Chapter 5
Current Multinational
Financial Challenges:
The Credit Crisis
of 2007-2009
The Goals of Chapter 5
• Introduce the notions of subprime debt and
securitization
• Introduce the crisis of 2007 and 2008: subprime
crisis, financial tsunami, and credit crisis
• Discuss several issues associated with the crisis
–
–
–
–
–
Market-to-market accounting rule
LIBOR
Collateralized Debt Obligations (CDOs)
Credit Default Swaps (CDSs)
Structured Investment Vehicles (SIVs)
• Lessons learned from the crisis
5-2
Subprime Debt and
Securitization
5-3
The Seeds of Crisis: Subprime Debt
• From 1995 to 2001, the Nasdaq index increased by a
factor of more than 6, which is called the dot-com boom
• After the collapse of the dot-com bubble in 2000 and
2001, capital tried to find a safer target and began to
flow toward the real estate sectors in the United States
• Some economists argued that much of the wealth
accumulated from the equity markets during that period
was now used to push the demand and prices of real
estate upward
• The U.S. banking sector found mortgage lending highly
profitable and saw it as a rapidly expanding market
– The mortgage lending business boomed due to the high
demand
– The bright prospect of the housing price enhanced the value of
collaterals for the mortgage
5-4
The Seeds of Crisis: Subprime Debt
• In 1999, the U.S. Congress pass the Gramm-LeachBliley Financial Services Modernization Act, which
repealed the Glass-Steagall Act of 1933 and
eliminated the barriers between commercial and
investment banks
• With the increase of the competition in the mortgage
lending business, a growing number of the borrowers
were with lower credit quality
• These borrowers who previously should be
unqualified to borrow mortgages, and their associated
mortgage agreements (subprime debt), carried higher
debt obligations with lower income
– In traditional financial management terms, the debt-service
coverage ratio, defined as the ratio of income available for
servicing interest and principal payments of the debt, was
increasingly inadequate
5-5
The Seeds of Crisis: Subprime Debt
• The competitiveness created various mortgage forms
to attract borrowers, e.g.,
1. Initially, borrowers pay floating rates, often priced at
LIBOR, plus a small interest rate spread, and the loans
would reset at much higher fixed rates within two to five
years
2. Borrowers pay interest only in early years with a initial
interest rates far below market rates, and have substantial
step-ups in payments after the initial period of interestonly payments
5-6
The Seeds of Crisis: Subprime Debt
• Mortgage loans in the U.S. marketplace are normally
categorized (in increasing order of riskiness) as:
– Prime (or A-paper)
• A-prime mortgages are conforming or conventional loans,
meaning it would meet the guarantee requirement and can be
resale to government-sponsored institutions, e.g., Fannie Mae
(Federal National Mortgage Association) or Freddie Mac
(Federal Home Loan Mortgage Corporation)
– Alt-A (Alternative A-paper)
• The Alt-A loans are still with low risk, but for some reasons are
not initially conforming, like borrowers with less than full
documentation, higher loan-to-value (LTV) ratio, and more
investment properties
– Subprime
• In principle, it reflects borrowers who do not meet underwriting
criteria and have a higher perceived risk of default, normally as
a result of some credit history, e.g., bankruptcy, loan
delinquency, default, etc.
5-7
The Seeds of Crisis: Subprime Debt
• Sub-prime mortgages are nearly exclusively floating-rate
structures, and carry significantly higher interest rate spreads
over the floating bases such as LIBOR
• Sub-prime borrowers typically pay a 2% premium over the rate
for the prime debt–the subprime differential, which depends on
several factors, including the borrower’s credit score, the
payment-income ratio, the mortgage loan-to-value (LTV) ratio
• However, the low interest rate policy adopted by the U.S.
