oI senior debt (ABCP plus MTNs) to capital notes. Typical
leverage varies in the 12-14 range.

44
A variant oI a SIV is the SIV-Lite structure. In these types oI vehicles, capital has a Iinite maturity. The
vehicles typically hold residential mortgage backed securities and home equity backed securities. The
Iixed maturity implies that at launch, the maximum permitted leverage is Iixed through the liIe oI the
vehicle. This is not the case with a SIV.
45
In the case oI K2, Dresdner does not anticipate to make substantial losses as its assets are entirely
investment grade and do not contain any exposure to subprime mortgages and related structured credit
products.
46
In the event oI a bond deIaulting, the monoline agrees to make whole interest and principal payments on
their respective due dates.
47
The only exception was ACA which was rated single-A and which guaranteed US$26.6 billion oI CDOs
backed by subprime mortgages. As long as the monoline maintains its single-A rating, the counterparties
don`t require the monoline to post collateral even iI the value oI the securities it insured Iell in value.
48
As mortgage delinquencies rose, so did paper losses. In November, the monoline CIFG, which had
exposure oI approximately US$6 billion to the US subprime market, received a US$1.5 billion injection
Irom two French banks. AIter the injection, Fitch re-aIIirmed CIFG AAA ratings. MBIA and AMBAC
wrote assets down by a combined US$8.5 billion in the third quarter oI 2007. There is now a general
market concern that monolines have insuIIicient resources to honor their commitments. Recently MBIA
added US$3.5 billion in write-downs on its credit derivatives portIolio Ior the Iourth quarter oI 2007 and a
US$2.3 billion Iourth quarter loss. MBIA has raised about US$2.5 billion in capital since November and
has plans Ior more, possibly involving obtaining reinsurance on portions oI its portIolio. Fitch recently cut
its triple-A rating to double-A on AMBAC, Security Capital Assurance and FGIC, citing their Iailure to
raise capital. Fitch also put the triple-A rating oI CIFG on negative watch, just weeks aIter aIIirming its
rating. In March, Moody`s, then S&P and Fitch, downgraded CIFG Irom triple-A to single-A plus and
rating agencies are now questioning the long-term viability oI CIFG as a guarantor as shareholders have
declared they may not be prepared to recapitalized the monoline a second time. AMBAC beneIited Irom a
capital inIusion oI US$1.5 billion, which allowed it to maintain its triple-A rating.
ACA might be the Iirst monoline to Iile Ior bankruptcy. S&P slashed ACA rating to CCC, a low
junk level, Irom A in December 2007. The stock oI ACA was delisted Irom the New York Stock Exchange
last December and ACA is now on a run-oII mode.
MBIA and AMBAC were downgraded to AA rating status in June, 2008.

49
There is concern that banks might have to write down an additional US$40 to US$ 70 billion consecutive
to the downgrade or the bankruptcy oI monolines.
50
A potential bailout oI FGIC, the third biggest municipal bond insurer in the U.S. with about US$315
billion oI insured bonds outstanding, is being led by Calyon, the investment banking unit oI France`s Credit
Agricole. Other bank in the consortium include UBS, Soc Gen, Citigroup, Barclays and BNP Paribas.
51
According to Eliot Spitzer speed to resolve the monoline recapitalization issue is critical as the
diminishing conIidence in the monoline to meet their obligations has already hurt markets like the auction-
rate securities. Just beIore Eliot Spitzer injunction, the auction-rate securities market, a US$330 billion slice
oI the municipal bond market shut down. (These securities are also issued by student loans authorities,
museums and many others.) Investors stopped buying securities at regular municipal auctions because they
were concerned about the Iate oI the bond insurers who guarantee around 80 percent oI the entire market.
The Port Authority oI New York and New Jersey Iound itselI paying a rate oI 20 percent on US$100
million oI its debt, almost quadruple its cost a week beIore. Auction bonds are initially sold as long-term
securities but are eIIectively turned into short-term securities through auctions where interest rates are
determined by bidding that typically occurs every 7, 28 or 35 days. When there are not enough buyers, the
auction Iails and bondholders who wanted to sell are leIt holding the securities. Rates at Iailed auctions are
set at a level spelled out in oIIicial statements issued at the initial bond sale.
52
It is not clear that this will help monolines keep their current credit ratings.
53
The plan advanced by William Ackman did directly address this issue.
54
In the U. S. banks are required to have minimum level oI reserves on average Ior a two week period,
known as a 'maintenance period. II a bank has excess reserves, it can lend then in the Fed Iunds market
and iI insuIIicient reserves, it can borrow in the Fed Iunds market. The Fed adds and drains credit Irom the
market, so as to keep the eIIective Fed Iunds rate (the actual rate that banks borrow or lend) near to the
target oIIicial Fed Iunds rate.

