.

Spring 2010

Lecture Notes
for
Mathematical Methods in Financial Economics

c
Tom Cosimano (Finance) & Alex Himonas (Mathematics)
University of Notre Dame

1
 Preface
These notes have been designed for Mathematical Methods in Financial Economics (MMFE),
which is listed as Math 40570 & 50570 and Fin 40820 & 70820. MMFE is an interdisciplinary course
in that it has been developed by faculty from and is designed for students of different disciplines.
We have found in our research that major advances in financial economics can be achieved through
the cooperation across disciplines. The hope is that students will go on to make contributions to
financial economics. We want the students to interact with other students who are not in the same
field of study. For example, math majors can help business students with their analytic training
and business majors can help math students with their business knowledge.
This is the third time that the MMFE has been taught. In the previous two times each of us
taught the material in which we specialize. Now we are going to rotate from year to year in which
one of us teaches the course and the other person acts as a facilitator. The facilitator serves as a
resource for the class in case a situation arises in which his expertise are needed. Also, this will
enhance the interdisciplinary knowledge of both of us.
These notes are written so that all the necessary mathematical background is provided for finance
and economics majors, while all the necessary financial information is developed for mathematics
and economics majors. They are subdivided into units which cover a broad range of topics in finance
and economics as well as the mathematical methods needed for their quantitative analysis.
• The first unit provides an overview of the subprime lending crisis. This unit provides an
overview of the challenges faced by quantitative analysts of financial problems given that
most people view the financial crisis as an outgrowth of mathematical finance.
• A survey of financial instruments which will be analyzed in this course.
• How do financial analysts assess risk and investor’s reaction to it?
• The binomial model of derivative pricing and how it leads to the Black-Scholes model.
• Estimating the probability of a default by a corporation using the Black-Scholes model.
• How do individuals choose portfolios of stocks and bonds?
• The determination of the equilibrium price of stocks in a binomial world, including the rela-
tionship between equilibrium and no arbitrage price of stocks.
• Stochastic calculus.
• Derivation of Black-Scholes-Merton option pricing formulas using stochastic calculus and par-
tial differential equations.
• The equilibrium pricing of stocks and bonds using stochastic calculus.

We benefited from the comments of students who have taken this course in the past. In par-
ticular, we would like to thank Marianne Beyer, Conor Bruen, Kyle Dempsey, Curtis Holliman,
John Holmes, David Karapetian, Peter Kelly, Katherine Manley, Jonathan Poelhuis, Rachel Sun
and Dan Xu for providing detailed comments on earlier drafts of these notes. Finally, we would
like to thank Provost Thomas Burish for providing the initial support for the development of this
course as part of the Provost’s Initiative on Team Teaching.

2
1 Introduction: The Subprime Lending Crisis and Quants
In these lectures we will use the Subprime lending crisis to illustrate various ways quantitative ana-
lysts, quants, used risk management techniques and financial instruments to increase the availability
of home mortgages. We also discuss some of the mistakes and fraudulent behavior by quantitative
analysts which occurred during the Subrime lending crisis. Through this discussion we want to pro-
vide examples as to why managers need to learn about quantitative methods. In addition, we want
to caution quantitative analysts about the possible misuses that can occur with these techniques.
In this overview of the Subprime crisis we will introduce various terms and concepts which you
will become familiar with over the semester. To focus your attention we highlight unresolved issues
which will be discussed throughout the semester. Also, those terms in bold are defined in the
glossary at the end of the chapter.

1.1 Commercial Banking and Mortgage Loans

The core business of a commercial bank

is to accept deposits from millions of in-
dividuals who have small amounts to save.
These funds are then invested in many
companies and mortgage loans which
are lent to corporations and individuals. It
is the bank’s fiduciary responsibility to
make sure the borrowers have a reasonable
chance of paying back the loan. Thus, the
main service provided by a bank is to mon-
itor these borrowers, so that the depositors
do not lose any of their funds.
Figure 1. Balance Sheet Commercial Banks

Businesses and homeowners usually are going to undertake a project which usually takes a long
time to pay off, such as the building of a factory. As a result, they want long term loans with a
fixed interest rate. This means that loans are not liquid in that it is not easy to sell the factory or
house without taking a substantial loss. This makes the bank’s revenue relatively certain for a long
period of time. On the other hand the depositors like the flexibility of being able to withdrawal
their funds whenever they want. This makes the funding from deposits unstable and subject to
fluctuation in market interest rates.1 As a result, the bank has liquid liabilities and illiquid assets.
To meet unanticipated deposit withdrawals a prudent bank holds 5% in cash and 14% in marketable
securities such as U. S. government securities (see the balance sheet for top 508 banks that have
1
Since the 1930’s the federal government insures small deposits through the Federal Deposit Insurance Corporation
(FDIC). In September 2008, the insurance was increased from $100, 000 to $250, 000 for individual deposit accounts,
the insurance now covers all commercial checking accounts. The insurance applied to money market funds for
one year, because of concerns raised by the Subprime lending crisis. In particular, depositors of money market funds
withdrew over $400 Billion after the failure of Reserve Market Fund to maintain 100% net asset value for its money
market fund. This failure followed large losses by Reserve Market Fund from holding of Lehman Brothers commercial
paper.

3
more than $1 Billion).2 As a result, the bank can serve both the needs of the depositors and the
borrowers. The bank holds equity to guard against the fluctuation in deposits, as well as possible
default of some loans. In the balance sheet above we see that the typical commercial bank issues
56% of its assets as loans and holds 10% of its assets as equity. Equity is the difference between
the bank’s assets and liabilities. Equity is how much assets would be left over after all the bank’s
liabilities are paid off. This equity is the property of individuals who hold shares of stock in the
bank.

Unresolved Issue 1: How does one calculate the current value of assets? How does one measure
the sensitivity of an asset to changes in interest rates?

In this discussion we will focus on home mortgages, since they are the source of the Supprime
lending crisis. The typical home mortgage is for 30 years and has a fixed rate for the term of the
loan, 5.09% in January 2010. To qualify as a prime mortgage borrower the home owner puts up
20% of the home value and must have a good credit rating. These mortgages are relatively safe,
since the price of a house would have to fall by 20% before it is in the interest of the borrower to
declare bankruptcy. As a result, a prime mortgage goes into default only when the homeowner
faces some difficulty such as unemployment and/or poor heath. In this case the bank has the
right to repossess the property in a legal procedure which is called a foreclosure. Even today the
foreclosure of prime home mortgages is less than 2% of mortgages per year.

Historical Note: Before 1930 home loans were for a much shorter term, so that the homeowner
had to refinance the mortgage every few years. If banks did not have enough deposits, they would
not issue a new loan. In this case the homeowner had to sell the house to pay off the loan. To solve
this problem in 1932 the U.S. government set up Federal Home Loan Banks to insure prime
home mortgages, when a bank did not have sufficient funds. In this case FHLB would provide the
bank with sufficient funds, when there was a sudden decline in deposits, so that the bank did not
have to force early repayment of the loan by the borrower. As a result, FHLB was designed to help
banks with the illiquidity of home mortgages. Freddie Mac was a private corporation set up in 1970
by U. S. Government to further increase the availability of home mortgages.