Federal Reserve to aid the U.S. economy in its recovery from the
2000-2001 recession lower the overall interest rate paid by the
subprime borrowers as well
• Lower interest rates stimulate the growing demand for loans or
mortgages from subprime borrowers, and subprime loans
became a growing segment of the market during 2003-2005
• In fact, subprime mortgages had never exceeded 7% to 8% of all
outstanding mortgage obligations by 2007, but by the end of
2008, they were the source of more than 65% of bankruptcy
filings by homeowners in the U.S.
5-8
Asset Values
• One of the key financial elements of this growing
mortgages was the value of the assets collateralizing
the mortgages–the houses and real estate itself
• As the market demands pushed up prices, housing
assets rose rapidly in market value since 2000
• The increased values were then used as collateral in refinancings or second mortgages
– Many mortgage holders became more indebted and
participated in more aggressively constructed loan agreements
• Mortgage brokers or banks, driven by additional fee income,
pushed for continued refinancing or second mortgages
– Consequently, mortgage debt as a percentage of household
disposable income continued to climb in the U.S. in the post2000 business environment (from 80% in 1990 to 100% in
2000 and 140% in 2007)
5-9
Asset Values and Interest Rates
• The combination of the effect of decreasing asset values
and the increasing interest rates
Housing boom reversed
and finally burst after
2007, but the interest
rate continued to rise
※ The data of housing price index is from Federal Housing Finance Agency
※ The data of U.S. 3-mon Treasury yield is from the Department of the Treasury in the
U.S.
5-10
Asset Values and Interest Rates
• After U.S. house prices peaked in mid-2006 and began
their steep decline thereafter, refinancing became more
difficult
• As adjustable-rate mortgages began to reset at higher
rates in the meanwhile, mortgage delinquencies soared
• Consequently, securities backed with subprime
mortgages, widely held by financial firms, lost most of
their value
• The result has been a large decline in the capital of many
banks and U.S. government sponsored enterprises
5-11
The Transmission Mechanism:
Securitization
• The transport vehicle for the growing lower quality
debt to spread worldwide was a combination of
securitization and re-packaging provided by a series of
new financial derivatives
• Securitization: pooling loans and issuing standardized
securities backed by those loans
– This process is able to turn illiquid loan assets into a liquid
saleable asset
• The loan sale market is illiquid due to the possible adverse
selection or the moral hazard
– Adverse selection: the customer who has a higher demand for
borrowing is with a higher probability to default
– Moral hazard: if a bank knows that a loan will be sold in the future,
the motive to evaluate the credit rating of the customer carefully is
weakened
5-12
The Transmission Mechanism:
Securitization
– Meanwhile, the credit risk of borrowers also transferred to
holders of securitization securities
– In the securitization process, the originating bank changes its
role from a risk taker to a service provider
– Securitized assets took two major forms, mortgage-backed
securities and asset-backed securities
– Asset-backed securities included second mortgages and
home-equity loans based on mortgages, in addition to credit
card receivables, auto loans, and a variety of others
5-13
The Transmission Mechanism:
Securitization
• By selling securitized securities to investing public or
other financial institutions, the originating institutions
can free up more capitals for conducting more lending
business
• Thus, more subprime mortgages and loans to be
written, which is essentially not a bad thing because it
provides lower-cost financing for home buyers and
makes home ownership more affordable
• Consequently, more low quality debt in the U.S. are
spread all over the world via the securitization
process, i.e., not only financial institutions in the U.S.
