The Credit Crisis and beyond: Lessons from the Financial Crisis & Sound Practice Principles


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This lecture has been part of the European and International Financial Institutions module at Glasgow-Caledonian University (GCU) and was delivered by Markus Krebsz on 7th March 2013 in London.

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The Credit Crisis and beyond: Lessons from the Financial Crisis & Sound Practice Principles

  1. 1. The Credit Crisis and beyond: Lessons from the Financial Crisis & Sound Practice PrinciplesMarkus Krebsz7 March 2013, LondonEuropean & International Financial Institutions lecture
  2. 2. 1) Lessons from the Financial CrisisLesson 1: Data, Disclosure and StandardizationLesson 2: Due diligenceLesson 3: Deal motivesLesson 4: ArbitrageLesson 5: Rating shopping & Over-reliance on ratingsLesson 6: Models, Assumptions & Black boxesLesson 7: Proprietary analysis & Risk managementLesson 8: Senior management awarenessLesson 9: Lack of drill-down capabilityLesson 10: Mark-to-market, Mark-to-model & Illiquidity ________________________________________________________________________________________________________________________Source: “Securitization & Structured Finance post Credit Crunch” – Part I 2
  3. 3. 3
  4. 4. Lesson 1:Data, Disclosure +Standardization 4
  5. 5. Data, Disclosure & Standardization• Banks’ due diligence vs. outsourced analysis (CRA)• Historical information  Future performance: NO!!!• Model = Always model, NOT true reflection of reality• Paper reports  issues & problems• Electronic reports  depends on file format really• Data feeds & APIs• Definitions  Product taxonomy• Non-comparability of ratings across CRAs• Lack of clear reporting or underwriting standards 5
  6. 6. Lesson 2:Due diligence? 6
  7. 7. Due diligence• Activities investors should undertake prior to purchasing new or secondary market bond issuance• CRAs don’t do “due diligence” but only “servicer reviews” – investors don’t always know this• Thorny issues & digging deeper: not really• CRAs are always conflicted in their opinion given that they are paid by the bond issuer for the rating!• Issuer pays model (since 1970) 7
  8. 8. Lesson 3:Deal motives 8
  9. 9. Deal motives• Investors need to ask more questions such as: “What is in it for us?” (i.e. the investors) AND “What is in it for THEM?” (i.e. the issuers)• Plausible explanation for a particular deal?• Why has the deal been structured?• Capital structure of the transaction? 9
  10. 10. Lesson 4:Arbitrage 10
  11. 11. Arbitrage• Financial motivation, such are arbitrage• Aim is to leverage an actual or perceived advantage• Regulatory arbitrage: applying different rules for calculating capital charges under BII regime• Informational arbitrage: different levels of insights or information on underlying assets• Technological arbitrage: more sophisticated models with perceived or real analytical edge• Financial arbitrage: Cash flow advantage, excess 11
  12. 12. 5:UsingCRAs’analysissensibly 12
  13. 13. Rating shopping and Over-reliance on Ratings• Rating by one CRA missing?  It’s worth digging deeper!• Reasons: cheaper credit enhancement (C/E)  Indicating rating shopping!• Happened often in the run up to the Credit Crisis• If you are an investor, simply ASK the CRA• Credit ratings have been key investment criteria• Outsourcing analysis possible, BUT: outsourcing losses is not 13
  14. 14. Timely rating actions and DeferralTimeliness of Rating changes Bond maturity profile • Process stages to reach • Legal final vs. expected rating decisions maturity • Detection of bond- vs. • Life-time ratings (40+ years) asset class-specific • Timely payment of interest & and/or systemic issues ultimate payment of principal 31 July 07 20 Aug 07 31 Aug 07 9 Oct 07 16 Oct 07 25 Oct 07 Cut-off date CRA analyst Proposal: RWN CRA Analyst Proposal: DG Indiv. or Asset-class? Bulk rating actions & Report format & frequency, Analyst’s experience, Models, Quorum ... Criteria 15 Aug 07 27 Aug 07 25 Sept 07 12 Oct 07 23 Oct 07 You get Distribution st 1 Analysis result st 1 Committee nd 2 Analysis result nd 2 Committee the idea... Changes 14
  15. 15. Constructive Criticism• Business model: Too slow to react• Assumptions, methodologies & models• Conflict of interest (‘issuer-pays’ model)• Limited capture• Split ratings• Notching of competitor’s ratings• Implied ratings & internal competition• “Getting it wrong”, “Fat fingers”• etc. 15
