Structured Finance and the Financial Turmoil of 2007 2008

Seller just pays the notional amount of the bond to

Info icon This preview shows pages 30–31. Sign up to view the full content.

View Full Document Right Arrow Icon
seller just pays the notional amount of the bond to the buyer, while the buyer needs to deliver the actual reference asset to the seller (for example here the bond issued by Ford Motor Company) (see Figure 7B). The spreads of single-name CDS contracts related to specific banks are extremely useful indicators for both policymakers and market participants regarding market assessments of the soundness and risk-profile of these institutions. Both theoretical and empirical analysis have shown that the development of these spreads provides important information about various risks faced by banks, such as overall credit risk and more specific counterparty and liquidity risk, and even have predictive power [see for example: Di Cesare (2006); Düllmann and Sosinska (2007)]. Econometric techniques exist that can be used to calculate the probability of default of a specific bank as well as its counterparty risk from its CDS spread, such as perceived by financial markets. The actual movement of the spreads of banks’ single name CDS contracts is indicative of specific tensions related to these banks and may be used to monitor how they have been affected by the 2007-2008 financial turmoil. Chart 9 shows the development of the CDS spreads for a number of selected globally operating banks in two panels. Panel A provides information on a number of US investment banks (Merrill Lynch, Goldman Sachs, JP Morgan, Morgan Stanley and Lehman Brothers), whereas Panel B shows a mixture of European banks (BNP Paribas, Deutsche Bank, Barclays, UBS, Santander and BBVA). From the development of these CDS spreads, it is clear that the peak of the financial turmoil was reached in March-April 2008, after having started in August 2007. Furthermore, financial markets differentiated substantially in their assessment of individual banks, with the spreads of particularly affected banks such as Lehman Brothers, Merrill Lynch and UBS increasing to much higher levels than other banks. Chart 10 presents the development of the actual CDS spread of Bear Stearns (Panel A) and the one and five year default probabilities of Bear Stearns derived from this spread (Panel B), which indicate the probability such as perceived by the market that this investment bank would go bankrupt within one year and within five years. Bear Stearns has been the highest profile victim in the financial turmoil and had to be rescued from bankruptcy in March 2008 through a takeover by JP Morgan orchestrated by the Federal Reserve. Panel A shows that the CDS spread of Bear Stearns increased to levels significantly surpassing those of CDS spreads of other banks (see for example Chart 9), whereas Panel B indicates that the one and five year default probabilities of the bank spiked in March to respectively 12% and 45%, which are extremely high compared both with historical levels and those of comparable investment banks.
Image of page 30

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 31
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern