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Malaysia Campus
Nottingham University Business School
MBA Programme
Portfolio Management and Investment Analysis (N1DM29)
Convenor: Dr. Ghulam Sorwar
Assignment on:
Credit Crunch
Soh Chiew, Khor (UNIMKL 004178)
Zhijing, Eu (UNIMKL 004151)
Shoun Shin, Leow (UNIMKL 004205)
Soon Hek, Lim (UNIMKL 004176)
Date: 31.07.2008
COPY I
Abstract
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This paper will focus on the basic principles of credit risk transfer, the factors
that lead up to the ongoing global credit crisis, the dire consequences
resulting from the crisis, and suggestions on preventive measures to avoid a
repeat scenario.
A key finding from this paper is that the speed of transmission and severity of
the credit crisis can be traced to the fundamental issue of asymmetric
information within the structure of the credit market that lead to moral
hazard and adverse selection exacerbated by a climate of low interest rates,
a boom in the housing sector and poor corporate governance.
Improvements to the existing financial controls must focus on the creation
and enforcement of mechanisms to promote much more transparency and
fair competition in credit marketplace transactions, standardization of risk
management methodologies, and stronger accountability and responsibility
in the oversight of regulatory compliance within commercial financial
institutions.
A simple message from this current credit crunch should be clear to all the
key players within the financial marketplace: “There is no such thing as a free
lunch.”
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Table of Contents
1.0 Credit Crunches and Financial / Economic Crises ..................................3
2.0 Definition of Credit Risk .........................................................................4
3.0 Derivative Instruments ..........................................................................5
3.1 Common Credit Derivative Instruments ......................................5
3.2 Credit Derivative Instruments Market ..........................................6
4.0 The Causes of Credit Crunch ..................................................................7
5.0 Contagion Effect & Global Impact ........................................................10
5.1 US : Bear Sterns ........................................................................11
5.2 UK : Northern Rock ....................................................................12
6.0 Preventive Measures ............................................................................13
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6.1 Improvements in Accountability in Regulatory Compliance .......14
6.2 Transparency and Fair Competition ...........................................15
6.3 Standardization of risk management methodologies ................16
6.4 The Emergence of the Islamic Banking/ Finance .......................17
7.0 Conclusion ...........................................................................................17
8.0 References ...........................................................................................18
9.0 Bibliographies ......................................................................................22
Words Count: approximately 3163
1.0 Lim : Factors that have lead up to the credit crunch.
What Is a Credit Crunch?Credit Crunches and Financial/Economic
Crises
Credit Crunches and Financial / Economic Crises
Historically, the world has witnessed a series of credit crunches
stemmed from a diverse form of financial or economic crises such as
1990 recession in US, stagnation of Japan economy in 1990s, 1997-98
Asian financial crisis, Argentina peso crisis in 2002 and the most recent
one, the US’s subprime-mortgage debacle in 2007. The subprime
mortgage turmoil has caused massive write-downs in several major
global financial institutions with fire sale of Bear Steams,
nationalization of Northern Rock and liquidation of Carlyle Capital
investment fund.
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There are few existing theories regarding credit crunches, in each of
these, a credit crunch is defined as a reduction in the available supply
of credit. Bernanke and Lown (1991) define a credit crunch as decline
in the supply of credit that is abnormally large for a given stage of
business cycle,. A whereas Owens and Schreft (1992) define a credit
crunch as a period of sharply increased of non-pricing rationing and
according to Scott (2003), a credit crunch is a period during which
borrowed funds are difficult to obtain, even if funds can be found,
interest rates are very high.
While the outcome is the same under each interpretation – the decline
of loan supply, however the cause of this phenomenon may differs.
The next section will shed some light on the causes of credit crunch
stemmed from subprime mortgage debacle.
Historically, credit crunches often stem from financial or economic
crises such as 1990 recession in US, stagnation of Japan economy in
1990s, 1997-98 Asian financial crisis, Argentina peso crisis in 2002.
Although the outcome is the same in each case – the decline of loan
supply, the specific causes of this phenomenon may differs.
The most recent instance is the US subprime-mortgage debacle in
2007 which has directly (and indirectly) caused massive write-downs in
several major global financial institutions. It is widely held that this
particular crisis had it’sits roots in the mismanagement of credit risk
transfer processes within the global financial system.
This paper will focus on the how credit risk transfer works , the factors
that lead up to the crisis, the dire consequences resulting from the
crisis , and provide some suggestions on future preventive measures
to avoid a repeat scenario.
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2.0 Definition oOf Credit Risk
Credit risk arises whenever a lender originates a loan due to the risk of
the borrower to fail to pay. Reasons for this could arise be due to credit
events such as bankruptcy, default, debt restructuring or delinquency.
Traditionally, lenders have dealt with credit risk through the use of
financial guarantee agreements and/or collateral securities (Kothari ,
2002).
3.0 Common Credit Derivative Instruments
3.1 Common Credit Derivative Instruments
In the early 1990s in the United States, the credit derivatives
market developed to meet large banks’ need ofto managinge
their risk exposure to large lenders. The earliest credit derivative
instrument, the credit default swap (CDS) was invented in 1995
by Blythe Masters who was then the head of JP Morgan’s Global
Credit Derivatives group (Tett, 2006).