Example 1. A Typical Mortgage has a term to maturity of 30 years. Assume a homeowner

takes out a $100, 000 mortgage on a house worth $125, 000. At current rates of 5.09% the monthly
payment would be $433.87 for 30 years. In the first month the interest payment is $339.33 and the
payment of principal is $94.54. In the 360th month the interest payment is $1.83 and the payment
of principal is $430.77.

Exercise 1. Verify these numbers using Math 10260 (Calculus for Business) formulas.

2
Data is from FDIC call reports for commercial banks.

4
1.2 The Advent of Mortgage Backed Securities
A Savings and Loan Association S&L is a financial corporation that accepts deposits and only
invests in home mortgages. As a result of the large increase in interest rates in the late 1970’s and
early 1980’s many S&Ls went into bankruptcy, since the cost of deposits went up but the revenue
on the fixed rate mortgage loans stayed constant.3

Example 2. In December 1971 the 30 year home mortgage rate was 7.48%, while the six month
certificate of deposit (CD) rate was 4.89%. By December, 1979 the six month CD rate was at
13.42%. As a result, S&Ls that issued mortgages in December 1971 made 2.59% for expenses and
profits per each dollar of mortgages. Yet, by December 1979, the banks were losing 5.49% on the
30 year home mortgages which were issued in 1971. They also had to cover their expenses. As a
result, the S&Ls lost substantial amount of equity in 1979. In addition, the CD rate did not drop
below the 1971 mortgage rate until 1986.4

Figure 2. Balance sheet of SIV Figure 3. Balance sheet of Insurance Company

Based on this experience the commercial banks wanted to reduce the reliance on home mortgages.
As a result, quants developed mortgage backed securities. In this case the bank sets up a
separate company called an Structured Investment Vehicle (SIV) to fund the mortgage backed
security. Suppose the bank wants to remove $100 million of 1000 mortgages, worth $100, 000 each,
from its balance sheet. For a plain vanilla mortgage backed security the bank would enter into a
contract with the SIV which promises the interest and principal payment each month for 30 years
from the 1000 mortgages.5 For the typical mortgage in example 1 the payment would be $433, 870
per month for 360 months. This promise is recorded as an asset on the balance sheet of the SIV in
Figure 2. The SIV would then issue $100 million of mortgage backed security to pay the bank for
the mortgages. The SIV would then sell the MBS to someone with long term liabilities such as an
insurance company. As a result, the MBS becomes an asset of the insurance company in Figure 3.
The insurance company pays for the MBS with the proceeds from insurance policies which promises
payments to individual’s heir when the policy holder dies. As a result, the insurance company has
3
The estimated cost to the U.S. government was $124.6 billion. See Wikipedia (2008).
4
You can find historical data as in this example at http://research.stlouisfed.org/fred2/ .
5
MBS can also be structured so that one MBS pays only the interest and another MBS pays only the principal.

5
long term assets and liabilities, while the bank ends up with short term assets and liabilities. To
encourage this activity Fannie Mae and Freddie Mac would provide insurance for these mortgages
in case of default by the original borrower.

Why use an SIV? The commercial banks used SIV’s to circumvent regulations. Commercial
banks are required to hold at least 6% of their risk adjusted assets as equity which the regulators
call Tier 1 capital.6 They also must hold at least 10% of their risk adjusted assets in the form
of total capital. Total capital is equity plus long term bonds. These long term bonds are called
subordinated debt.
By setting up an SIV which is legally separated from the bank, the assets of the SIV are not
included in the assets of the commercial bank. As a result, the bank does not have to hold any
equity to back up the mortgages. This procedure is called moving assets off balance sheet. It turns
out that this was mainly an illusion created for the regulators. When the SIV’s created by Citibank
as well as other major banks failed because of the decline in MBS prices, these banks recorded the
losses on the MBS as a decline in their equity.

The mortgage backed security provides a useful function. The MBS reduces the risk of both
the banks and the insurance company by reducing the exposure of both companies to fluctuation
in interest rates. With less risk the banks charge the homeowner a smaller interest rate, since the
banks do not have to collect as many funds to pay for the fluctuations in market interest rates. In
addition, the banks can focus on credit evaluation and monitoring of the borrowers, while insurance
companies specialize in providing insurance. Thus, everyone is made better off from the instrument
developed by the quants.

Unresolved Issue 2: Explain how changes in interest rates can cause bankruptcy when the assets
and liabilities of a financial corporation have different terms to maturity. Why does it make sense
for pension funds and life insurance companies to hold mortgage back security?

1.3 The Development of New Financial Instruments

With MBS the banks role is to originate the loan, monitor the borrowers’ payments, collect the
monthly payments, and distribute these payments to the holder of the MBS. This role for the finan-
cial intermediatory is called the Originate-to-distribute model of mortgage financing. Eventu-
ally, companies that specialized in the origination of home mortgages, such as Countrywide, became
the major providers of home mortgages.
The problem with this business model is that the originator of the loan was paid based on the
origination of the loan.7 Once the loan was sold off as a mortgage backed security, the originator
had little interest in whether the mortgage was paid off. As a result, the originators started to lessen
the credit standards to qualify for a loan. To fund these riskier mortgages, MBS were developed
6
The regulators allow the banks to hold less equity for safer assets, like Treasury Securities, while they have to
hold more equity to back up loans.
7
Typically, the originator of the mortgage is paid 1% of the mortgage.

6
for Alt-A and Subprime loans. Alt-A mortgages were more risky than prime mortgages, and
Subprime mortgages are riskier than Alt-A mortgages. The riskier the mortgages, the higher is the
probability of default. As the probability of default increases the expected losses increase so that
the ultimate lenders insist on higher interest rates.
Eventually, the mortgage originators could not find enough lenders to sell the Subprime MBS.
They turned again to the quants who created a derivative security called a Collateralized debt
obligation (CDO).8 In this case the MBS payments are divided into three main tranches, each
with an associated return and priority in case of default: Senior (lowest risk – AAA), Mezzanine
(intermediate risk – BBB), and Equity (highest risk, – not rated). This is illustrated in Figure 4.
Usually, the Subprime CDO would have 75% of its value in the Senior tranche which are sold to
average investors who want a low risk investment. The basic idea is that if less than 25% of the
mortgages went into default, then the senior investors would not lose on any of their investment,
see Figure 5.9 The riskier investments were sold to Hedge Funds which use leverage to increase
the return, and attract investors willing to assume additional risk for higher return. A company
increases leverage by borrowing more to finance assets rather than using its own equity.

Figure 4. Balance sheet of a CDO Figure 5. Payment priority for CDO

Example 3. How can leverage boost return on investment? Suppose a $100 investment pays $110
in one year under normal circumstances. Also suppose there is a 5% chance the investment can
fall to $95 in one year. You do not have $100 to buy this investment so you borrow $96 from a
friend for one year. In one year 95% of the time you pay back the $96 and end up with $14, so you
make a return of 14−44
= 2.5 or a return of 250%. However, 5% of the time use lose 100% of your
investment. Notice your former friend losses $100 in the bad case.