55
This Iacility was used the Iirst time by Lehman in April 2008. Lehman shiIted around US$2.8 billion in
loans, including some risky LBOs it had been unable to sell, into a new investment vehicle it named
'Freedom which issued debt with 20 subordination that was assigned a single-A rating by rating
agencies and thereIore was eligible as collateral at the PDCF oI the Fed.
56
The decision to close one oI the Synapse Iunds apparently arose due to the Iailure to reach agreement
with its prime broker, Barclays Capital, about the valuation oI assets held by the Iund. The Iund did not
hold subprime mortgages. See Davies, Hughes and Tett (2007).
57
See the Statement oI Financial Accounting Standards, rules SFAS 157 and SFAS159.
58
Price is deIined as the amount that would be received to sell an asset or paid to transIer a liability.
59
For a recent discussion and reIerences to extant literature, see O`Brien (2005).
60
It was not clear what assets these structures held.
61
In the second week oI August, Coventree, a Canadian investment Iirm could not sell US$229 million oI
commercial paper. It shares Iell by 80 beIore trading was stopped. Three days later, in the asset backed
commercial paper market, 17 Canadian issuers Iailed to sell short term debt and sought Iinancing Irom
banks and the market closed down. The Iunds had backstop lines oI credit. However, the criterion Ior
usage is more restrictive in Canada than the U. S. It requires a general market disruption. As some Iunds
could still roll over their ABCP, some banks took this as evidence that there was no general market
disruption and reIused to honor their commitments, triggering the Iunding crisis in Canada. In Europe and
Australia, many special investment vehicles reported problems. For example, in Europe Mainsail II, an
aIIiliate oI Solent Capital Partners (London) and Synapse Investment Management and in Australia, Ram
Home Loans, all reported problems in rolling over the asset backed commercial paper.

62
The Iund agreed to waive its annual management Iees.
63
Sowood played credit spread vs. equity prices and was crushed when spread widened while equity
markets didn`t Iall.

64
King County oIIicials bought US$53 million in Mainsail commercial paper, when rated AAA by S&P. It
is now rated B. An oIIicial Irom the county is quoted as stating 'we rely heavily on that (the rating) see
Henry (2007). Words in italic have been added.
65
SachsenLB had asked Ior the return oI its investment in the Iund. Synapse was unable to Iind alternative
Iunding.
66
Some institutions do disclose the aggregate amount oI such commitments. However, at this level oI
aggregation, the investor does not know the types oI Iirms or individual levels oI support provided by the
bank.
67
The size oI U. S. money market Iunds is approximately US$2.70 trillion, according to the Institute oI
Money Market Fund Association.
68
Credit Suisse recorded a third quarter loss oI US$128 million aIter removing assets Irom one oI its
money market Iunds. At the beginning oI summer, it had money market assets oI US$25.5 billion and six
months later these had sunk to approximately a quarter oI that size. In November 2007, it transIerred
approximately US$6 billion oI the remaining assets onto its balance sheet to meet redemption claims. In
December 2007, Columbia Management, a unit oI Bank oI America, closed its Strategic Cash PortIolio
aIter withdrawals reduced the Iund Irom US$40 billion to US$12 billion. Prior to the shut down, the bank
had provided US$300 million in support.
69
It is unclear how the Iund would have avoided this issue, iI assets are purchased at market prices. At the
end oI the year, the three major banks abandoned the idea oI the Iund. It had met with a lukewarm
response Irom other investors.
70
The asset values are reported to have Iallen Irom US$3.47 billion to US$1.6 billion. Paribas stated the
Iunds were invested in AAA and AA rated structures.