but also financial institutions worldwide suffer serious
losses as long as they possessed any kinds of
mortgage-back securities
5-14
The Transmission Mechanism:
Securitization
• In addition, for the pass-through mortgage-backed
securities which is the most common MBS in the
market, if the originating bank does not hold any
share of MBS, its incentive to continuously monitor
borrower behavior over the life of the debt is
weakened
– Thus, the securitization process may degrade credit quality
of MBSs comparing with the original mortgage loans
– This moral hazard problem is viewed as another reason for
the subprime crisis
5-15
The crisis of 2007 and
2008
5-16
The Crisis of 2007 and 2008
• The housing market began to falter in late 2005, with
increasing collapse throughout 2006, and the housing
boom bubble finally burst in 2007
• Starting with the fail of two major hedge funds at Bear
Stearns and the rescue of Northern Rock, the global
financial markets slid toward near panic
– The Bear Stearns Companies, Inc., based in New York City,
was a global investment bank and securities trading and
brokerage and lost its two major hedge funds in July 2007
– Northern Rock Bank moved into sub-prime lending via a deal
with Lehman Brothers in 2006
• On 14 September 2007, Northern Rock Bank sought and
received a liquidity support facility from the Bank of England,
following problems in the credit markets caused by the U.S.
subprime mortgage financial crisis
– Both cases held a variety of collateralized debt obligations
(CDOs) and other mortgage-based assets
5-17
The Crisis of 2007 and 2008
• In 2008, with oil prices peaking in July, and the
substantial increase of every other commodity prices,
the subprime debt problem became more serious
• In March 2008, Bear Stearns failed, and the Fed
arranged the sale of Bear Stearns to JPMorgan Chase
with the agreement to cover the lose of $29 billion
• On August 10, 2008, the Fed purchased record-high
$38 billion mortgage-backed securities to inject
liquidity into the market
• In September 2008, the U.S. government announced it
was placing Fannie Mae and Freddie Mac into
conservatorship
– In essence, the government was taking over these
institutions as result of their near insolvency
5-18
The Crisis of 2007 and 2008
• Over the following week, Lehman Brothers, one of the
oldest investment banks eventually filing for the
largest single bankruptcy in American history on
September 14
– Lehman Brothers was founded in 1850 by a pair of
enterprising brothers
– After moving the firm to NY following the American Civil
War, the firm had long been considered one of the highest
return, highest risk small investment banking firms on the
Wall Street
– Why did the U.S. government let it fail?
• Although the “too big to fail” doctrine has long been a mainstay
of the U.S. financial system, this doctrine, however, had largely
been confined to commercial banks rather than investment
banks which intentionally bear risk in exchange for profit
5-19
The Crisis of 2007 and 2008
• The rescue loan from the Fed is limited by the amount of
asset collateral specific institutions, but it is not enough to
save Lehman
– Due to the extensive holdings of mortgage-backed
securities and dominant role to issue commercial papers,
allowing Lehman to fail is to send shock waves worldwide
through most common instruments in the banking system,
and turn a financial tremor into a tsunami
• On the next day, equity markets plummeted and the
LIBOR rates of Eurodollars shot skywards as a result
of the growing international perception of financial
collapse of U.S. banking institutions
5-20
The Crisis of 2007 and 2008
• On the following day, American International Group
(AIG), who had extensive credit default swap (CDS)
exposure, received an $85billion injection from the
U.S. Federal Reserve in exchange for its 80% equity
• The problems of Lehman and AIG caused many
banks to question credit quality of other banks in not
only U.S. but also international financial markets
• Traditional commercial bank lending were squeezed
out by the huge losses from the investment in
mortgage-related instruments
– E.g., working capital financing, automobile loans, student
loans, and credit card debt are influenced
– This problem deteriorated for small firms, which heavily
depend on short-term debt for working capital financing
5-21
The Crisis of 2007 and 2008
• All corporate borrowers were confronted by banks
reducing their access to credit
– Companies that did not have preexisting lines of credit could
not access funds at any price
– Companies with preexisting lines of credit were receiving
notification that their lines were being reduced
• The commercial paper (CP) market nearly ceased
– Due to the default of Lehman, which was one of the largest
CP issuers in the world, the market no longer trusted the
credit quality of any counterparty
– The Fed quickly announced that it would buy billions in CP
issuances in order to add liquidity into the market
• The subprime crisis finally became the worldwide
credit crisis, during which the world’s credit markets–
lending of all kinds–nearly stopped
5-22
Global Contagion
• The rapid collapse of the mortgage-backed securities
markets in the United States spread to the global
marketplace
• Equity markets fell worldwide from the summer of
2008 until the spring of 2009 (see Exhibit 5.11 for
severe global contagion)
• Capital invested in equity and debt instruments in all
major financial markets fled not only for cash, but for
cash in traditional safe-haven countries and markets
• Currencies of the more financially open emerging
markets felt a significant impact, e.g., Icelandic krona,
South Korean won, Mexican peso, Brazilian real, etc.