To make the CDO’s attractive the quants turned to another derivative product called a Credit
Default Swap (CDS). The issuer of a CDS guarantees that the holder of the CDO is paid even if the
mortgages goes into default. In this case the credit risk is transferred to someone willing to take on
the additional risk. These CDS were sold by insurance firms, such as AIG, and investment banks,
such as UBS.
8
This CDO was a modified version of a derivative created by Drexel Burnham in 1987.
9
See Barajas (2008).

7
Unresolved Issue 3: How does the quant establish the price of the CDO and CDS? How would
this product be structured so that the investor would take on little risk?

The role of Repurchase Agreements: Lehman Brothers and Bear Stearns relied on repurchase
agreements to lower the cost of their short term funding for mortgage backed securities. A Re-
purchase or REPO agreement is a short term loan with a security used as collateral on the loan.
Initially, Repo’s were negotiated in terms of U.S. government securities which are relatively safe
and liquid. The borrower sends a government security for 100% of the value of the loan to the
lender or an independent agent under the conditions that the security is sent back to the borrower
when the loan matures as well as an agreed upon interest payment. The loan is considered safe
since the lender possesses the security so that they can keep the security when a borrower declares
bankruptcy. The length of the Repo is generally from 1 to 90 days. Thus, Repos are considered safe
short term investments. Eventually, Repos were developed in which the security was a mortgage
backed security. If the MBS were considered riskier, then the borrower would require a hair cut. A
hair cut would let the borrower receive less than 100% of the security. The riskier the security the
bigger the hair cut.

Lehman Brothers Bankruptcy and CDOs: Lehman Brothers declared bankruptcy on Septem-
ber 14, 2008 as a result of large losses on subprime mortgages. Figure 6 illustrates the financial
position of Lehman Brothers before bankruptcy. They had invested in MBS and equity tranche
CDOs. Lehman Brothers had a leverage ratio of about 30 to 1 in that they held only about 3% in
the form of equity.10 They funded these assets with commercial paper which was highly rated be-
cause of the the past history of Lehman Brothers. As the default rate on subprime mortgages went
up the market price of the MBS and CDOs decreased so that Lehman Brothers assets declined by
more than 3% in value and the equity of Lehman Brothers went negative. Thus, they had to declare
bankruptcy.11 When the subprime crisis first developed in the summer of 2007 MBS decreased in
value. The hair cut on Repos for MBS started at 1% in July 2007 and increased to 8% by November
2007 and 45% by November 2008.12 As the haircut increased Bear Stearns and Lehman Brothers
faced a liquidity crisis since they could not fund their holding of MBS with Repos. First, Bear
Stearns was sold to J.P. Morgan on March 19, 2008 which was financed by $29 Billion in loans from
the Federal Reserve Board. On September 14, 2008 Lehman Brothers declared bankruptcy since
the Federal Reserve and U.S. Treasury did not find someone like J.P. Morgan to buy the assets of
Lehman Brothers.13
10
The leverage ratio is total assets dividend by equity.
11
When a company declares bankruptcy the individuals who hold the company’s liabilities are paid off according
to the language in the contracts. The individuals who hold share of stock in the company are paid whatever is left
over once all the liabilities are met.
12
See Gorton and Metrick (2009).
13
See Wessel (2009).

8
 Lehman Brothers Merrill Lynch

Commercial Paper Money Market Funds

of Lehman $1999
MBS and Commercial
$970
CDOs Paper $970
U.S. Treasury Securities
$990 Equity $30 $1030
Equity $1
Cash Reserves
$10

Figure 6. Balance sheet of a CDO Figure 7. Payment priority for CDO

This bankruptcy of Lehman Brothers had severe repercussions for the commercial paper market.
The commercial paper of Lehman Brothers was bought by investment banks like Merrill Lynch who
attracted short term deposits from average investors (see Figure 7) . These deposits are called
money market funds. Merrill Lynch promised investors that they would only invest in short term
US Treasury securities and short term commercial paper issued by highly rated companies. As a
result, Merrill Lynch did not hold much equity or cash reserves, since they invested in short term
safe assets. On September 16, 2008 Reserve Primary Fund declared that its mutual fund was now
worth 97% of its original value, since it had a large exposure to Lehman Brothers commercial paper.
Over the next few weeks institutional investors withdrew $193 Billion from money market funds.
As a result, the collapse of Lehman Brothers lead to a collapse of the funding for commercial paper
for all companies. This collapse of money market funds is similar to the collapse of banks in the
1930’s in that investors became concerned about the value of the company’s assets so they withdrew
the liquid deposits. On September 19, 2008 the US Treasury stepped in an announced that money
market funds would be insured like bank deposits for the next year.
If one compared the balance sheet of a commercial bank in Figure 1 with the combined balance
sheet of Lehman Brothers and Merrill Lynch one can see why there was a collapse of this shadow
banking system. The combined companies funded long term illiquid assets with short term liabilities.
Once the underlying assets lost more value then the equity the depositors become concerned about
the possibility of getting their deposits back. The depositors are concerned because they would not
get their funds back if they are the last person to withdrawal their funds since there is not enough
assets to pay all the depositors. As a result, the depositors rush to get their funds out of the bank.
This explains why the US treasury stepped in to insure these deposits to avoid a further collapse.14

AIG Bankruptcy and CDS: At the end of 2007 AIG held $562 Billion in CDS for MBS which
was more than half AIG’s assets. A London based subsidiary of AIG which was called AIGFP, and
managed by Joseph Cassano, had sold these CDS. When the Subprime lending crisis started AIG
had to pay off on these CDS. As a result, a small subsidiary of the largest insurance company in the
world was able to force AIG to the brink of Bankruptcy in September 2008.15 One question to ask
is why the managers of AIG let this rogue group continue to operate without appropriate hedging
14
See Diamond and Rajan (2009).
15
Forbes September 28, 2008. See WSJ article 10/31/08 ”Behind AIG’s Fall, Risk Models Failed to Pass Real-World
Test,” for article on role of quant, Gary Gorton, in the downfall of AIG.

9
of risk. Was it because the Managers of AIG did not realize the risk taken on by AIGFP? Was it
because the Manager’s of AIGFP were given incentives to take on excessive risk? Was the Bailout
of AIG by the U.S. Treasury appropriate? In particular, should they have allowed 100% payment
on the CDS to large financial firms such as Goldman Sachs?

1.4 The Subprime Meltdown

To understand the Subprime lending crisis we need to recall the economy after the 2001 recession.
There was a general expansion of global liquidity and savings which led to an investment boom
across the world. Global savings per year increased from $35 trillion in 2000 to $68 trill in 2006.
Most of this increase in savings was done in emerging markets such as Brazil, China, India, and
OPEC countries. As a result, total financial investment increased from $94 trillion in 2000 to $167
trillion in 2006. Most of these financial investments were made in the United States and Europe.
This lead to relatively low interest rates across the world. In addition, U.S. monetary policy was
easy. For example the federal funds rate fell from 6.5% in early 2001 to a minimum of 1% in
2003 where it stayed for over a year.16
16
See Barajas (2008).