71
The problems oI rating credit related structures are currently illustrated by the ratings assigned to the
monoline CIFG. S&P give it an investment grade A (negative), while Moody`s a Ba1 and Fitch a near
deIault rating oI CCC (June 8, 2008).
72
Prepayments oI principal include both voluntary and involuntary (deIault) prepayments. Voluntary
prepayments depend strongly on the path Iollowed by interest rates. Interest rate risk is a key source oI
uncertainty in the analysis oI cash Ilows.
73
There are many diIIerent types oI Iactors that inIluence deIault dependence. For example, iI the local
economy deteriorates, then deIaults might increase or iI a particular sector oI the economy deteriorates,
then this will adversely aIIect obligors within the sector.
74
The recent work oI Chava, SteIanescu and Turnbull (2007) examines the multi-period loss distribution
Ior single corporate assets.
75
See Nomura (2006) Ior a discussion about bond rating conIusion. The issues also extend to municipal
bond ratings.
76
See Deventer (2007).
77
See the recent papers by DuIIie, Eckner, Horel and Saita (2006) and Chava, SteIanescu and Turnbull
(2007).
78
The same issue has been raised about the rating Ior municipal bonds compared to corporate bonds, as
both deIault and recovery rates are quite diIIerent Ior the same rating.
79
Synthetic CDOs are structures that contain credit deIault swaps.
80
Schnbucher (2003, chapter 10) provides a clear introduction to this topic.
81
C. Lagarde is France`s minister oI economy, Iinance and employment.
82
Examples oI such indices are the CDX and iTraxx Ior synthetic CDO structures, LCDX Ior loans, ABS
Ior asset backed securities and CMBX Ior commercial mortgage backed securities.
83
See Jarrow, Mesler and van Deventer (2007).
84
The size oI the CPDO market is only approximately US$3.5 billion.

85
This was also the root oI the problems with the British bank Northern Rock Pic, that caused the Iirst
bank run in 140 years in Britain.
86
Adrian and Shin (2008) argue that mark-to-market accounting can cause pro-cyclicality.
87
One recent proposal is Ior auditors to estimate the maximum losses Ior a Iinancial institution and
recognized these losses in the proIits see Guerrera and Hughes (March 14, 2008). Given that auditors
have in general even less expertise than credit rating agencies at making such estimates and rating agencies
have done a poor job in the current crisis, investors will be Iorced to rely on their own estimates without the
beneIit oI market opinion. The outcome may be a 'market Ior lemons with even greater declines in asset
values than under the mark-to-market Iramework.
88
The recent U.K. House oI Commons Treasury Committee Report on the Iailure oI the Northern Rock
Bank notes the Iailure oI the regulators to recognize the implications oI positive Ieedback mechanisms.

89
The head oI the New York Federal Reserve has recently suggested such a plan (June 9, 2008).
90
The recently announced Iramework Irom the Treasury Department represents a start oI this diIIicult
process (March 31, 2008).
91
A start has been made by the New York Attorney General (June 4, 2008). The agreement requires rating
agencies to be paid Ior any preliminary work they do, irrespective oI whether they are selected to give a
Iinal rating. This will help provided there are at least two agencies employed and the details are made
public.

92
VaR measures perIorm well under normal conditions but are unable to capture severe market shocks.

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