132_Credit_Crisis_JoD_2008

132_Credit_Crisis_JoD_2008 - I T I S I L L E G A L T O R E...

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Unformatted text preview: I T I S I L L E G A L T O R E P R O D U C E T H I S A R T I C L E I N A N Y F O R M A T F ALL 2008 T HE JOURNAL OF DERIVATIVES 81 This article examines the different factors that have contributed to the subprime mortgage credit crisis— search for yield enhancement, investment manage- ment, agency problems, lax underwriting standards, rating agency incentive problems, poor risk man- agement by financial institutions, lack of market transparency, limitation of extant valuation models, complexity of financial instruments, and failure of regulators to understand the implications of the changing environment for the financial system. The article sorts through these different issues and offers recommendations to help avoid future crises. T he credit crisis of 2007 started in the subprime mortgage market in the U.S. 1 It has affected investors in North America, Europe, Australia, and Asia, and it is feared that write-offs of losses on securities linked to U.S. subprime mort- gages and, by contagion, other segments of the credit markets, could reach US$1 trillion. 2 It brought the asset-backed commercial paper market to a halt, hedge funds have halted redemptions or failed, CDOs have defaulted, and special investment vehicles have been liq- uidated. Banks have suffered liquidity problems, with losses since the start of 2007 at leading banks and brokerage houses topping US$300 billion, as of June 2008. 3,4 Credit-related prob- lems have forced some banks in Germany to fail or to be taken over, and Britain had its first bank run in 140 years, resulting in the effective nationalization of Northern Rock, a troubled mortgage lender. The U.S. Treasury and the U.S. Federal Reserve Bank (Fed) helped to broker the rescue of Bear Stearns, the fifth largest U.S. Wall Street investment bank, by JP Morgan Chase during the weekend of March 17, 2008. 5 Banks, concerned about the mag- nitude of future 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 of lending to one another and, consequently, have been charging each other much higher interest rates than normal in the interbank loan markets. 6 The severity of the crisis on bank capital has been such that U.S. banks have had to cut dividends and call global investors, such as sovereign funds, for capital infusions of more than US$230 billion, as of May 2008, based on data compiled by Bloomberg. 7 The credit crisis has caused the risk premium for some financial institutions to increase eight- fold since last summer. It has now become more expensive for financial than for nonfi- nancial firms, with the same credit rating, to raise cash....
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This note was uploaded on 12/09/2008 for the course NBA 5550 taught by Professor Jarrow,robert during the Fall '08 term at Cornell.

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132_Credit_Crisis_JoD_2008 - I T I S I L L E G A L T O R E...

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