5-23
Exhibit 5.11 Selected Stock Markets
during the Crisis
5-24
Three Stages of the Credit Crisis
• Three stages of the credit crisis are summarized:
1. The failure of specific mortgage-backed securities started in
the summer of 2007 (causing the fall of values of specific
funds and instruments)
2. The crisis spread to the very foundations of the organizations
at the core of the global financial system, the commercial and
investment banks on all continents
※The financial tsunami from the U.S. causes the global credit
crisis
3. A credit-induced global recession happened
• Not only had lending stopped, but also in many cases, borrowing
and investing had ceased
• This is because prospects for investment returns of all types were
dim; corporations failed to see returns on investments
• As a result, there was widespread retrenchment among
industrialized nations as corporations cut budgets and headcount
※In order to stimulate the economy, all countries adopted the
expansionary monetary policy and lowered the interest rate
5-25
Several Issues Associated
with the Crisis
5-26
Several Issues associated with the
Crisis
• Some issues and financial products associated with
the crisis will be discussed
–
–
–
–
–
Market-to-market accounting rule
LIBOR
Collateralized Debt Obligations (CDOs)
Credit Default Swaps (CDSs)
Structured Investment Vehicles (SIVs)
5-27
Mark-to-Market Accounting
• One of the continuing debates about the global credit
crisis is whether the use of mark-to-market
accounting contributed significantly to the failure of
financial institutions
• Market-to-market rule is a long-term accounting
practice to require that financial institutions re-value
all financial assets and derivatives daily, even though
there is no intention to liquidate the asset at that time
• If there is not really a market value, the revaluation
must follow a theoretical process to calculate the asset
value, which is called mark-to-model method
5-28
Mark-to-Market Accounting
• The problem in normal periods is that many
instruments do not trade in markets, or trade only in
very thin markets, so establishing a fair value can be a
very difficult task
• In panic-induced free fall of the crisis, the asset values
are extremely low and may result in significant
reduction in the organization’s equity
• It thus causes insolvency results in accounting sense
although the organization had no intention of
liquidating the asset at that time
5-29
LIBOR’s role
• The global financial markets have always depended upon
banks’ services for their core business activity
• The banks in turn have depended on the interbank
borrowing and lending market for liquidity which had
historically operated on a “no-names” basis
– “No-names” basis meant that for the banks at the highest level
of international credit quality, interbank transactions could be
conducted without discriminating by name
• In the summer of 2007, however, much of this changed,
increasing focus on each individual institution and its
particular credit risk profile
– This is because even for traditionally highly-rated banks, they
may suffered a lot of losses in the subprime crisis and be near to
bankrupt
5-30
LIBOR’s Role
• The British Bankers Association (BBA), the
organization charged with the daily tabulation and
publication of LIBOR Rates for 15 different maturities
and 10 different currencies, became worried about the
validity of its own published rate
– Due to the cases of Lehman and AIG, many banks doubted
the credit worthiness of other banks in the interbank market
– It caused the U.S. LIBOR rate skyrocket and extremely
volatile in September and October of 2008 (see Exhibit 5.10)
– A skeptical attitude was about the quotations of BBA, even
these LIBOR rates are based on the quotes from 16 major
banks
• These banks did not dictate the rate they quoted to conduct the
lending business between themselves or to non-bank borrowers
5-31
LIBOR’s Role
• The real borrowing rates and borrowing amount in the interbank
market depended on the risk profile of each individual borrower
※ In fact, instead of asking the quoted rate only, the BBA already
changed the survey wording–“at what rate could the bank
borrow a reasonable amount?”