10
In this environment of chasing FRB: Monetary Policy Report to the Congress, July 15, 2008
returns, the new mortgage in-
struments proved to be attrac-
tive. The MBS market grew
from $2, 800 Billion in 2000 to
$6, 600 Billion in 2007. The
Alt-A mortgages went from $44
Billion in 2000 to $765 Billion
in 2007. The Subprime mort-
gages increased from $81 Billion
in 2000 to $730 Billion in 2007.a
With the huge expansion in
mortgage lending there was a
corresponding increase in the
price of housing through 2005
(see Figure Housing Prices).b As
a result, more people thought the
price of housing would always go
up. To accommodate this per-
spective home owners originators
developed what are called 2/28
Subprime loans. For a borrower
who had not saved 20% of the
value of the house, they would be
qualified for a Subrime mortgage
with a very small down payment.
a
Source Gordon (2008).
d
b
Source Federal Reserve Monetary
Report to Congress July 2008.
The rising volume of foreclosures likely has contributedt
the upward
The interest rate on the 2/28 Subprime would be trend
fixed forthat
the began
first twoin lateat2006,
years about
a low rate, then550,000 lo
in the first quarter of 2008--more than doublethe average
after two years it would increase to a higher rate, equal to LIBOR plus a risk premium to account
for the high probability of default. Some of these borrowers could not afford the higher payment,
Thiswould
but it was presumed that housing prices rise increase
in foreclosure starts
enough so that thewill increase
borrower theout
could take supply of h
a prime loan after two years. The can makewould
originator up themakemissed payments
more money when theorprimearrange with the len
mortgage
would originate a new 3
their loans modified. Lenders and mortgageservicers ha
was issued after two years, since they loan. As a result, these Subprime
loans were more risky if the price of housing fell. The trend in down payment on mortgages was
remarkable. For mortgages issues inborrowers
1976 the downto payment
modifywas loans
18% to allow borrowers
on average. By 2005 − 2006to remain in
the median down payment decreased borrowers
to 2%, and maymorenot thanbehalf
able to afford
of the borrowerseven reduced
had no down month
payment. may not wish to keep their propertiesin an environmento
share
As the price of housing increased of foreclosure
less and less individualsstarts that ultimately
could afford result in the loss
a home. In particular,
higher in the current episodethan customarily
housing became more expensive relative to renting (see Figure 1 from Ceccehti (2008)). Ashas
a been th
result starting about 2005 the increase in the price of housing started to decline. Subsequently,
" Recent
delinquency rates on Subprime mortgages Federal
increased fromReserve
a usual 5% Initiatives
to 15% by to 2005Address
and stayedProblems i
there (see Figure 1.8, IMF (2008)).
The rates of delinquencycontinuedto rise in the first few
categoriesof mortgageloans. Problems remainedespecia
However, 11
the growth rate of subprimedelinquencieshas s
prime and near-prime delinquencies- -particularly on adju
 APRIL 2008 2

Figure 1 Ratio of home prices to rents

15

14

13

12
Average 1960 to 1995 = 10.0

11

10

8
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Source: Ratio of F ederal Reserve Board flow of funds v alue of residential real estate, table B.100 line 4 to Bur eau of Economic Analysis national
income and product accounts housing service consumption, table 2.3.5 line 14.

As we will see, while these changes may have helped residential mortgage pools might not be what they
Forthey
a bit, Subprime
have notloans originated
been able to keep atthethe peak
problem s inof prices in 2005
should have(2006)
been. Todelinquency rateshappened,
understand what increasedwe to
the financial
30% (35%) by system
2008. fromAhaving
similar anpattern
impact on real eco- in Alt-A
developed can lookandat prime
a few selected pieces of information,
loans, however start-
the delinquency
nomic activity. In the end, the losses financial
rates decreased as the riskiness of the loan declined. interme- ing with home prices. Figure 1 plots data on the r atio
diaries incurred have damaged their capital. With lower of the total value of residential real estate to a measure
levels
Withof capital, there has
the increase inbeen a forced
default ratesreduction
the hedge in fundsof the rentalto
started value
loseatmoney.
an annual rate. Equivalent
Although to ait
initially
credit extended. Fixing thi
s requires recapitalization of price-earning s
was a relatively small amount. When a home owner defaults there is maybe 90% of the house value ratio for equity, data beginning in 1955
the financial
left, so the loss system,on not
thejust changeswould
portfolio in central bank30% default
equal make clearratehow× extraordinary
10% loss ontheeach first five years =
default of the
3%.
lending practices. 21st century were. Normally, home prices are between 9
Thus, only the equity tranche of the CDO suffered losses. Thus, hedge funds losses increased but
and 11 times the annual level of rent paid. That makes
itPrwas
elude notto catastrophic.
the crisis sense, as it implies an average user cost of housing of
around 10 percent. But since 2000, prices have skyrock-
Over the last several decades, the financial system has eted, leaving rents in the dust. The price-to-r ent ratio
evolved in a way that improves the efficient operation peaked at the end of 2006, reaching the rather extraor-
of the economy. In the past, payment streams and risks dinary level of 14.5, clearly suggesting the existence of
tended to come bundled together . Bonds were a "bubble" in r esidential housing. Home prices were at
sequences of coupons with a principal payment at levels far higher than justified by fundamental values (or
R P O L IC Y IN S IG H T N o. 21

maturity. T oday bonds can be stripped so that coupons replacement costs).

and principal can be purchased separately. More gener-
ally, it i s possible to purchase or sell virtually any pay-
ment stream with any risk characteristics.
This ability to separate financial instruments into their
most fundamental pieces - the financial analog to par-
ticle physicists separating atomic nuclei into protons
and neutrons - has had pr ofound implications for the
way in which risk is bought and sold. Today, risk is
much more likely to go to those people who are most
able to bear it. The r esult is that we can insure virtual-
ly anything and engage in many activities we wouldn't
have undertaken in the past.
In a critical development, the slicing and dicing of risk
extended to consumer lending. Home mortgages,cred-
it card debt, automobile loans, student loans and the
like were all pooled, or grouped together, and assets
were issued that were backed by the groups. These asset
pools were structured in a way that both reduced the
risk faced by the buyer of the "asset-backed" securities, 12 equity loans). What we see is that as the value of resi-
and allowed borrowers access to credit they otherwise
The preliminary conclusion from information like that
in Figure 1 i s that either the price of home price would
have to fall, r ents would have to rise, or some combina-
tion of the two. And the size of the adju stment needed
to be large - at least 20 per cent.3
The residential real estate price rise that began in
2000 had a number of important side effects. Fir st,
when the value of housing rises, it cr eates wealth and
wealthier people consume more. This consumption-
wealth effect is substantial. Using data from 14 devel-
oped countries Case, Quigley, and Shiller (2005) esti -
mate that a one percent increases in housing wealth
raises consumption by between 0.11 and 0.17 percent.
The simplest way to convert housing wealth into con-
sumption is to borrow. And this is where, in hindsight,
we can find the second sign of trouble. Figure 2 sepa-
rates the value of residential housing into owners' equi-
ty and borrowing (combining mortgages and home
 CHAPTER 1 ASSESSING RISKS TO GLOBAL FINANCIAL STABIL