Credit derivatives differ from traditional credit risk management
in that these instruments were concluded thru a standard
master agreement, subject to ongoing market valuation and did
not constitute a claim on the debtor of the underlying position
(Kothari, 2002). Aside from the improvement in risk
management of market traders, these instruments improved
market liquidity of otherwise illiquid loans, allowed for risk
seperationseparation of credit risk from other asset risks and
presented large financial institutions with a reliable funding
source (Choudhury, 2006).
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Credit derivative instruments are built on the concept of trade in
risk transfer without direct ownership of the underlying
reference asset. The CDS (Credit Default Swap) is the most
common credit derivatives instrument. A CDS is similar to an
insurance policy where issuers of a debt (protection buyer)
enters into an agreement to make periodic payments to a
counterparty (protection seller) in return for the promise of a
pay-off if the third party ( The “reference entity”, i.e. the
borrower of the initial issue of debt) defaults on the re-payment
of the debt.
The CDS contract price is quoted in terms of a premium of basis
points against the reference credit asset. CDS pricing depends
on the expected recovery rates associated with the reference
entity and the protection seller, credit risk of the protection
seller and the default correlation between the reference entity
and the protection seller .(Bomfim, 2001). The most important
factor is the credit quality of the reference credit asset where
the poorer the credit quality, the greater the risk of default but
also the greater the premium/reward.
CDS reference only single entities. However CDS--s were soon
followed by collateralized debt obligation (CDO) instruments.
CDOs are a structure of fixed income securities whose cash
flows are linked to the incidence of default in a pool of debt
instruments such as loans or other asset backed securities such
as mortgatesmortgages that cover multiple reference entities .
(Lehman Brothers Guide).
3.2 Credit Derivative Instruments Market
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This securitisationsecuritization in CDOs allows credit risk to be
transferred to the capital markets thru the act of embedding a
credit derivative feature into a capital market security. CDOs are
then marketed thru the formation of special investment vehicle
(SIV) companies which transfer credit risk from protection
buyers to investors by creating securities associated with
differing “tranches” of credit quality based on the initially poor
credit quality underlying asset that can be re-sold to match the
risk-return appetite level of investors.
There is no agreed single model that can provide a fair value for
these credit derivative instruments. In practice rating agencies
such as Standard & Poor, Moody’s or Fitch provide information
based on historical default probabilities. Also the mathematics
involved in the modellingmodeling the probability of default is
complex. In a practice many banks use in-house valuation
models but the wide range of differences in assumptions and
methodologies across models often lead to different results.
Credit derivative contracts are not publicly traded on exchange
markets and instead often rely on investment banks to privately
match counterparties in Over The Counter (OTC) transactions.
Therefore credit derivative trades participants tend to be
institutional investors such as banks, securities houses, hedge
funds or insurance companies rather than retail investors.
4.0 The Causes of Credit Crunch
The genesis of the US subprime meltdown in mid 2007 can be traced
to the housing boom of 2001-05. Additionally, low interest rates, .
increasing foreclosure rates and unwillingness of many homeowners to
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sell their homes at reduced market prices significantly all contributed
to the increase in the supply of housing inventory.
The housing markets thrived amid historical low interest rate and at
the same time, the lenders became more creative, and enticed new
and increasingly less creditworthy home buyers into the market with
exotic mortgages, such as “interest only’ loans and “option adjustable
rate” mortgages (option ARMs).
Low interest rate, Eeasy credit, coupledombined with the assumption
that housing prices would continue to appreciate, encouraged many
subprime borrowers to obtain exotic mortgages such as Adjustable-
Rate-Mortgage’s (ARM). Option ARMs accounted 8.9% of mortgages
written in 2006 (Ivry and Shenn, 2008). These loans involve low or no
down payments and initially carry very low “teaser” rate, but then are
later reset in a way that causes the minimum payment to skyrocket.
Option ARMs accounted 8.9% of mortgages written in 2006 (Ivry and
Shenn, 2008).
This excess supply of home inventory placed significant downward
pressure on prices. Once housing prices started depreciating
moderately in many parts of the U.S., refinancing became more
difficult. Some homeowners were unable to re-finance and began to
default on loans as their loans reset to higher interest rates and
payment amounts. Other homeowners, facing declines in home market
value or with limited accumulated equity, choose simply to stop paying
their mortgage.
In addition, theAnother underlying factor was the increase in
unregulated mortgage brokers became the key player in the market;
they who accounted for 80% of market share of all mortgages
origination by 2006 (Whalen, 2007). The brokers are motivated by
commission, and do not hold loan or have long-term relationship with
borrowers . Ttherefore they pushed option ARMs hard as option
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ARMsthese exotic mortagatesmortgages offer the brokers high
commissions.
Besides that they do not hold loan and do not have long-term
relationship with borrowers. This has driven further growth of option
ARMs.
With theThe growing utilization of complex structured credit products
through securitization of mortgagess, it hasalso increased uncertainty
about the valuation of financial assets. The high leverage embedded in
these products tends to blur the size of commitment in each layer of
securitization. This “originate-to-distributetransfer” model of financing
has weakened the link between lenders and borrowers, and
consequently, diluted the incentives to rigorously assess the credit
worthiness of the borrower and to monitor the obligator’s financial
state. (The Economist, 2008). Among theThe biggest purchasers of
such structured products have been hedge funds, which took
advantage of their largely unregulated status and use these mortgage
bundles as collateral for highly leverages loans – often using the loans
to purchase still more mortgage bundle. This is the key issue of
subprime mortgage mess andlack of structural regulation underscores
one of the key structuralal weaknessweaknesses in the evolution of
modern credit market.