– As the crisis deepened, many corporate borrowers began to
publicly argue the LIBOR rates published were in fact
underestimating their problems
• Because many loan agreements have “market disruption clauses”
that allow banks to actually charge corporate borrowers their
“real cost of fund,” not just the published LIBOR
• In its role as the basis for all floating rate debt
instruments of all kinds, the LIBOR rate has the
potential to cause significant disruptions due to its
skyrocketed and volatile behavior and inability to
reflect the true cost of fund
5-32
Exhibit 5.10 USD & JPY LIBOR Rates
(September–October 2008)
※ Comparing to the JPY LIBOR, the USD LIBOR was extremely volatile in the
period of Sep.–Oct. 2008
※ Wachovia, one of the largest providers of financial services in the U.S., provides a
broad range of banking, asset management, wealth management, and corporate and
investment banking services
※ On October 3, 2008, Wachovia agreed to be bought by Wells Fargo for about $14.8
billion in an all stock transaction
5-33
LIBOR’s Role
• The larger, more creditworthy companies did not have
to borrow exclusively from banks, but may issue debt
directly to the market in the form of commercial paper
– However, the CP market also quickly fell as many traditional
buyers of CP–commercial banks, hedge funds, private equity
funds, and even the SIVs discussed later–lost their
confidence in the future condition of the economy and the
creditworthiness of issuers of CPs
– As the lending business of commercial banks froze, the
LIBOR skyrocketed, and the CP market locked-up, the
corporate borrowers almost lost all possibilities to access the
short-term debt
– The lending crisis is illustrated in Exhibit 5.12
5-34
Exhibit 5.12 LIBOR and the Crisis
in Lending
5-35
LIBOR’s Elements
• During the credit crunch of 2007 and 2008, the Bank
for International Settlements (BIS) in Basle,
Switzerland, had published a study of the LIBOR
market’s behavior of late
• The study described the risk premium added to
interbank quotes as:
Risk Premium = Term Premium + Credit Premium + Bank
Liquidity Premium + Market Liquidity
Premium + Micro Premium
– In this study, the interbank quotes are the LIBOR overnight
interest rates
– The term premium is a charge for longer maturities
– The credit premium is a charge for the perceived risk of
default by the borrowing bank
5-36
LIBOR’s Elements
– Bank liquidity premium is the access of the individual
lending bank to immediate funds
– The market liquidity premium is a measure of general
market liquidity
– A micro premium is a charge representative of the market
micro-structure of how banks conduct interbank lending
• The microstructure research is about how market structures
or rules affect trading costs, e.g., assets are traded through
dealers who keep an inventory, while other markets are
dominated by brokers who act as intermediaries
• The BIS concluded that for the U.S., the Euro, and
the U.K., although there seemed to be some
evidence of a small increase of the credit premium,
most of the total risk premium was explained by
bank and market liquidity
5-37
Collateralized Debt Obligations
• Banks originating mortgage or corporate loans could
create a portfolio of these debt instruments and
repackage them as asset-backed securities
• One of the key instruments in the growing market of
securitized products was the collateralized debt
obligation (CDO) (see Exhibit 5.6)
• During the securitization process, the bank passed this
portfolio to a special purpose vehicle (SPV) (also
known as special purpose entity (SPE))
– SPVs own this portfolio of debt instruments on behalf of the
holders of CDOs and serve as the legal entity to issue CDOs
– SPVs are typically used to isolate the transactions from the
financial risk of the originating bank
– Since SPVs are individually legal entities, different accounting
or tax rules from that for the originating bank is applied
5-38
Exhibit 5.6 Global CDO Issuance, 2004–2008
(billions of U.S. dollars)
[Insert Exhibit 5.6]
※ From 2004 to the second quarter of 2007, the amount of CDO issuance grew nine
times, which is equivalent to 110% growth rate for each year
5-39
Collateralized Debt Obligations
• Similar to all other securitized securities, the CDO
was sold into the market through underwriters and
freed up the bank’s financial resources to originate
more and more loans, earning a variety of fees