Figure 1.8. U.S. Mortgage Delinquencies by tro

Vintage Year de
(60+ day delinquencies, in percent of original balance)
lik
If the story stopped here, then the impact
Subprime 40 Th
on the economy would have been minor.
Also, few individuals would care if some 2006 fa
35
rich people, who invested in hedge funds, 2005 w
2001 30 de
went into bankruptcy. However, as mort-
2000
gages are foreclosed the originating bank 25 ra
sells off the houses, so that an increase in 2002 th
2007
20
foreclosures leads to a further decline in 2004
(F
home prices. With a decline of home prices 15
more foreclosures occur. As the foreclo- 2003
10 Pr
sures and expected losses on loans escalate, de
the senor tranches of the CDOs start to 5
lose money as well. The realization, that 0
ha
senior CDOs were not as safe, led hold- 0 10 20 30 40 50 60
st
ers of MBS to question the safety of these
co
assets as well. Thus, the market price of 18
MBS started to fall relative to the original
Alt-A co
2006 16 hi
value (see Figure 1.9, IMF (2008)). While
the losses on MBS backed by Government 14 ho
Sponsored Enterprises (GSE), such as Fan- 12
th
2007 2000
nie Mae and Freddie Mac, were not too big, fro
10
the MBS not backed by GSE’s lost as much un
8
as 90% of the market value (see Figure 1.9,
2001
tig
2005
IMF (2008)). 2004
6 th
2002
The subcrime crisis finally became appar- 4 th
ent at the end of June 2007, when a ma- 2003 2
in
jor disruption to liquidity occurred. Sev- 0 ch
eral hedge funds, operated by Bearns Stern 0 10 20 30 40 50 60 20
and Lehman Brothers, had to meet mar- be
gin calls. (F
3.0
Prime
The margin calls were due to the loss of off
value for Lehman Brothers’ investments in 2.5
CDOs, precisely at a time in which there 2000 St
2006 2.0
was little liquidity in the market for MBS. w
A lender issues a margin call when the
value of a the collateral on a loan goes be- 2005 1.5
2007 al
2001
low the amount of the loan. The Hedge co
funds had to either sell assets or announce 1.0
an
their inability to meet margin calls. This 2004
2002 0.5 ca
led to a huge increase in uncertainty about
pr
the value of CDOs so that transactions 2003
0 lo
stopped in this market. 0 10 20 30 40 50 60
Months after origination

Sources: Merrill Lynch; and LoanPerformance.

13 be
ro
 (e.g., higher loan-to-value and debt service
coverage ratios). Econometric analysis indicates
that private consumption strongly affects the
level of CRE charge-off rates. Charge-offs may
Without
rise to aeffective transactions
17-year high taking
of about 1.7 place
percent by in Figure 1.9. Prices of U.S. Mortgage-Related
CDO, little information for pricing the different
the end of 2009, or to 1.9 percent under our Securities
CDO tranches was available. As a result, hedge (In U.S. dollars)
stress scenario, remaining elevated for some
funds stopped trading and credit originators had
time, though still below the levels reached in the 120
nowhere to sell their Alt-A and Subprime mort-
early 1990s.
gages. Thus, originators stopped originating
new loans, many originators went bankrupt, and 100
Tighter access
Countrywide wasto taken
credit isover
pressuring
by Bankleveraged
of America
in companies
Decemberand small and mid-sized enterprises, while
2007. 80

nonfinancial investment-grade firms’ access remains

Generalized lack of confidence in asset quality 60
relatively robust.
meant that the asset bank commercial paper
ABCP A weakening
market shut economic down.environment Subsequently, is any Agency MBS
Jumbo MBS 40
already leading
investment bank and to corporate
commercial credit bank,deteriora-
that had THE DEFAULT CYCLE
Alt-A
tion, especially
a large amount offorMBS, fi rmswere closely tied to
unable to theborrow ABX AAA 20
consumer. Credit
funds needed to finance quality has
their deteriorated
holding
Table 1.2. Estimates of Potential Losses of on
MBS. ABX BBB
leveraged
This led to the buyout ondeals
failure Loans in the last
of Bearns Stermfew years,
in March as 0
(In billions of U.S. dollars; 2007:Q2 through August 2008)
shown
2008 by thethe
in which rising ratio of
Federal rating downgrades
Reserve managed its 2006 07 08
7 Secondary Base Stress
to upgrades
take over by JP in Morgan
this sector. Chase. Outstanding market
In addition, the
Case Case Difference
Sources: JPMorgan Chase & Co.; and Lehman Brothers.
commercial banks
liquidity for leveraged had to raise
loans remains
All residential
almost $600
4,700low170
Bil-
and 210 40 Note: ABX = an index of credit default swaps on mortgage-related
lion (see Figure Commercial
1.14, IMF real(2008)).
estate 2,400 90 100 10 asset-backed security; MBS = mortgage-backed security.
banks and managers Consumer ofloans
collateralized 1,400 loan 45 50 5
obligations are selling Corporate loans 3,700 110 130 20 Figure 1.14. Financial Sector Losses
Leveragedloans loans at signifi 170 cant 10 losses.
15 5 (In billions of U.S. dollars; 2007:Q2 through August 2008)
Total for loans 12,370 425 505 80
Some of these sales have been to private equity Americas Europe Asia 800
Source: IMF staff estimates.
fi rms, partly encouraged by lower
Note: The analysis prices
applies the and standards index Figure 1.10. U.S. Residential Real Estate Loan
specific lending 700
for each loan class, and the assumptions for them are discussed in 600
seller-provided fiBox nancing
1.6 in Annexfor 1.3. the purchases. Charge-Off Rates 500
(In percent)
Consequently,Fannie
Subsequently, the leveraged Mae and loan pipeline
Freddie has 400
300
Macdeclined
was taken to $70overbillion
by Federalfrom a peak HomeofLoan $304 2.2 Charge-off rate1 4
cies have begun to rise on mortgage-related and 200 Estimate
onbillion
September 7,
in mid-2007, 2008. On September 14, Residential real estate lending standards
otherrelieving one source of they vary 100
asset-backed securities, though (right scale)2
2008 the federal government decided to 1.8 0 3
potential stress on assetvintage,
by sector, prices.and collateral type. Collateral Bank writedowns by region
Home price appreciation (inverted, right scale) 2
let Lehman Brothers go into
performance bankruptcy,
has issuance
been weakest on U.K. mort-
High-yield corporate bond has 800
which led to complete gage-related
shut down assets, forof which
lending primary markets 1.4 Mortgages SIVs/conduits 2
slowed considerably, are and
inactive, fi rms
secondary are facing
market liquidity is thin
Loans/leveragedTighter
Other
finance lending
Trading standards;
Monolines
700
between banks and corporations within the lower home prices 600
reduced access, higher (with therates, exception and shorter dura-
of AAA-rated securities),
1.0 1
week. As a result, the
and spreads on
U.S. Government
related securities continue to
500
tions on their
had to lend AIG $85 commercial paper obligations. 400
widen.Billion the next day 300
As the cycle has
followed by a loan ofAs begun in the
$37.8 toBillion.
turn,States,
United default rates
the U.K.
October household 0.6 200
0

