Book 1. Foundations of Risk Management

FRM Part 1

FRM 10. Anatomy of the Great Financial Crisis of 2007–2009

Presented by: Sudhanshu

Module 1. The Global Financial Crisis

Module 1. The Global Financial Crisis

Topic 1. Financial Crisis Overview

Topic 2. Role of Subprime Mortgages

Topic 3. Role of Collateralized Debt Obligations (CDOs)

Topic 4. Role of Banks and Financial INtermediaries

Topic 5. Role of Mortgage Brokers and Lenders

Topic 6. Role of Rating Agencies

Topic 7. Trends in Short-Term Wholesale Funding Markets

Topic 8. Impact on Systemic Risk

Topic 9. Central Bank Intervention

Topic 1. Financial Crisis Overview

  • Historical Background

    • Timeline: 2007-2009 Global Financial Crisis

    • Scope: Started as U.S. subprime crisis, quickly spread globally

    • Unprecedented Scale: Unlike previous U.S. crises, this affected multiple asset classes and geographical locations

  • Key Contributing Factors​

    1. ​​Low Interest Rate Environment

      • Interest rates kept at historically low levels in the U.S.

      • Cheap cost of money facilitated easy borrowing
      • Fueled rapid and unsustainable increase in house prices

    2. Financial Innovation and Securitization

      • Introduction of mortgage securitization

      • Mortgages could be easily originated, repackaged, and sold to investors
      • Reduced credit risk for originators
      • Led to relaxed lending standards

    3. Easy Access to Credit​

      • Widespread availability of credit

      • Encouraged real estate speculation

      • Created asset price bubbles

Topic 2. Role of Subprime Mortgages

  • Definition: Loans secured by residential property made to borrowers with poor credit

  • Borrower Characteristics

    • History of delinquent payments

    • Large loan-to-value ratios (low up-front deposits)

    • Large loan-to-income ratios

  • Structure: 30-year adjustable-rate mortgage

    • Initial Period: 2-year low fixed "teaser" rate

    • Adjustment: Much higher variable rate for remaining 28 years

  • Dangerous Loan Features

    • 100% Loan-to-Value: No up-front payment required, no equity cushion

    • Interest-Only Loans: No principal reduction during mortgage life

    • NINJA Loans: No Income, No Job, No Assets verification

    • Liar Loans: Little evidence collected to confirm employment/income

    • Topical Subprime Loan Structure: 2-28 ARM

Topic 3. Role of Collateralized Debt Obligations (CDOs)

  • Structure and Process

    • ​Pooling: Multiple mortgages bundled together

    • Tranching: Pool sliced into senior, junior, and equity tranches
    • Waterfall Structure: Senior tranches receive cash flows first, absorb losses last
    • Rating: Senior tranches received AAA ratings despite underlying poor-quality mortgages

  • CDO-Squared

    • Junior tranches from multiple CDOs bundled together
    • Created even more complex and opaque structures
    • Extremely difficult to value, even for sophisticated investors

Practice Questions: Q1

Q1. Which of the following statements is incorrect in relation to the use of collateralized debt obligations (CDO) during the financial crisis?

A. Some CDO tranches were repackaged into CDO-squared.

B. CDOs were opaque and complex to value, especially at the peak of the crisis.

C. Cash flows and defaults were determined according to a waterfall structure.

D. Despite containing subprime mortgages, investors could safely rely on the assessment given by the rating agencies.

Practice Questions: Q1 Answer

Explanation: D is correct.

Rating agencies provided unrealistically high assessment of CDOs, especially of the senior tranches. This was partly due to the conflict of interest that existed between the rating agencies and the issuers of CDO structures.

Topic 4. Roles of Banks and Financial Intermediaries

  • Originate-to-Distribute (OTD) Model

    • Traditional Model: Banks held mortgages on balance sheet
    • New Model: Mortgages moved to bankruptcy-remote Structured Investment Vehicles (SIVs)
    • Impact: Reduced incentive for quality underwriting
    • Result: Relaxed lending standards, focus on quantity over quality

Topic 5. Roles of Mortgage Brokers and Lenders

  • Problematic Practices:

    • Compensation Structure: Based on quantity rather than quality
    • Unsuitable Products: Mortgages sold to people who couldn't afford them
    • Ignored Suitability: Cheaper products available but not offered
    • Volume-Driven: Prioritized loan origination numbers over borrower welfare

Topic 6. Roles of Rating Agencies

  • Critical Failures:

