MBA Panel on the crisis, Montreal November 2008

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This presentation was made as part of a panel discussion organized for the McGIll MBA programme in November 2008

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MBA Panel on the crisis, Montreal November 2008

  1. 1. Structured Finance and the recent turmoil J. Ericsson
  2. 2. Primer on Structured Credit   Credit default swaps.   Collateralized debt obligations. © Leaders Name Course Number
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  5. 5. Intuition   Buying a corporate bond and insuring the default risk (CDS) is the same as buying a government bond to start with.   Buying a treasury and selling insurance (CDS) is equivalent to buying a corporate bond synthetically.   AIG was a big seller of various forms of default insurance.   Lehman was an important counterparty to CDS contracts (300 vs. 6 $B) 5 © Leaders Name Course Number
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  7. 7. Basic CDO structure Individual CDS ... are pooled ... ... and tranched Contracts / credits 7 © Leaders Name Course Number
  8. 8. – who were the CDO tranche buyers? – how does one sell an equity tranche to a pension fund? – problems – leverage and transparency combined with a brand new market barely understood by many participants. © Leaders Name Course Number
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  10. 10. A not very virtuous loop of –  low rates > –  increasing RE prices > –  new categories of homebuyers accepting harsher terms > –  Institutions securitizing lower quality loans and creating “safer” securities (and some riskier equity tranches) > –  Buy side financial institutions funding investments in these securities by borrowing short term at lower yields (cf riding the yield curve). © Leaders Name Course Number
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  17. 17. FED REACTION – liquidity vs solvency   crisis mainly viewed as a market liquidity problem between late summer 2007 and 2008   central bank significantly extended its balance sheet to address the liquidity problem and the seizure of money markets.   This led to perverse incentives -- “problem collateral” found its way to central banks. © Leaders Name Course Number
  18. 18. •  Take over of Fannie and Freddie and the collapse of Lehman Brothers, and the near failure of others have demonstrated that the problem is one of solvency as well as illiquidity. © Leaders Name Course Number
  19. 19. – Now that the crisis is viewed more as a solvency problem , FED is approaching the problem by seeking to “nationalize” problem assets and hold them until the housing prices stabilize. – This raises questions about incentives: a) recapitalization requirements, b) equity stake for tax payers etc... © Leaders Name Course Number
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