Another key elementfactor behind the 2007 credit crunch is the
conflict of interest among credit-rating agencies. These agencies not
only rate debt packages but also offer the issuer assistancehelp in
constructing the product in order to obtain certain rating. This service
has become a lucrative business for the rating agencies, for instance,
structured finance deals accounted 40% of Moody’s total revenue in
2006 (Levitt, 2007). In addition, the rating agencies are paid by the
issuers of the securities, not by investors. Hence, they are always in
the pressure to providegive good rating unless absolutely unavoidable
(Howley, 2006).
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As the result of above mentioned situations, the subprime mortgage
market , with an increasing portion made to borrowers with less-than-
perfect credit histories, grew rapidly after 2003. However,, as the the
Fed began to riseincrease in the interest rate in July 2004 by the Fed
and the subsequent slowdown in real estate market which has built
have caused a substantial increase of default on US subprime
mortgages. excess supply of home inventory placed significant
downward pressure on prices. Hence, housing prices started
depreciating moderately in many parts of the U.S., refinancing became
more difficult. Some homeowners were unable to re-finance and began
to default on loans as their loans reset to higher interest rates and
payment amounts. Other homeowners, facing declines in home market
value or with limited accumulated equity, choose simply to stop paying
their mortgage. This has caused a substantial increase of default on US
subprime mortgages. This quickly spilled over onto the balance sheet
of hedge funds and other investment funds and has also affected
banks through their off-balance sheet financial “conduits” – structured
investment vehicle (SIV), as SIVs were brought back onto banks’
balance sheet when asset values declined sharply. (Lee and Park,
2008).
Uncertainty about the valuation, disclosure of structure products and
rising risk aversion, has since spread the contagion. As financial
institutions have become concerned about counterparty risk and
unknown exposure to subprime mortgages and related credit
derivatives, this added pressure on assessment risk has driven
financial institutions to become very cautious and hoard liquidity.
Consequently, strains in the short-term funding markets in the US and
elsewhere – notably interbank and asset-back commercial paper
markets have intensified and by August 2007 a third of home loans
originated by mortgage brokers failed to close due to no take-up from
investors (Whalen, 2007),
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basically by that moment a full-blown of credit crunch phenomenon
has arrived. As Whalen (2007) put it, the US credit crunch of 2007 can
aptly be described as a “Minsky moment”.
Z : Main types of financial instruments which have been used to deal
with the credit risk and how they have been priced and how they
have been sold
Credit risk arises whenever a lender originates a loan due to the risk
of the borrower to fail to pay. Reasons for this could arise be due to
credit events such as bankruptcy, default, debt restructuring or
delinquency. Traditionally, lenders have dealt with credit risk through
the use of financial guarantee agreements and/or collateral securities
(Kothari 2002).
In the early 1990s in the United States, the credit derivatives market
began to develop to meet large banks need to manage their risk
exposure to large lenders. The earliest credit derivative instrument,
the credit default swap (CDS) were invented in 1995 by Blythe
Masters who was then the head of JP Morgan’s Global Credit
Derivatives group (G.Tett 2006).
These credit derivatives differ from traditional credit risk
management in that these instruments were concluded thru a
standard master agreement, subject to ongoing market valuation and
did not constitute a claim on the debtor of the underlying position
(Kothari 2002). Aside from the improvement in risk management of
market traders, these instruments improved market liquidity of
otherwise illiquid loans, allowed for risk seperation of credit risk from
other asset risks and presented large financial institutions with a
reliable funding source (Choudhury 2006).
Credit derivative instruments are built on the concept of trade in risk
transfer without direct ownership of the underlying reference asset.
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The CDS (Credit Default Swap) is the most common credit derivatives
instrument.A CDS is similar to an insurance policy where issuers of a
debt (protection buyer) enters into an agreement to make periodic
payments to a counterparty (protection seller) in return for the
promise of a pay-off if the third party ( The “reference entity”, i.e the
borrower of the initial issue of debt) defaults on the re-payment of
the debt.
The CDS contract price is quoted in terms of a premium of basis
points against the reference credit asset. CDS pricing depends on the
expected recovery rates associated with the reference entity and the
protection seller, credit risk of the protection seller and the default
correlation between the reference entity and the protection seller.
(Bomfim 2001). The most important factor is the credit quality of the
reference credit asset where the poorer the credit quality, the greater
the risk of default but also the greater the premium/reward.
CDS only single reference entities. However CDS-s were soon
followed by the introduction of collateralized debt obligation (CDO)
instruments. CDOs are a structure of fixed income securities whose
cash flows are linked to the incidence of default in a pool of debt
instruments such as loans or other asset backed securities such as
mortgates that cover multiple reference entities.(Lehman Brothers
Guide)
This securitisation in CDOs allows credit risk to be transferred to the
capital markets thru the act of embedding a credit derivative feature
into a capital market security. CDOs are then marketed thru the
formation of special purpose vehicle companies which transfer credit
risk from protection buyers to investors by creating securities
associated with differing “tranches” of credit quality based on the
initially poor credit quality underlying asset that can be re-sold to
match the risk-return appetite level of investors.
