“The Subprime Credit Crisis of 07” by Michel Crouhy, Robert Jarrow and Stuart Turnbull

1. “The Subprime Credit Crisis of 07”by Michel Crouhy, Robert Jarrow and Stuart Turnbull Discussion by Chester S. Spatt Carnegie Mellon University (former Chief Economist, SEC) 8th FDIC Bank Research Conference Arlington, VA September 18, 2008

2. Overview • Crisis had many roots • What are some of the key economic issues identified by the “crisis”? • How has the “crisis” altered our thinking about economics and our economy? • What are some of the current challenges? • One direct comment—Plots of the relative performance over time of different instruments would be useful

3. Systemic Risk • Potential for correlated defaults across the economy—counterparty risk huge, forced sales and downward valuation pressures • Many asset managers investors often invest on the same side of a position—e.g., long the ‘credit spread’--common training, expertise and tools • Securities firms incredibly levered—perhaps far too leveraged to have been the optimal holder • Bearing of risk reflects common incentive structure for the general partner and “moral hazard” from regulation

4. Compensation Structure • Compensation reflects short-term metrics • Option grants and restricted stock value tied to subsequent development, but not bonuses • Focus on “how paid” by employee and the firm • “Limited” employee wealth and risk aversion makes it hard to internalize franchise risk (compensation lit. theme)

5. Sources of Financial Institution’s Risk • Explicit portfolio holdings • Do “carry” trades produce economic profits? • Profit streams from various businesses • Production risk from various businesses • “Reputation” risk and use of “balance sheet”

6. Leverage and Capital • Need for capital—economics • not “just” accounting—debate about “fair value accounting” • How realistic are the “marks”? At the heart of poor financing decisions (evaluations of offers of capital) • Reasonable leverage -- Does leverage add value (absent taxes): M&M • FNMA, Freddie examples • What was “capital”? • Nominal leverage

7. Opacity • Who holds what exposures?—Counterparty risk • Reliable and verifiable prices for illiquid instruments (“standardization” of “marks”) • Reluctance to sell instruments with largest losses due to illiquidity, so selling and problems spill to more liquid assets (problems in prime jumbo loans!) when need to reduce leverage—led to collapse of some institutions • Transmission of liquidity problems across markets (including globally) • Need to create serious transparency

8. Agency and Adverse Selection • Orginate to distribute model • Borrower’s contract and decision • What does lender retain? • What does securitizer retain? • What does the seller know? • Tranching—despite adverse selection and illiquidity in secondary trading • Flexibility for optimal modification--early study of optimal modification in Dunn and Spatt, JF, 1985

9. Credit Ratings • Scope for mis-valuing an entire asset class rather than individual loan and idiosyncratic risk • Many participants relied upon these and so potentially a source of systemic risk • Outsourcing due diligence (especially to few players) is an odd basis for asset management—creating diverse signals • “Ratings shopping” and “selection” • Move toward less regulatory reliance on ratings • Are “ratings triggers” optimal contracts? —Discontinuous structure, “death spirals”

10. Mortgage Insurers • Monolines (Ambac, MBIA), AIG • What is insurable risk? What is diversifiable? • Academics viewed muni bond insurance as puzzling—after all, risk could be priced and diversified through the capital market • Muni defaults would be very correlated so ability to insure seemed questionable • Similar issues in insuring mortgages (monolines) damaged ability of insurers to earn their muni profits

11. Maturity Mismatch • Bank run (e.g., Northern Rock) • Auction rate municipal market • Counterparty risk • Fragility of liquidity—funding short (carry trade) is “risky” • Distinction between contingent contract and dynamic strategy (fragile)

12. Standardization • Past emphasis on customization; specific financings • Liquidity, uniformity and depth • Transparency on trading platform, spreads • Less adverse selection (except for cherry picking options) • Settlement, counterparty risk-Bear Stearns • Basis risk and risk aversion

13. Systemic Risk and the Regulatory Response • Externalities; “freezing” financial markets • What is framework for intervention? (e.g., FDIC) • Whom do we “tax” for creating systemic risk? • Importance of time consistency and the cost of flexibility (“bazooka” for FNMA/Freddie) • “Making it up” as we lurch from one crisis—“blinking” or “playing chicken” • Ex ante and ex post are not very far apart—bargaining with authorities over intervention based upon prior ones • Market discipline re: moral hazard, risk taking

14. Blaming the “shorts”? • Why do asset prices fall? • Because buyers are willing to pay less for the instruments than previously • Raise the cost of short-sale executions? --Due to liquidity process about 35% of sales are short sales, but overall short interest small --Return to the tick test and even more strongly bar shorts without a nickel up-tick --“Abusive naked” short sells is not a problem in liquid stocks • Regulators need to focus on core challenges