3, have
2008 started
Congress to increase,
sector
established is rising
highly thetoTroubled
leveraged 2.5 percent.
and is now undergo- 100

Through ing a similarof

mid-September deleveraging-cum-housing-defl
this year, globally, ation 0.2 0 –1
Asset Relief Act cycle to lend the banks $700
(Figure 1.15). So far, mortgage arrears
Bank writedowns by type

57 corporate
Billion. issuers
By November have have 10,defaulted,
picked up2008 the compared
moderately AIGlow histori-
from Banks Insurers 900
8 –0.2 –2
with just
bailout 22 issuers
increased to in alland
$150
cal levels, of 2007.
Billion
bank with The
charge-offs $40 cur-
on mortgages 1991 93
Hedge funds/other
95 97
GSEs
99 2001 03 05 800
07 09
14 700
Billion in preferredremain stock verybeing
low. However,
fundedwith byhouse prices 600
a falling rapidly, arrears and losses are likely to
TARP. Sources: Federal Reserve; S&P Case-Shiller; and IMF staff estimates.
500
7A more pronounced rise several times over.
deterioration Nevertheless,
in recent our analysis
leveraged 1As a percent of loans outstanding; annualized rate. 400

loans may ultimately materialize where “covenant-lite” to breach

suggests that U.K. defaults are unlikely
a 2Series
See WSJ 11/10/2008. standardized over the period from 1991:Q1 to 2010:Q4.
300

agreements may have their historicalearly

hindered peak,intervention
reached in theby early 1990s, 200
100
lenders. with mortgage loss rates likely to be consider-
0
ably lower than those observed in the United Financial sector writedowns
8In the United States, the ratio of rating agency
States (Figure 1.16). 15 Moreover, the effects of
upgrades to downgrades on high-yield bonds is at its low- Sources: Bloomberg L.P.; and IMF staff estimates.
est level in four years. Note: SIVs = structured investment vehicles; GSEs = government-sponsored
enterprises.

14These data may understate the actual level, since

they exclude many of the lenders that specialize in

the nonconforming market, several of which have 14
already experienced diffi culties and scaled back their
operations.
Unresolved Issue 3: How does the correlation between foreclosures and housing prices lead to
a viscous cycle in which the Senior tranche of the CDO losses value? How does the change in
foreclosure rates impact the market price of CDO’s. How does this change in the price of CDOs
lead to the failure of Bearns Stern, Lehman, and AIG.?

1.5 Federal Reserve Policy in Response to the Crisis

The financial crisis started with the shadow banking system which consist of financial institutions
like Countrywide, Lehman Brothers and Bear Stearns which were not subject to the regulations
imposed on commercial banks.17 These regulations included capital requirements and deposit insur-
ance. In addition, the shadow banking system did not have the safety nets such as deposit insurance
and an ability to borrow from the Federal Reserve Banks. As a result, the Federal Reserve and the
U.S. Treasury had to be creative in developing programs which may or may not be authorized by the
Congress and President. These programs prevented the complete collapse of the financial system as
in the early 1930s.18 Eventually, these programs lead to the purchase of a large percentage of the
assets held by the shadow banking system by the Federal Reserve. In particular, Figure 8 shows
that the assets of the Federal Reserve increased by about $1, 142 Billion through the crisis. Thus,
the Fed nationalized the shadow banking system.

Figure 8. Federal Reserve Balance Sheet

Policy actions to address the impact of the crisis on commercial banks tended to focus on easing
liquidity conditions. Starting in August 2007, the Federal Reserve embarked on a series of interest
rate cuts totaling 2.25% over seven months, and toward the end of the year began a process of
expanding access to existing lending facilities and creating others, both for banks and for non-bank
financial institutions. As Sarkar (2009) argues, two separate stages can be distinguished. During
17
This section comes from Barajas, Chami, Cosimano and Hakura (2010).
18
For example the Term Securities Lending Facility TSLF to make loans (up to $200 billion) to primary dealers
with collateral such as US Treasuries, federal agency debt, federal agency MBS and investment]grade debt securities.
Previously the Fed was only a lender of last resort to commercial banks.

15
the first stage, the Fed acted to provide liquidity to solvent institutions, in response to a severe
contraction in interbank markets that threatened to bring financial intermediation to a halt via
an ”illiquidity spiral.” This was followed by a second stage, in which credit risk was the primary
concern, and liquidity was provided directly to key borrowers and investors.
As the crisis developed, and particularly in the wake of the Lehman Brothers bankruptcy in
September 2008, the focus of policy began to move beyond liquidity provision and toward injection
of capital. In particular, the well-known Troubled Asset Relief Program (TARP) dedicated a
substantial portion of its funds ($250 billion out of the total $700 billion) to the Capital Purchase
Program (CPP), designed to purchase preferred stock of financial institutions. After an initial
injection of $125 billion into nine large and systemically important institutions on October 14th , 2008
the program has broadened to include over 550 smaller institutions, with an overall injection of just
over $200 billion as of October 2009.
Both types of policies appear to have yielded benefits. There is evidence that specific liquidity
provision efforts helped to offset the extreme tightness in market liquidity which became evident in
the summer of 2007. For instance, the Term Auction Facility (TAF), introduced in early December
2007, has been associated with at least temporary reductions in the LIBOR-OIS spread, in the excess
deviations from covered interest parity that had spiked during the crisis, and in the divergence of
LIBOR over the Federal Funds rates. As for the capital injections undertaken through the CPP,
there is evidence that the funds were well-targeted, in terms of being allocated to larger, systemically
important banks that had suffered greater capital losses but had relatively strong loan portfolios,
that is, healthy but vulnerable banks. Furthermore, the injections themselves were associated with
positive valuation effects for the recipient banks - excess stock returns - which were also greater for
those banks that had suffered greater capital losses.
However, to date it is not clear whether there has been a positive impact of these two types of
policies - either focused on liquidity or capital - specifically on bank lending. In fact, a particular
concern has arisen that these policies have done little to reactivate credit, and that instead, excess
reserves held by banks have risen to unprecedented levels. From a level of about $1.5 billion
throughout 2007 and most of 2008, excess reserves climbed rapidly following the Lehman Brothers
bankruptcy, reaching $900 billion by January 2009, and remaining above $800 billion through June
2009.
Barajas, Chami, Cosimano, and Hakura (BCCH 2010) examined the behavior of large bank
holding companies from 2006 Q1 to 2009 Q2 in response to the financial crisis of 2007-2009. The
main conclusion was that banks with less capital had smaller growth of deposits and loans but were
not liquidity constrained-at least when measured by the liquid asset ratio.
Next, BCCH implemented a test of a model of bank regulatory capital, according to which banks
hold additional capital when they anticipate that the regulatory constraint is going to bind in the
future. Additional bank capital is demanded by banks when they have less initial total capital and
lower interest expense, as well as non-interest expenses. In addition, this demand for bank capital is
convex in each of these variables. The overall predictive power of this model was quite satisfactory
for all three measures of capital and the main predictions of the model were confirmed. Thus, there
is strong evidence that banks optimally choose their capital position.
Finally, BCCH implemented a test of monopoly power In this case they reject the two extremes
of competitive and monopolistic behavior in the banking industry, so that there is, monopolistic
competition pricing practiced by the large bank holding companies. In particular, the banks sys-