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However an issue in the pricing of credit derivative instruments there
is no single clear agreed model that can provide a fair value for these
instruments. In practice rating agencies such as Standard & Poor,
Moody’s or Fitch provide information based on historical default
probabilities but as witnessed by the recent turn of events in the sub
prime credit crisis these values may not completely accurate.Also the
mathematics involved in the modelling the probability of default is
complex. In a practice many banks use in-house valuation models but
there are wide range of differences in assumptions and
methodologies across models that lead to different results.
Credit derivative contracts are not publicly traded on exchange
markets and instead often rely on investment banks to privately
match counterparties in Over The Counter (OTC) transactions.
Therefore credit derivative trades participants tend to be institutional
investors such as banks, securities houses, hedge funds or insurance
companies rather than retail investors.
However there are efforts to increase transparency , regulation and
standardisation. As an example, most credit derivative contracts now
reference standard definitions published by the International Swaps
and Derivatives Association. Also more recently, some financial
exchange organisations have launched standardised indices for
credit derivatives such as Itraxx in Europe (MarkIt Website) and the
fully exchange-traded CME credit index event contracts originated in
the Chicago Merchantile Exchange which reflects a shift towards
centrally cleared standardised contracts that reference a fixed
number of obligors.(CME Website 2007)
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Albert : problems they are currently facing
5.0 Contagion Eeffect & of the credit crisis and impact on global
levelGlobal Impact
In recent years, overbuilding of American home during the boom
period, increasing foreclosure rates and unwillingness of many
homeowners to sell their homes at reduced market prices have
significantly increased the supply of housing inventory available. This
excess supply of home inventory places significant downward pressure
on prices. As prices decline, more homeowners are at risk of default
and foreclosure. Easy credit, combined with the assumption that
housing prices would continue to appreciate, also encouraged many
subprime borrowers to obtain Adjustable-Rate-Mortgage’s they could
not afford after the initial incentive period. Once housing prices started
depreciating moderately in many parts of the U.S., refinancing became
more difficult. Some homeowners were unable to re-finance and began
to default on loans as their loans reset to higher interest rates and
payment amounts. Other homeowners, facing declines in home market
value or with limited accumulated equity, are choosing to stop paying
their mortgage.
Many US analysts called it aconsidered domestic problem when the
cCredit crisisCrisis caused by sSubprime mMortgage crisis would
contain landed domestically problem andthat would impact only the
US housing markets-- one that would only affect US housing markets.
However, almost a year later, it can be seen that this is not the
casethe after-effects of the credit crisis have spreadhad far reaching
consequences through-out the entire global financial system.
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For instance, the Bank of China announced in August of 2007, that it
holds $9.7 billion dollars of US Subprime debt (Shaw, 2007)1. In January
of 2008, Korean markets fell due to the "selling spree" of shares
caused by subprime ripple effect of US mortgages (Arirang News, Jan.
2008)2. Because of the global economy, and the huge Subprime "pool"
of mortgages that was bought by investors world wide, the
International Monetary Fund (IMF) “saysestimated that the worldwide
losses stemming from the US subprime mortgage crisis could run to
$945 billion.”
Crisis The crisis has caused panic in financial markets and encouraged
investors to cut off their holding in take their money out of risky
mortgage bonds and shaky equities and divertedput it into
commodities as "stores of value". This has partly contributed to Most
of the recent increases in global food prices, as result of 3 have been
the result of speculation and weakening of US dollarthe collapse in the
value of the US dollar. (MacWhirtler, 2008)4.
Many banks, mortgage lenders, real estate investment trusts (REIT),
and hedge funds suffered significant losses stemmed fromas a result of
mortgage payment defaults or mortgage asset devaluation, with
recognized . As of May 21, 2008 financial institutions had recognized
subprime-related losses and write-downs exceeding U.S. $379 billion
by May, 2008 (Onaran, 2008)5.
1Subprime Effects Felt Worldwide, August 24th, 2007, downloaded at http://www.straightstocks.com/foriegn-markets/subprime-
effects/felt-worlwide2Arirang News, “Subprime Ripple Effect Sends Stocks Down Worldwide”, Jan.23, 2008, downloaded at
http://english.chosun.com/w21data/html/news/200801/200801230005.html3 The cost of food: Facts and figures, May 29th, 2008 downloaded at http://news.bbc.co.uk/2/hi/7284196.stm
4 Mother of all bubbles prepares to burst, downloaded at
http://www.sundayherald.com/news/heraldnews/display.var.2104855.0.mother_of_all_bubbles_prepares_to_burst.php5 Yalman Onaran. "Subprime Losses Top $379 Billion on Balance-Sheet Marks: Table", Bloomberg.com, Bloomberg L.P., 2008-05-
19. Retrieved on 2008-06-04.
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5.1 US : Bear Sterns
The credit crisis has also brought down share price of one of
largest US investment bank, Bear Sterns, from $169 to $ 2,
clearly due to the loss of confidence in credit markets. Bear
Sterns had been concentrated its main investments mainly on
sub-prime mortgage instruments, collateralized debt obligations
(CDOs) and other securities which are now seen as highly risky.