• The collateral for the CDO is the real estate,
equipment, or property that the loan was used to
purchase
• The overall picture of the CDO arrangement is
illustrated in Exhibit 5.5
5-40
Exhibit 5.5 The Collateralized Debt
Obligation
※ In addition to mortgage loans, corporate loans, and corporate bonds, the underlying
assets of the CDO could be other asset-backed securities and mortgage-backed
securities
※ In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were
backed by corporate loans, and only less than 10% of CDOs were backed by fixed
5-41
income securities
Collateralized Debt Obligations
• CDOs were sold to the market in categories
representing different credit quality: senior tranche
(rated AAA), mezzanine or middle tranches (AA
down to BB), and equity tranche (usually unrated)
– For the default and failure events in the portfolio, the equity
tranche absorbs the principal loss first
– After the principal of the equity tranche is used up, the losses
from default events begin to undermine the principal of the
mezzanine tranches (in decreasing order of riskiness)
– The above rules gives the senior tranche most protection, so
the senior tranche is with the lowest interest yield
– In fact, the distribution of cash for different tranches follows
the waterfall method, i.e., cash would fill from the top-down,
from the senior tranche to the equity tranche (see the figure
on the next slide)
5-42
Illustration of a CDO Construction
※ Waterfall rule: Only once the senior class has been paid what its due, the junior
class gets paid, i.e., for both interest income and principal repayment, tranche AAA
gets first, then does the tranche A, tranche BBB, and finally equity tranche
※ If the principal losses in the events of default represents 13% of the total amount,
the equity tranche loses all its principal, tranche BBB loses 30% (=3%/10%) of its
principal, and tranches A and AAA do not lose any principal
5-43
Collateralized Debt Obligations
• The introduction of the equity tranche is to provide
credit enhancement for other tranches
• Similarly, the mezzanine tranches A and BBB are the
subordinated debt to tranche AAA, providing further
protection for the senior tranche AAA
• CDOs would be rated by rating agencies, who often
complete the analysis quickly based on the
information provided by the underwriter, rather than
undertake the typical ground-up credit analysis
themselves
– The false estimations of the credit risk of CDOs are also
one of the reasons for the subprime crisis
5-44
Collateralized Debt Obligations
• The determinant factors for the value of the CDO
– The performance of the debt it holds, i.e., the ongoing
payments being made by the original borrowers on their
individual mortgages
– The second driver, uncovered until the crisis occurred, was the
willingness of the many institutions and traders of CDOs to
continue to make a market for this kind derivative, i.e., the
liquidity of the market
• In the crisis of 2007-2008, the market prices of CDOs are far
lower than their theoretical prices due to the lack of the liquidity
• Other COD instruments
– Synthetic CDOs: structures in which the CDO itself does not
actually hold debt, but is constructed purely of derivative
contracts combined to “mimic” the cash flow of other debt
instruments (like CDSs introduced later)
5-45
Collateralized Debt Obligations
– CDO-squared: a CDO that holds shares from other CDOs,
which is created by Merrill Lynch in October 2006
• For example, a bank can collect some mezzanine tranches
from different CDOs and use the same skill to arrange the
sequence for different tranches to absorb the losses for the
events of default, so CDO-squared still can generate another
AAA tranche
• The CDO-squared instruments not only holds lower and lower
quality loans and bonds, but also they are typically highly
subordinated CDOs to the original instruments that they
supported
• The experience from the crisis tells us the AAA tranche
generated in this way cannot provide secure cash flows that
should offer by a AAA debt instrument
5-46
Credit Default Swaps
• The credit default swap (CDS) is a derivative
instrument, which derives its value from the credit
quality and performance of any specified asset
• Invented by JPMorgan in 1997, the CDS was designed
to shift the risk of default from protection buyer to
protection seller (see Exhibit 5-7)
– For protection buyer, CDS provides insurance against the
possibility that a borrower might not pay
– For protection seller, CDS makes the bet without ever holding
or being directly exposed to the credit instrument itself
• According to The Economist, the participants in the
CDS market in 2007 were widespread across a variety
of financial institutions: 44% banks, 32% hedge funds,
17% insurance companies, 4% pension funds, and 3%
other investors
5-47
Exhibit 5.7 Cash Flows under a Credit
Default Swap
5-48
Credit Default Swaps
• Concerns for CDSs
– Participants in the market, protection buyers and protection
sellers, do not need to have any actual credit exposure
• Participants simply have to have a viewpoint
• As a result, the CDS market, estimated at about $60 trillion at
its peak in 2007, grew rapidly since 2000 and reached a size
many times the size of the underlying credit instrument it was
created to protect (see Exhibit 5.8)
– CDSs actually allow banks to disconnect their links to their
borrowers, reducing incentives to screen and monitor the
ability of borrowers to repay–a moral hazard
– There is no real record or registry of issuances for CDSs
– No requirements on buyers and sellers that they had
adequate capital to assure contractual fulfillment
– Since CDSs depend on one-to-one counterparty settlement,
there is no real market for assuring liquidity
5-49
Exhibit 5.8 Credit Default Swap Market
Growth
5-50
Credit Default Swaps
• Possible reforms
– New proposals for regulation have centered first on
requiring participants (protection buyers) to have an actual
exposure to a credit instrument or obligation, eliminating
outside speculators
– Establish a clearinghouse to provide systematic trading and
valuation of all CDS positions at all times
5-51
Structured Investment Vehicles
• The structured investment vehicle (SIV) was the
ultimate financial intermediary device first created by
Citigroup in 1988: it borrowed short and invested long
• The funding of the SIV: using minimal equity from the
sponsoring bank and issuing its commercial papers,
which are short-term lower-cost funding sources
– Sponsoring banks provided backup lines of credit to assure
the highest credit ratings for CP issuances
– SIVs used their proceeds to purchase portfolios of higher
yielding securities with investment grade credit ratings, e.g.,
mortgage-backed securities, collateralized debt obligations,
etc.
– A SIV may be thought of as a virtual bank. Instead of
gathering deposits from public, it borrows money by selling
short maturity CPs in the money market
5-52
Structured Investment Vehicles
• SIVs, acting as a middleman in the shadow banking
process, can earn the interest spread, roughly 0.25% on
average
– The shadow banking system consists of non-bank financial
institutions that play a critical role in lending businesses
– By definition, shadow institutions do not accept deposits like
a bank and therefore are not subject to the same regulations
for banks
• As the housing boom collapsed in 2006 and 2007 
subprime loans failed  asset values of SIV fell 
SIV-based CP cannot be marketed  Sponsoring
banks are forced to fund their own SIVs or reaborbed
these SIVs
• As of October 2008, no SIVs remain
5-53
Exhibit 5.4 Structured Investment
Vehicles (SIVs)
5-54
Structured Investment Vehicles
• SIV vs. Special Purpose Vehicle (SPV)
– SIV is an evergreen structure and planned to stay in business
indefinitely, whereas SPV is designed for one-time transaction
– The funding of SIV is primarily from issuing CPs, but the
funding of SPV could be arranged in different ways, e.g.,
issuing pass-through equities or long-term bonds
– The assets of SIVs are exclusively securitized instruments, but
SPVs could own a portfolio of loans or other assets physically
– SIV is designed to earn spread, but SPV is designed to hold
assets on behalf of investors of asset-backed securities
– The credit worthiness of SIVs are supported by the originating
bank, but the credit worthiness of SPV fully depends on the
quality of the assets it owns and its capital structure
• Many SPVs are set up as “orphan” companies by depositing
assets and shares in a trust and hiring an administration company
to provide professional management to ensure that there is no
connection with the originating financial institution
5-55
Lessons Learned From
the Crisis
5-56
Lessons Learned From the Crisis
• So how about the financial markets worldwide now?