16
tematically raised the net interest margin as the Federal Reserve lowered the cost of funding by 5
percent from 2007 through December 2008. Thus, the evidence suggests that the large bank hold-
ing companies responded to their capital constraints by raising the net interest margin, the spread
between the loan and deposit rates, so as to optimally build up bank capital over time. Lending by
banks will not expand appreciably until this buildup of bank capital is completed.
The results of BCCH can help in designing a policy by which the Federal Reserve privatizes
the excess assets which they have acquired over the crisis. As pointed out by Cochrane (2009)
the flight to safe liquid assets throughout the crisis has increased the present value of all future
expected surpluses of the US government since they are now being discounted at a lower effective
rate of return. This has allowed the Federal Reserve to acquire 1, 142 billion of additional assets
which were held by the shadow banking system. While this amount is 152 billion below the peak
in December 2008, the 793 billion decline in TALF, CP and Foreign Swaps has been replaced by
507 billion in private and agency mortgage backed securities (see Figure 8). As the crisis abates,
the liquidity premium will disappear so that the US government will have to privatize these assets
to avoid a fiscal crisis within the U.S. government.
In privatizing these assets the Federal Reserve will want to avoid a replay of the financial crisis
so that the assets must be sold to private intermediaries subject to prudent regulations. This
means that 114.2 billion in total capital-10 percent of the required balance sheet expansion-must
be added to the banking system for these institutions to be well qualified under current regulations
of commercial banks. The results here imply that the banks must be given a clear signal that they
will be able to acquire these assets at a competitive risk adjusted rate of return. Given such clear
signals the banks would find it optimal to raise sufficient capital to fund these assets without taking
on excessive risk. In addition, the higher loan rate required to fund these loans will help to alleviate
excessive risk taken by borrowers.

1.6 Final Thoughts

The IMF estimates the losses from the Subprime lending to be $1, 405 Billion. The break down of
the losses are summarized in Table 1.1 (See IMF (2008)).

17
 THE DEFAULT CYCLE

Table 1.1. Estimates of Financial Sector Potential Writedowns

(In billions of U.S. dollars)

Base Case Estimates of Writedowns

on U. S . Loans Writedowns on U. S . Loans
April October Other
estimated estimated Pensions/ GSEs and (hedge
Outstandings losses losses Banks Insurance Savings government funds, etc.)

S ubprime 300 45 50 35–40 0–5 0–5 — 10–15

Alt-A 600 30 35 20–25 0–5 0–5 — 5–10
Prime 3, 800 40 85 25–30 0–5 0–5 45–55 0–5
Commercial real estate 2,400 30 90 60–65 5–10 0–5 — 10–20
Consumer loans 1,400 20 45 30–35 0–5 0–5 — 10–15
Corporate loans 3,700 50 110 80–85 0–5 0–5 — 25–30
Leveraged loans 170 10 10 5–10 0–5 0–5 — 0–5
Total for loans 12,370 225 425 255–290 5–40 0–35 45–55 60–100

Base Case Estimates of Mark-to-Market Losses

on R elated S ecurities Los s es on S ecurities
April October
estimated estimated Other
mark-to-market mark-to-market Pensions/ GSEs and (hedge
Outstandings losses losses Banks Insurance Savings government funds, etc.)

ABS 1, 100 210 210 100–110 40–45 35–55 10–15 10–25

ABS CDOs 400 240 290 145–160 55–75 30–45 15–20 15–30
Prime MBS 3,800 0 80 20–25 10–15 10–20 20–25 0–5
CMBS 940 210 160 80–90 20–25 15–35 10–20 15–20
Consumer ABS 650 0 0 — — — — —
High-grade corporate debt 3,000 0 130 65–75 20–30 20–35 — 5–20
High-yield corporate debt 600 30 80 45–50 10–15 15–20 — 5–15
CLOs 350 30 30 15–20 0–5 0–5 — 5–10
Total for securities 10,840 720 980 470–530 155–210 125–215 55–80 55–125
Total for loans and securities 23,210 945 1,405 725–820 160–250 125–250 100–135 115–225
Sources: Goldman Sachs; JPMorgan Chase & Co.; Lehman Brothers; Markit.com; Merrill Lynch; and IMF staff estimates.
Note: The prime residential loans category includes a portion of GSE-backed mortgage securities. ABS = asset-backed security;
DO = C col-
lateralized debt obligation; CLO = collateralized loan obligation; GSE = government-sponsored enterprise; CMBS = commercial
tgage-backed
mor
security; MBS = mortgage-backed security.

to adversely affect economic prospects more
broadly. Both high- and low-grade corporate
debt have been signifi cantly weakened by devel-
opments in the fi nancial sector, while non-fi nan-
cial sectors, such as industrials and utilities, are
also starting to weaken. 11 The prime residential
mortgage market has been affected by a com-
bination of factors, including especially rising
unemployment and falling U.S. house prices.
The impact of these factors had previously been
felt mostly by less creditworthy borrowers of
mortgage loans.
18
11Potential losses due to the bankruptcy of Lehman
While writedowns have mushroomed over
the last year, there is still a signifi cant gap
between reported and estimated writedowns.
Reported writedowns reached $760 billion by
end- September, $580 billion of which were
incurred by global banks (Figure 1.14). 12 As
expected, losses have been mostly mortgage-
12Writedowns for individual banks have been some-
what higher than expected. This appears to be mainly
due to one or more of the following factors: (1) earlier
incomplete disclosure of exposure to problem loans or
securities; (2) higher-than-expected loss provisions for
loans held to maturity; (3) losses on restructurings and
sales of subsidiaries with credit market exposure; and (4)
 $
r
(
d
Figure 1.13 (See IMF (2008)) shows that b
the losses by commercial banks are esti- Figure 1.13. Comparison of Financial Crises u
mated to be about the same as the 1990’s
40
H
1600
banking crisis in Japan. Whether this cri- Banking losses (in billions of U.S. dollars, left scale) a
sis will harm the U.S. and Global economy 1400 Other financials 35
(in billions of U.S. dollars, left scale) l
as much as the Japanese economy is still Percent of GDP (right scale) 30 i
1200
an open question and dependent on gov-
l
ernment policy undertaken over the next 1000 25
o
year. 800 20 fi
The Subprime crisis gives us an opportu- 600 15
nity to study the cost and benefits of quan- .
titative analysis in finance.a Throughout 400 10
s
the semester we will study the quantita- 200 5
tive finance issues which arose in the Sub-
0 0 l
prime crisis. This analysis will help you to U.S. savings Japan Asia U.S.
and loan crisis banking crisis banking crisis subprime crisis (
realize what can and cannot be done with
quantitative methods.
(1986–95) (1990–99) (1998–99) (2007–present) 3
Sources: World Bank; and IMF staff estimates.
s
a
For example, the bankruptcy proceedings are Note: U.S. subprime costs represent staff estimates of losses on banks and other l
made public, so that we will have detailed infor- financial institutions from Table 1.1. All costs are in real 2007 dollars. Asia includes
mation about what various groups within the cor- Indonesia, Malaysia, Korea, the Philippines, and Thailand. h
porations did to fulfill their legal responsibility. p
b
Discussion Questions
I
1. Why does the il-liquidity of assets and liquidity of liabilities for a financial institution lead to
p
periodic financial crisis in which lenders rush to withdrawal their funds from financial firms?
m
2. Explain why MBS were developed to alleviate this mismatch of assets and liabilities.
q
3. Why did the holding of MBS and CDO by Lehman Brothers and Bear Stearns lead to the
U
financial crisis?
i
4. Explain the role of Repos in the demise of Lehman Brothers and Bear Stearns. p
t
5. How did the failure of subprime lenders spiral into the collapse of the financial system?
e
6. Discuss the steps undertaken by the Federal Government to minimize the fallout from the
financial crisis.