Bear Sterns then precipitatingIn the first stage of global credit
crunch when , two of its hedge funds, Bear Stearns High-Grade
Structured Credit Fund and Bear Stearns High-Grade Structured
Credit Enhanced Leveraged Fund, had lost nearly all of their
value amid a rapid decline in the market for subprime
mortgages. Following thatSubsequently, Bear Sterns then
pledged a collateralized loan of up to $3.2 billion to "bail out"
the Bear Stearns High-Grade Structured Credit Fund, while
negotiating with other banks to loan money against collateral to
another fund (Creswell et. al., 2007)6. Now However due to a
loss of confidence, other banks werhavee become unwilling to
invest money in Bear Stearns to keep its operations going and ,
leading Bear Sterns no longer has enough cash on hand, known
as liquidity, to fund its operationsto a liquidity crisis that quickly
escalated to a solvency crisis (BBC News, March 2008).7
If Bear Stearns collapsed, it would be forced to sell its assets,
such as sub-prime mortgage securities, into the market at cut
down prices. This would have lowered their value even further
and that could have affected the solvency of many other big US
banks due to the counterparty liability complexities involved. In
a vicious cycle, iIf other largebig banks went bust, then credit
would dry up rapidly across the whole economy andthen slowing
6 Creswell, Julie & Bajaj, Vikas, New York Times (2007-06-23), “$3.2 Billion Move by Bear Stearns to Rescue Fund”,
http://www.nytimes.com/2007/06/23/business/23bond.html.7 “Q&A: Bear Stearns banking crisis”, 17 March 2008, downloaded at http://news.bbc.co.uk/2/hi/business/7296827.stm
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down economic activity, contagion effect of this credit crisis
cwould be leading to another Great Depression. Therefore,
JPMorgan Chase, in conjunction with the Federal Reserve Bank of
New York stepped in quickly by , providinged a 28-day
emergency loan to Bear Stearns in order to prevent the potential
market meltdowncrash that would result from Bear Stearns
becoming insolvent (Associated Press, March 2008)8.
5.2 UK : Northern Rock
Northern Rock (NR) was a building society and converted to a
stock-form UK bank in 1997, its business grew rapidly to become
Britain’s fifth-biggest mortgage provider. NR’s success crucially
hinged on a particular business model that relied heavily on
securitization and funding from wholesale markets, rather than
“conventional” model of banking of funding from retails deposits
and holding the loans on the balance sheet until maturity
(Yorulmazer, 2008). Hence, business model of NR made it
vulnerable to adverse development in wholesale markets.
The contagion effect from US subprime crisis led to a drying up
of liquidity in short-term debt markets such as the asset-backed
commercial paper (ABCP) where “conduits” and SIV rely on.
When the ABCP market seized to provide the needed liquidity,
“conduits” had no alternative but to tap their bank lines of
credit. But due to uncertainty issue associated with liquidity
needs and asymmetric information on complex financial
structures led banks hoard liquidity, which resulted in drying up
of liquidity in wholesale markets and the LIBOR reaching record
high levels (Yorulmazer, 2008). As the result, this has adversely
8 Associated Press, “JPMorgan Chase Funding Bear Stearns”, March 14, 2008, downloaded at
http://biz.yahoo.com/ap/080314/bear_stearns.html.
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affected NR that depended on securitization and whole markets
for funding.
Subsequently, this triggered an old-fashioned bank run, the first
run in UK since the collapse of Overend Gurney in 1866.
However, the run has been contained by the bailout
announcement of the UK government that guaranteed all
deposits in NR (Giles et. al., 2007). Eventually, Northern Rock
was nationalized by the Bank of England in February 2008 after
an unsuccessful attempt to search for a buyer for Northern Rock
(Stephen Castle, 2008).
Elsewhere,half a world away, Northern Rock, being one of the
top five mortgage lenders in UK in term of gross lending, to free
capital for its rapid growth in mortgage lending, sold its credit
card business to The Co-operative Bank for a profit of more than
£7 million to free up capital for its rapid growth in mortgage
lending. Until November 2007 Northern Rock continued to sell
credit cards under their own brand through The Co-operative
Bank9.
The decision to stop was made before the 2007 crisis and
Northern Rock was struggling to raise money to fund its lending.
However, fFollowing the widespread losses made by investors in
loans to US homebuyers with poor credit history, investors have
become wary of buying all mortgage debt, including Northern
Rock's. The bank's assets were always sufficient to cover its
liabilities, but it had a liquidity problem because institutional
lenders became nervous about lending to mortgage banks
following the US sub-prime crisis.
