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Financial Crisis Inquiry Committee Presentation February 26th/27th, 2010 1 collateral 2 3 Risk build-‐up phase Credit bubble Crisis phase Amplification “endogenous risk” hubris externalities 1. Liquidity spirals + fire-‐sale externality 2. Network externalities 3. Runs large 4 Fire sales shock Loss of capital Precaution + tighter margins Volatility Price 5 I-Bank A fixed floating P-Equity Fund Hedge Fund I-Bank B 6 I-Bank A fixed floating P-Equity Fund C Hedge Fund everything nets I-Bank B 7 I-Bank A fixed floating P-Equity Fund Hedge Fund novation I-Bank B 8 I-Bank A fixed floating P-Equity Fund Hedge Fund novation I-Bank B 9 I-Bank A P-Equity Fund Hedge Fund netting I-Bank B 10 Special privileges for credit products Reduces domino (knock-‐on) effects, but undermines bankruptcy code Runs -‐ get funds/collateral out before others “collateral run” by hiking margins/haircuts Not worried about survival, since secured by collateral “destruction of franchise value” Seize and sell collateral before others depress price (QFCs only apply to commercial banks) Collateral requirements were one-‐sided! I-‐banks received (from HF) but did not put up collateral 11 1. Did emergence of CDS burst the bubble? No direct channel Investors sell derivatives – others buy (net = 0, adding up constraint) Drives derivatives price down = spreads up As long as underlying (house, Greek bond) is not shorted no impact Indirect channel -‐ requires adverse feedback loop 1. 2. CDS spread increase leads to rating downgrade, investors require higher return CDS aggregates info and raises concerns of naïve buyers 2. Did CDS amplify the fallout? Yes, because of uncertainty (endogenous risk) due to market structure 12 Privileges for “credit securities” played crucial role in Run up and credit bubble Amplification in downturn correction occurs too late Liquidity spirals margins/haircuts delevering large price movements Network Privileges: implicit priority, short-‐maturity Aim: isolate players to reduce domino effects … but Run on individual institutions is more likely since privileges undermine bankruptcy code collateral requirements are one-‐sided (except for tri-‐party) amplified by liquidity spirals 13
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