The road to systemic risk

1. What were the main causes for the financial crises according to prof.
Corcoran? In what order would he rank them and why? Do you agree with
him?
- Causes :
The fundamental issue was a misjudging of risks (ex: securitization of
subprime loans) taken and an inability to manage or curtail them
Banks had gone to great lengths to raise their leverage levels to
unprecedented highs, based on the premise that higher leverage
necessarily improved returns but the premise began to lose validity when
losses mounded and provisions for losses were inadequate
Risk had become hard to understand, much less tame and was
underestimated

- Rank order :

2. Who were the key players in crises and how might their behavior have
contributed to it?
- Key players :
Financial institutions
Rating agencies
The SEC
The FED
Bear Stearns
US government

3. What could be learned from other crisis during Japanese lost decade during
1990? How similar 2007-2009 crisis is to that one?
- Japan :
A financial crisis in the financial services sector is the worst
It took 5 years to move from asset sales to capital injection ( for US it took
2 months)
Some banks need more money than others

4. What suggestions does prof. Corcoran offer for getting out of the crisis? Why?
What suggestions could you add to the list?
- Suggestions :
The global environment necessitated international coordination and smart
regulation (starting with the banking sector)
Raise capital (sell assets, cut payouts and expenses,get injections)
Return to profitability ( M&A, green, infrastructure)
 Invest (in people and systems)
Raise confidence (transparency, expertise)
Value risk management ( give managers more authority,pay them
well,incentive accordingly)
Hope for a turnaround
Risk management must be elevated

The weekend that changed Wall Street

1. Why did Leeman brothers fail? What are the consequences of Leeman
Brothers failure for investment sector and the markets in a broader context?
Explain
- Why :
Bad mortgage-related investment resulted in billions of dollars in write downs
Liabilities exceeded assets
Real-estate portfolio was in worse shape than expected

- Consequences :
Bad (huge negative) impact on commercial paper and credit-default-swap
(CDS) markets
o It was one of the largest dealers in commercial paper market
o It was a top 10 counterparty in CDS market
Far reaching impact on investors, resulting in a seismic shock to financial
markets around the world
o Investors lost confidence in the model that was the backbone of Americas
financial system (FED)

2. What is the importance of the commercial paper market? Why did Leeman
Brothers failure have an impact on it?
- Importance :
As part of the global money market, commercial paper was a short term
unsecured instrument issued by a corporation as a means to finance short-
term debt obligations
The short term nature of the commercial paper and the credit worthiness of
the issuer and borrowers resulted in being the most safe and liquid
investment on the market which comprised a very large part of money
market funds

- Why :
After the support offered by the FED to the sale of Bear Stearns to JPMorgan,
the investors had assumed an ultimately false sense of security that had
 seismic consequences when the Leeman Brothers failed, causing a reaction
which was possibly the largest melt down in the history of commercial paper
market
Before the fail, investors did not hesitate to buy commercial paper from
Leeman Brothers, but after, The Reserve Primary Fund, a large money market
fund that invested largely,, broke the buck (asset value droped below 1$)
causing a ripple effect through investors who pulled their money to invest in
shorter-term investments resulting in drying up the commercial paper
market.

3. What is a CDS? Why do funds invest in them? How do they create them?
- What is :
Contracts that involve the transfer of credit risk associated with debt by
allowing the owner of the debt protection against default and credit rating
downgrades
Insurance for the buyer by paying a premium for protection against default

- Why :
Originally created to lower financial institutions exposure to risk by providing
credit insurance on bonds against default
By growing and evolving, the market transformed form one in which CDSs
were used as insurance to one in which they became speculative instruments
that allowed investors to bet on a companys default. With increased
speculation, the market grew exponentially

- How :
Sale of insurance to investors against the chance of other firms default
Contracts that allow the transfer of credit risk to another party without the
sale of the loan

4. What is counterparty risk? How might investment in CDS lead to systemic

risk?

- What : counterparty risk is the risk that a counterparty in a trade fails to satisfy
its obligations

- What : buying CDS contracts, investors are shorting bonds which limited their
exposure to risk

Systemic risk = the collapse of an entire system or an entire market

- In the case of Leeman Brothers, systemic risk was the failure of the banking
model