9 Sean Farrell, The Independent, February 12, 2008, "Northern Rock and Co-op cancel credit card tie-up", downloaded at
http://www.independent.co.uk/news/business/news/northern-rock-and-coop-cancel-credit-card-tieup-781102.html
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In general, aAll banks are had having greater difficulties than
normal getting in obtaining funding from the market but
specifically, Northern Rock is much more exposed than its rivals
to this disaster for mortgage debt as its business is
overwhelmingly focused on providing mortgages, rather than
other kinds of banking business.10 as a specialist mortgage
lender, no-one really wants to lend to Northern Rock. Northern
Rock was then forced to turn to Bank of England for emergency
funding to finance its lending ever since money markets seized
up over the summer 2007. The British Government moved to
reassure investors with the bank, with account holders urged not
to worry about the bank going bust11. Northern Rock is much
more exposed than its rivals to this disaster for mortgage debt
as its business is overwhelmingly focused on providing
mortgages, rather than other kinds of banking business.12
6.0
10 "Northern Rock gets bank bail out", September 13, 2007, downloaded at http://news.bbc.co.uk/2/hi/business/6994099.stm
11 Chris Giles, Jane Croft, Kate Burgess and Gillian Tett, "£3bn lent to Northern Rock", Septemnber 22, 2007, The Financial Times
Limited, downloaded at http://www.ft.com/cms/s/0/dbe3a046-68a4-11dc-b475-0000779fd2ac.html?nclick_check=1.12
"Northern Rock gets bank bail out", September 13, 2007, downloaded at http://news.bbc.co.uk/2/hi/business/6994099.stm
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7.0 Soh Chiew : how to avoid scenarios in future
7.0 Preventive Measures
Subprime mortgage-backed securities that sparked the credit crunch
and crisis represent an extreme version of the credit risk transfer
process in which the core banks have engaged for a long time pursuing
the business model for originate of loan and distribute the underlying
risk to a myriad of outside investors. Preventive actions that intend to,
which deter the re-the difficulty of occurrence of the current credit
crisis must necessarily focus on minimisingminimizing the possibility of
circumstances that encourage dysfunctional financial
behaviouralbehavioral such as conflict of interest , undesirable
eventsmoral hazard or adverse selection .is the main defense to avoid
the above scenarios in future Therefore, improvements to the existing
financial controls must focus on the creation and enforcement of
mechanisms to promote much more transparency and fair competition
in credit marketplace transactions, standardisationstandardization of
risk management methodologies, and stronger accountability and
responsibility in the oversight of regulatory compliance within
commericalcommercial financial institutions. (Riehl, 2008)
Improvements In Accountability In Regulatory Compliance .
Government has a role to play in advancing people prosperity by
providing stable macroeconomic and financial conditions for
sustained growth, demanding transparency and ensuring fair
competition in the marketplace.
7.1 Improvements in Accountability in Regulatory
Compliance
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Firstly, the heightened competition generated excessive risk-
taking by banks which was not supported by commensurate
enhancements to corporate governance processes and the risk
management infrastructure. This resulted in a significant
underestimation of risks being borne by banks. Effective
corporate governance and a good risk management practice by
banks that will protect against the seduction of high yields and
profits which result from assuming excessive and unpredictable
credit risks . (Riehl, 2008)
An applied example would be such as credit crunch is the use of
the Product Program Processs , building that build a sound
internal control and enhance effective internal audit function.
The Product Program Process scrutinizing scrutinizes and x-
raying rays complex products such as sSub- prime mortgage, for
assessing credit and liquidity risks. It and helps assure customer
suitability and appropriateness of a financial product . (Riehl,
2008). A Home Score system that will allow consumers to find
out more about mortgage offers and their capability to make
payments can be proposed. (Obama’08, 2008)
The Committee of Sponsoring Organizations (COSO) internal
control is assuring segregation of responsibilities, strengthen
managements’ oversight responsibilities, the use of best
practices protecting against errors and frauds which resulted the
credit crunch. A tough new penaltiesTough new penalties on
fraudulent lenders can be proposed.Toproposed . (Obama’08,
2008). To enhance the internal audit function’s effectiveness, an
audit quality assurance should be developed by professional
staff and reporting directly to the Board of Independent
Directors. (Riehl, 2008)
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7.2 Transparency and& Fair Competition
The subprime problem is a clear reminder of how fast and
decisively market conditions can change when the credit and
liquidity risk landed back on bank. It points to the danger of
thinking that banks will have enough lead-time to ramp up their
capital as economic conditions deteriorate. Regulators such as
central banks need to find a way to deal with the off-balance
sheet operations of banks that to improve transparency
concerning banks’ effective exposure to risk and ensure that
banks have a strong enough capital cushion to withstand a
downturn. (FDIC, 2007)
Furthermore, regulators must remain vigilant on trading activity
that crosses the line to market manipulation. The regulators
should investigate and punish any kind of market manipulation.
For instance, Central Bank of Malaysia continues to direct
significant effort and resources towards strengthening
surveillance capabilities enhanced with more holistic risk
assessments to detect, monitor and to deal anticipatorypre-
emptively with emerging risks and vulnerabilities in the financial
system. (Riehl, 2008)The enhanced supervisory intervention
powers such as strengthen safety net by the lender of last resort
is to be embodied in the amendments to various registrations
administered by central bank.
Investors were also over-reliant on credit ratings which were
based on methodologies which lacked transparency about the
rating parameters. Improvement of the credit rating quality play
important role to increase credit worthiness and to avoid future
credit scrunch scenarios. The rating process should be re-
examined and improved through such means as third party
reviews of rating processes to encourage greater transparency _____________________________________________________________
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to the risks involved with any investments products (Riehl,
2008).
. (Wikepedia, 2008)
Furthermore, banks themselves should be responsible for
educating the customer on the fundamental mechanisms, logic
and the intent of a product and to evaluate the suitability and
appropriateness of a product for a given customer. (Riehl, 2008)
7.3 StandardisationStandardization of risk management
methodologies
The capacity for regulatory framework stimulus to be
undertaken to manage the risks to growth is important to avoid
the credit crunch scenario such as Basel II (the second of the
Basel Accords), which are issued by the Basel Committee on
Banking Supervision. Regulatory frameworks such as The
purpose of Basel II, (the second of the Basel Accords), which are
issued by the is Basel Committee on Banking Supervision, canto
also drive the creation ofcreate an international standards that
banking regulators can use to set up rigorous risk and capital
management requirements requirements. designed to ensure
that a bank holds capital reserves appropriate to the risk the
bank exposes itself to through its lending and investment
practices and to ensure more risk-sensitive capital. Basel II uses
a "three pillars" concept – minimum capital requirements
(addressing risk), supervisory review and market discipline – to
promote greater stability in the financial system (FDIC, 2008).