• Dismissing the absolute extremes, on one end that
capitalism has failed, and on the other end that
extreme regulation is the only solution, what practical
solutions fall in between?
• The following six parts associated with the financial
markets are discussed, including debt, securitization,
derivatives, deregulation, capital mobility, and illiquid
markets
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Lessons Learned From the Crisis
• Debt
– Was the mortgage boom the problem?
• The market boom was caused as a result of the combination of
few competing investment targets with the low cost and great
availability of capital
– One concern is the originate-to-distribute behavior weakening
the incentive of the originating banks to monitor the borrower
behavior over the life of the debt
• Two scenarios to avoid this moral hazard problem:
– For the pass-through MBS, if the originating bank holds a large
amount of MBS shares, it is inclined to monitor the borrowers
constantly for its own interest
– For CDOs or other complex MBSs, if the originating bank
purchases the equity or residual tranche, this arrangement gives
the originating bank strong incentive to do its best to collect any
repayment
– Another concern is questionable credit assessments and
classifications reported by rating agencies
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Lessons Learned From the Crisis
• Securitization
– Was the financial technique of combining assets into packaged
portfolios for trading the problem?
• Portfolio theory states that constructing portfolio with assets with
uncorrelated movements can reduce risk due to the benefit of
diversification
• In the case of mortgage-backed securities, however, the portfolio
components were so similar that they fall into delinquency
simultaneously, that violates the premise of the portfolio theory
– A dilemma
• Using homogeneous assets to form portfolios can purify and
enhance the accuracy of the prediction of the repaying behavior,
and these portfolios would not be too complex to be understood
by investing public and to be governed by authorities
• However, the portfolios of homogeneous assets cannot enjoy the
benefit of diversification and thus with higher risks
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Lessons Learned From the Crisis
• Derivatives
– This is not the first time that derivatives have been
viewed as the source for substantial market failures
– However, derivatives are the core of financial technology
innovation
– The creation of complex mortgage-backed assets and
derivative structures which ultimately made the securities
nearly impossible to value, particularly in thin markets,
was in hind-sight a very poor choice
– Renewed regulatory requirements and increased
transparency in pricing and valuation will aid in pulling
derivatives back from the brink
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Lessons Learned From the Crisis
• Deregulation
– Deregulation itself is important for the financial innovations
– However, they are many today who argue that financial
markets indeed need to be regulated, but the degree and
type is unclear
– For example, regulations for CDSs seems not enough and
complete
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Lessons Learned From the Crisis
• Capital Mobility
– Degree of capital mobility today is higher than ever before
– The increased capital mobility, combined with the growth
and openness of many economies around the globe,
especially some emerging markets, will produce more and
more cases of financial-induced crisis
– The dilemma between remaining openness and integrating
with the global financial market or imposing capital control
to retain monetary independence still confuse many
countries, especially those more financially open emerging
markets
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Lessons Learned From the Crisis
• Illiquid Markets
– This final issue will be the most troublesome
– Most of the mathematics and rational behavior behind the
design of today’s sophisticated financial products,
derivatives, and investment vehicles are based on
principles of orderly and liquid markets
– When the liquidity problem of trading highly
commoditized securities or overnight bank loans between
banks becomes the core source of instability in the system,
then all traditional knowledge and assumptions of finance
have indeed gone out the window
– Since the liquidity problem is usually associated with the
confidence of human beings, there still lacks a feasible
solution for this problem
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