Brunnermeier_Summary - Summary of Brunnermeiers Article by...

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Summary of Brunnermeier’s Article by: Anji Tang Part I: Trend towards “originate + distribute” model lending standards decline + boom in lending and housing prices, funding liquidity decrease = problematic 1. “originate + distribute”: Banks re-package loans and transfer to other financial investors rather than putting them on balance sheets A. Banks made structured products: collateralized debt obligations (CDOs); diversified portfolios of mortgages and loans + assets divided into tranches, sell to investors a. Safe = super senior tranche, low interest rate but first to be paid out of portfolio cash flow; junior/equity/toxic waste = paid after other tranches paid; mezzanine in middle B. Insurance = buying credit default swaps (CDS), pay fee regularly in return for payment in credit default 2. Finance asset holdings with shorter maturity instruments, vulnerable to funding liquidity dry-up A. Investors like short maturities (1. Flexible withdrawal, discipline bank with threats, confidence signal) but projects are usually long maturities B. Shadow banking: off-balance sheet, asset-backed commercial paper, owners can confiscate collateral assets in case of default a. funding liquidity risk: investors stop buying asset-backed commercial paper, sponsor bank gives credit line (liquidity backstop) C. Short-term repurchase agreements: repos, firm sells collateral asset now and promise to buy it back 3. Structured products: risk can be widely spread and moved to those can bear it = lower mortgage + interest rates; institutional investors can hold assets they previously could not A. Reasons for popularity: regulatory and ratings arbitrage: Basel I accord required banks to hold capital >= 8% of balance sheet loans (capital charge), lower for contractual credit lines, none for “reputed” credit lines a. Move loans to off-balance sheet, give credit line to get AAA rating = banks decrease capital holding w/out risk change B. Basel II: capital charge base on asset ratings banks pooled loans to off-balance sheet C. Overly optimistic statistical models: based on historical low mortgage default + delinquency, lack of nationwide housing decline after WWII, rating agencies collected higher fees 4. Lots of cheap credit, more securitization = banks less careful about approving/monitoring loans = liquidity bubble Part II: 2007-2008 financial market crisis: Logbook 1. Subprime mortgage crisis : increase in subprime mortgage defaults ABX price index (credit default swaps) decline
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This note was uploaded on 04/05/2012 for the course ECON 10 taught by Professor N.gregorymankiw during the Fall '09 term at Harvard.

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Brunnermeier_Summary - Summary of Brunnermeiers Article by...

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