  16. 16. Failures of CRAs AIG, Bear Stearns, Bradford & Bingley, Enron, Icelandic banks, Lehman Bros., Monolines, Northern Rock, Parmalat, Sovereigns (Eurozone), Sub-prime bonds etc.In their own words...Fitch: “… did not foresee the magnitude of the decline…or the dramatic shift in borrower behavior…”Moody’s: “…We did not . . . anticipate the magnitude and speed of the deterioration in mortgage quality or the suddenness of the transition to restrictive lending...”S&P: “…It is now clear that a number of assumptions used in preparing ratings on mortgage-backed securities issued between 2005 and mid-2007 did not work…”Source: US Government Oversight and Reform Committee, Oct 2008 16
  17. 17. Sensible use of CRAs’ analysis• Fully understand the instrument you are investing in – particularly when using other peoples’ monies• Understand ratings’ limitations and know how to mitigate rating-related risks (previous slide)• ‘Ignore’ ratings designators (i.e. AAA etc.) and focus on CRAs’ analytical narrative instead• Look out for what is NOT there in the narrative but should e.g. Why are obvious issues missing in the analysis? Why has this bond not been rated by all three CRAs?• Apply common sense and trust your gut feeling 17
  18. 18. Lesson 6:Captured Risks 18
  19. 19. Models, Assumptions & Black Boxes• Extensive use of financial models to do “analysis”• Fairly simple to highly complex quantitative models• A “model” is ALWAYS only a “model”!• Models CANNOT simulate reality!• Model failures exacerbated by using inadequate assumptions, i.e. through the cycle – 10-12 years only• Historic data points as input into model: limited data?• Black box: locked-down back-end with no access for users, i.e. not easy and often impossible to reconcile 19
  20. 20. Lesson 7:Proprietaryanalysis 20
  21. 21. Proprietary analysis & Risk management• Often overlooked: Good old-fashioned analysis• Done by dedicated teams of credit analysts• Analysis, loads of analysis• Gut feeling & Common sense (which is not so common)• Lack of qualified risk management practices• Firm’s strategy  Risk appetite  Risk policy  Investment guidelines etc.• Robust risk management function needs to be empowered by the firm to say “NO!” sometimes 21
  22. 22. Lesson 8:Senior managementawareness 22
  23. 23. Senior management awareness• Management reporting – or lack of it• Limited systems capabilities• Filtering of reports through distribution channels up the chain• Does the information at board level paint a full picture?• Senior mgmt. ignorance or misinterpretation of data• Senior mgmt. does not understand 23
  24. 24. Lesson 9:Lack of Drill-down +Group-wide Controls 24
  25. 25. Lack of drill-down capability & Group-wide controls • US subprime replaced with investments in CDO of ABS • Minor issue becomes major disaster • “Repackaged” garbage is still garbage! • One desk sells and the other buys, largely ignoring firm- wide strategy 25
  26. 26. Lesson 10:Mark-to-Market,Market-to-model+ Illiquidity 26
  27. 27. Mark-to-market, Mark-to-model & Illiquidity“Normal times”: Mark-to-market• Electronic trading matching bid/offers or• Collection of broker quotes by phone“Periods of limited market stress”: Mark-to-model• If there is no “normal” market  market-to-model• Based on pricing models which are based on “normal” markets“Periods of prolonged illiquidity”:• Difficult to price if there is no market at all! Force sale? 27
  28. 28. 2) Sound practice principlesDATAPrinciple 1: Access: Open sourcePrinciple 2: Information asymmetriesPrinciple 3: Data formatsPrinciple 4: Data deliveryPrinciple 5: On deal levelPrinciple 6: For the market at largePrinciple 7: Industry data portalsDEFINITIONSPrinciple 8: SimplificationsPrinciple 9: TransparencyPrinciple 10: Standardisation 28
  29. 29. STANDARDS Principle 11: Underwriting standards Principle 12: Reporting standards Principle 13: Representations & warrantiesINVESTOR FOCUSEDPrinciple 14: Government facilitiesPrinciple 15: Private investorsPrinciple 16: Incentive alignmentsMOTIVATION & DEAL DRIVERSPrinciple 17: ArbitragePrinciple 18: Rating shoppingPrinciple 19: Risk transfer & “Skin in the game” 29
  30. 30. ANALYSIS Principle 20: Reduced over-reliance on credit ratings Principle 21: Increased proprietary analysis Principle 22: Models, assumptions and common sense Principle 23: Risk management & Risk mitigationReferences & Appendix“Securitization & Structure Finance post Credit Crunch – A Best Practice Deal Lifecycle Guide”, M. Krebsz (Wiley 2011)Please see Part I of the book attached for your kind reference: 30