. (wikipedia, 2008)
Nevertheless, there are criticismstisms on whether the Basel II
advanced approaches can tie capital requirements to risk is
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subjective. Banks could be measuring identical risks in different
ways. Its wide latitude in capital requirements could lead to
inconsistency across banks, thus it could lead regulators to
accept capital requirements that are too low. (FDIC, 2007) In
general, an inadequate Pillar 1 capital requirement,
supplemented by inadequate consideration of potential stress
under Pillar 2, will end up with inadequately capitalized bank.
Given this uncertainty, regulators must proceed with caution.
Safeguards against precipitous and open-ended declines in risk
based capital requirements should be removed only when the
global framework has proved its capital sufficiency and
reliability.
Another notable improvement is that most credit derivative
contracts now reference standard definitions published by the
International Swaps and Derivatives Association. Also more
recently, some financial exchange organisationsorganizations’
have launched standardisedstandardized indices for credit
derivatives such as Itraxx in Europe (MarkIt Website) and the
fully exchange-traded CME credit index event contracts
originated in the Chicago MerchantileMercantile Exchange which
reflects a shift towards centrally cleared
standardisedstandardized contracts that reference a fixed
number of obligors.(CME Website 2007)
7.4 The Emergence of the Islamic Banking/ Finance
Islamic banks have been largely shielded from the U.S.
mortgage crisis because Islamic banks shunned collateralized
debt obligations linked to subprime, or high risk, mortgages
because such complex instruments do not comply with Muslim
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Sharia law. For instance, lenders in the Gulf and Malaysia, the
global hubs of Islamic finance, barely reported any subprime
related losses. (Thomson Reuters, 2008) Hence, conventional
banking could do well to learn from Islamic banking principles in
area of financial risk management. Investors were over-reliant
on credit ratings which were based on methodologies which
lacked transparency about the rating parameters. Improvement
of the credit rating quality play important role to avoid the credit
scrunch scenario in future. It helps evaluate and report on the
risk involved with various investment alternatives. The rating
process can be re-examined and improved such as third party
reviews of rating processes to encourage greater transparency
to the risks involved with any investments products. (Wikepedia,
2008)
Going forward, embedded cooperation arrangements among the
central bank and various regulatory agencies in advancing
cross-border cooperation in the region for dealing with crisis will
continue be further enhanced by various mechanisms for
cooperation and coordination in surveillance, information
sharing and crisis management. Furthermore, the banks are
responsible for educating the customer on the fundamental
mechanisms, logic and the intent of a product and to evaluate
the suitability and appropriateness of a product for a given
customer.
A simple message from this current credit crunch should be
clear to all the key players (losers) within the financial
marketplace starting from institutions that originate or trade in
credit derivative products to the rating agencies who assess
credit risk to government regulators who establish and monitor
the guidelines that shape the market to the (largely)
unassuming public investors: There is no such thing as a free
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lunch. Any iInvestment schemes orand businesses offering profit
margins significantly higher than the “risk-free” rate of return
must be must be subjected to the same scrutiny as investments
that cause losses. Whenever the returns are high, there must be
notable risks because there is no free lunch.
8.0 Conclusion
A simple message from this current credit crunch should be clear to all
the key players (losers) within the financial marketplace starting from
institutions that originate or trade in credit derivative products to the
rating agencies who assess credit risk to government regulators who
establish and monitor the guidelines that shape the market to the
(largely) unassuming public investors:; “There is no such thing as a
free lunch.” Any investment scheme or businesses offering profit
margins significantly higher than the “risk-free” rate of return must be
subjected to the same scrutiny as investments that cause losses.
9.0 References
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Lim’s References
[1] Bernanke, Ben S., and Lown, Cara S, 1991, “‘The credit
crunch”’, Brooking Papers on Economic Activity , Issue 2, p.
205-247.
[2] Owens, Raymond E., and Schreft, Stacey L., 1992, “‘Identifying
credit crunches”’, Federal Reserve Bank of Richmond Working
Paper No. 92-1.
[3] Scott, David L., 2003, Wall Street Words: An A to Z Guide to
Investment Terms for Today’”s Investor, Boston: Houghton
Mifflin.
[4] Lee, Jong-Wha and Park, Cyn-Young, 2008, ‘“Global Financial
Turmoil: Impact and Challenges for Asia’”s Financial Systems,
ADB Working paper Series on Regional Economic Integrtaion
No. 18.
[5] Whalen, Charles J., 2007, ‘“The US Credit Crunch of 2007 – A
Minsky Moment’”, The Levy Economics Institute of Bard
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[6] Ivry, B. and Shenn, J., 2008, ‘“Exploding ARMs Roil Bernanke'’s
Drive to Calm Markets’”. Retrieved 29th June, 2008 from
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[7] Howley, Kathleen M., 2007, ‘“Rating Subprime Investment
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2008 from http://www.bloomberg.com/apps/news?
pid=newsarchive&sid=ajdL7eUHeUro.