    • Unrealistically High Ratings: AAA ratings for securities backed by NINJA/liar loans
    • Flawed Methodology: Based ratings on historical prime mortgage data
    • Inadequate Due Diligence: Relied heavily on issuer-provided data without independent verification
    • Conflict of Interest: Paid by issuers, incentivized to provide favorable ratings
    • Market Ignorance: Failed to account for increasingly speculative marketplace

Practice Questions: Q2

Q2. One of the contributory factors of the financial crisis of 2007–2009 was the move to the originate-to-distribute model. Under this model, the lender:

A. may relax its underwriting standards.

B. needs to hold more regulatory capital.

C. is less likely to originate high loan-to-value mortgages.

D. originates mortgages and then retains them on its balance sheet until they mature.

Practice Questions: Q2 Answer

Explanation: A is correct.

Under the originate-to-distribute model, a lender sells mortgages to special investment vehicles (SIV), which issue collateralized debt obligations (CDOs). As the credit risk associated with the mortgage is transferred to other investors, the lender will need to hold less regulatory capital and relax its lending criteria.

Topic 7. Trends in The Short-Term Wholesale Funding Markets

  • Asset-Liability Maturity Mismatch:

    • Problem: Banks financed long-term assets through short-term liabilities
    • Risk: Significant liquidity risk exposure when unable to roll over funding
  • Primary Short-Term Funding Instruments

    • Asset-Backed Commercial Paper

      • ​Short-term paper backed by collateral (mortgages, credit card loans)

      • Required continuous rollover at maturity

    • Repurchase Agreements (Repos)

      • Bank sells asset with agreement to repurchase at higher price
      • Secured borrowing with haircuts based on collateral quality
      • Pre-crisis: 0% haircuts, high market confidence

Practice Questions: Q3

Q3. The use of asset-backed commercial paper (ABCP) and repurchase agreements (repos) by banks to fund investment mortgages led to problems because:

A. the commercial paper was unsecured.

B. it exposed banks to funding liquidity risk.

C. the duration of the liabilities exceeded the duration of the assets.

D. rating agencies provided unrealistically high ratings for the assets.

Practice Questions: Q3 Answer

Explanation: B is correct.

Banks funded long-term assets, such as mortgages, using short-term funding sources, such as asset-backed commercial paper (ABCP) and repos. This exposed them to funding liquidity risk in times of crisis when lenders refused to roll over these short-term funding sources.

Topic 8. Impact on Systemic Risk

  • Systemic Risk: Risk of system failure resulting in shutdown of entire financial market.

  • Crisis Timelines

    • August 2007: ABCP and repo markets shut down as lenders questioned asset quality
    • September 2008: Lehman Brothers bankruptcy triggered massive confidence loss
    • Peak Crisis: Haircuts rose from 0% to 45%, LIBOR-OIS spread exceeded 3.6%
  • Contagion Effects
    • Money Market Funds: Institutional runs due to ABCP exposure
    • Forced Deleveraging: Asset sales depressed prices, eroded equity
    • Interbank Market Freeze: Complete reluctance to lend between institutions
  • Key Lesson: Even with sufficient capital, overreliance on short-term funding is extremely dangerous as it can disappear overnight during crises.

Topic 9. Central Bank Intervention

  • Global Response Strategy

    • ​Objective: Prevent further systemic issues through liquidity support and interest rate cuts

    • Result: Massive expansion of central bank balance sheets globally
  • Federal Reserve Actions
    • Extended Lending: Long-term loans secured by high-quality collateral
    • Discount Window: Opened access to investment banks and securities firms
    • Asset Support: Provided liquidity for illiquid assets and ABCP purchases
    • GSE Support: Acquired Fannie Mae and Freddie Mac assets
  • Key U.S. Government Programs​
    • Term Auction Facility (TAF): Funds for depository institutions
    • Primary Dealer Credit Facility (PDCF): Fed lending via repos to primary dealers
    • GSE Bailout (Sept 2008): Nationalized Fannie Mae and Freddie Mac
    • TARP (Oct 2008): Purchased toxic assets from financial institutions

Practice Questions: Q4

Q4. To prevent further liquidity issues, the Federal Reserve and the U.S. government intervened in financial markets by implementing all of the following except:

A. lowering interest rates.

B. bailing out major financial institutions.

C. opening the discount window to commercial banks.

D. acquiring assets issued by major financial institutions.

Practice Questions: Q4 Answer

Explanation: C is correct.  

Historically, the discount window was available to commercial banks to meet their reserve requirements at the close of each day. At the peak of the crisis, the discount window was also made available to investment banks.