[8] Levitt, Jr., 2007, ‘“Conflicts and the Credit Crunch’”, Wall Street
Journal (Eastern edition), 7th September.
[9] The Economist, 2008, ‘“Ruptured credit’”, 15th May.
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2. Allen and Overy, 2002, Z’s References
3. International Swaps & Derivatives Association “AN
INTRODUCTION TO THE DOCUMENTATION OF OTC
DERIVATIVES”. Retrieved 4th July, 2008 from ALLEN & OVERY
May 2002
http://www.isda.org/educat/pdf/documentation_of_derivatives
.pdf
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[2] Credit Derivatives Explained :Market, Products, and
Regulations. Retrieved 4th July, 2008 from
http://www.investinginbonds.com/assets/files/LehmanCredDeri
vs.pdf.
[3] Bomfim, Antulio N., “Understanding Credit Derivatives and
their Potential to Synthesize Riskless Assets”, Antulio N.
Bomfim , Federal Reserve Board July 11, Retrieved 4th July,
2008 from 2001
http://www.federalreserve.gov/Pubs/feds/2001/200150/200150
pap.pdf
[4] V. Kothari, 2002, “Introduction to Credit Derivatives, Credit
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, ISBN Number: 81-901463-0-0Retrieved 4th July, 2008, from
http://credit-deriv.com/introduction%20to%20credit
%20derivatives%20article%20by%20Vinod%20Kothari.pdf.
[5] Tett, G., 2006, “The dream machine: invention of credit
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Published: March 24 2006 15:21 | Last updated: March 24
2006 15:21 http://www.ft.com/cms/s/0/7886e2a8-b967-11da-
9d02-0000779e2340.html?nclick_check=1.
[6]
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Shaw, R., 2007, “Albert’s References :
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[13][[14]] Associated Press, 2008 “JPMorgan Chase Funding Bear
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[21][[22]] Thomson Reuters, 2008, “Islamic banks shielded from
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/idUSL0421657020080204?pageNumber=2
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Soh Chiew’s References
?
Lim’s Bibliography
10.0 Bibliographies
[1] Wallenwein, A., 2007, ‘“Credit Crunch – or Credit Collapse?’”.
Retrieved 28th June, 2008, from
http://www.safehaven.com/article-8972.htm.
[2] Clair, Robert T. and Tucker, P., 1993, ‘“Six Causes of the Credit
Crunch’”, Economic and Financial Policy Review, 3rd Quarter,
p.1-19.
[3] Mishkin, Frederic S., 2007, The Economics of Money, Banking,
and Financial Markets, Eighth Edition, Pearson International, p.
234.
[4] Stiglitz, J., and Weiss, A., 1981, ‘“Credit rationing in markets
with imperfect information’”, American Economic Review,
Issue 71, p.393-410.
[5] K. Choudhury, 2006, “Credit Default Swaps: Development,
Pricing and Correlation To Default Risk”. Retrieved 4th July,
2008, from http://www.crisil.com/crisil-young-thought-leader-
2006/dissertations/Kaushik-Choudhury_Dissertation.pdf
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Gibson, M., 2007, “Z’s Bibliography
Credit Default Swaps : Development, Pricing and Correlation
To Default Risk , K.Choudhury 2006
http://www.crisil.com/crisil-young-thought-leader-
2006/dissertations/Kaushik-Choudhury_Dissertation.pdf
[6] Credit Derivatives and Risk Management , Finance and
Economics Discussion Series”. Divisions of Research &
Statistics and MonetaryAffairs Federal Reserve
Board ,Washington,D.C. Retrieved 4th July, 2008, from Michael
Gibson 2007
http://www.federalreserve.gov/Pubs/feds/2007/200747/200747
pap.pdf.
[7] Pool, F., and Mettler, B., 2007, Countdown to Credit Derivative
Futures. Retrieved 4th July, 2008, from
http://www.securitization.net/pdf/Publications/CreditDerivative_
Mar07.pdf.
Countdown to Credit Derivative Futures, Fiona Pool and Betsy Mettler
, Mar 2007
http://www.securitization.net/pdf/Publications/CreditDerivative_
Mar07.pdf
[8] BBA – Credit Derivatives Report 2006
[9] ISDA Market Survey Year End 2007. Retrieved 4th July, 2008,
from http://www.isda.org/statistics/recent.html.
[10] MarkIIt – ITraxx CDS Indices. Retrieved 4th July, 2008, from
http://www.indexco.com/
[11] CME Website - CME Credit Index Event Contracts. Retrieved 4th
July, 2008, from
http://www.cme.com/trading/prd/ir/creditevent.html
[12] Giesecke, K., 2004, “CREDIT RISK MODELING AND VALUATION:
AN INTRODUCTION”. Retrieved 4th July, 2008, from , Cornell
University, Kay Giesecke ,2004
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http://www.stanford.edu/dept/MSandE/people/faculty/giesecke/
introduction.pdf.
[13] James, J., 2008, “Credit derivatives - How much should they
cost?” Retrieved 4th July, 2008, from
http://www.financewise.com/public/edit/riskm/credit/cre-
deriv.htm.
Credit derivatives - How much should they cost? , Jessica James
Albert’s Bibliography
Soh Chiew’s Bibiliography
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