7. Suppose Ron Paul rather than Ben Bernanke was Chair of the Federal Reserve Board so that
the federal reserve would not have intervene
16 in the financial markets. What do you think
would happen? Do you think society would be better off?

19
 Glossary of Terms19
• An Alt-A mortgage – Short hand for Alternative A-paper, is a type of U.S. mortgage that,
for various reasons, is considered riskier than ”prime”, and less risky than ”subprime,” the
riskiest category. Alt-A interest rates, which are determined by credit risk, therefore tend to
be between those of prime and subprime home loans.
• Asset-backed commercial Commercial paper (ABCP) – Commercial paper is a loan to a cor-
poration for a period of less than one year. Commercial paper collateralized by a pool of
loans, leases, receivables, or structured credit products is called ABCP.
• Balance sheet (T-account) – A statement of the financial position for an individual or legal
organization. It is a summary of a person’s or organization’s balances. Assets (Own), liabilities
(Owe) and ownership equity are listed as of a specific date, such as the end of its financial
year.
• Bankruptcy – A legally declared inability or impairment of ability of an individual or organi-
zation to pay their creditors.
• Collateralized debt obligation (CDO) – A structured credit security backed by a pool of
securities, loans, or credit default swaps, where interests in the security are divided into
tranches with differing repayment and interest earning streams. The pool can be either
managed within preset parameters or static. If the CDO is backed by other structured credit
securities, it is called a structured- finance CDO, and if it is backed solely by other CDOs, it
is called a CDO-squared.
• Commercial banks – A corporation that accepts deposits and makes loans, as well as other
fee based services.
• Corporate Bond – A bond issued by a corporation. The term is usually applied to longer-term
debt instruments, generally with a maturity date falling at least a year after their issue date.
• Commercial paper – An unsecured promissory note with a fixed maturity of one to 270 days.
• Credit default swap (CDS) – A default-triggered credit derivative. Most CDS default settle-
ments are physical, whereby the protection seller buys a defaulted reference asset from the
protection buyer at its face value. Cash settlement involves a net payment to the protec-
tion buyer equal to the difference between the reference asset face value and the price of the
defaulted asset.
• Credit derivative – A financial contract under which an agent buys or sells risk protection
against the credit risk associated with a specific reference entity (or entities). For a periodic
fee, the protection seller agrees to make a contingent payment to the buyer on the occurrence
of a credit event (default in the case of a credit default swap).
• Credit score – A number that is based on a statistical analysis of a person’s credit report, and
is used to represent the creditworthiness of that person, the likelihood that the person will
pay his or her debts.
19
Definitions come from IMF (2008), and Wikipedia.

20
• Credit spread – The spread in interest rates between benchmark securities and other debt
securities that are comparable in all respects except for credit quality (e.g., the difference
between yields on U.S. Treasuries and those on single A rated corporate bonds of a certain
term to maturity).

• Derivative – A financial contract whose value derives from underlying securities prices, interest
rates, foreign exchange rates, commodity prices, or market and other indices.

• Deposit account – an account at a banking institution that allows money (currency or deposits)
to be deposited and withdrawn by the account holder, with the transactions and resulting
balance being recorded on the bank’s books.

• Equity – Shares of stock in a corporation on a stock market by individuals and funds in

anticipation of income from dividends and capital gain as the value of the stock rises.

• Fannie Mae – The Federal National Mortgage Association is a stockholder-owned corporation

chartered by Congress in 1968 as a government sponsored enterprise (GSE), but founded in
1938 during the Great Depression.

• Federal Funds Rate – Interest rate on an overnight loan from one commercial bank to another
in the United States. It is the interest rate used by the Federal Reserve to control the money
supply and inflation.

• FICO score – A credit score calculated using one particular credit scoring system.

• Fiduciary duty – A legal relationship of confidence or trust between two or more parties, most
commonly a fiduciary or trustee and a principal or beneficiary.

• Foreclosure – Foreclosure is the legal and professional proceeding in which a mortgage, or

other lienholder, usually a lender, obtains a court ordered termination of a mortgagor’s equi-
table right of redemption. Usually a lender obtains a security interest from a borrower who
mortgages or pledges an asset like a house to secure the loan.

• Freddie Mac – The Federal Home Loan Mortgage Corporation (FHLMC) is a government
sponsored enterprise (GSE) of the United States federal government which was created in
1970.

• Government-sponsored enterprise (GSE) – A financial institution that provides credit to spe-

cific groups or areas of the economy, such as farmers or housing. Most GSEs maintain legal
and/or financial ties to the U.S. government.

• Hedge fund – Investment pool, typically organized as a private partnership and often resident
offshore for tax and regulatory purposes. These funds face few restrictions on their portfolios
and transactions. Consequently, they are free to use a variety of investment techniques in-
cluding short positions, transactions in derivatives, and leverage to attempt to raise returns
and risk.

• Investment banks– A corporation who issues and sells securities in the capital markets (both
equity and bond), as well as providing advice on transactions such as mergers and acquisitions.

• Home Mortgage – The pledging of a house to a lender as a security for a loan.

21
• Leverage – The proportion of debt to equity (also assets to equity and assets to capital).
Leverage can be built up by borrowing (on-balance-sheet leverage, commonly measured by
debt-to-equity ratios) or by using off-balance-sheet transactions.

• Liquidity – An asset’s ability to be easily converted to cash through an act of buying or selling
without causing a significant movement in the price and with minimum loss of value.

• London Interbank Offer Rate (LIBOR) – Interest rate on an overnight loan from one com-
mercial bank to another in the United Kingdom.

• Loan – A borrower initially receives an amount of money from the lender (bank), which
they pay back, usually but not always in regular installments, to the lender. This service is
generally provided at a cost, referred to as interest on the debt. A loan is of the annuity type
if the amount paid periodically (for paying off and interest together) is fixed.

• Margin Call – A margin is collateral that the holder of a position in securities, options, or
futures contracts has to deposit to cover the credit risk of his counterparty (most often his
broker). The margin call occurs when the value of the collateral falls below some critical
value.

• Money Market Funds– A mutual fund that invest in short-term debt instruments such as
treasury bills and commercial paper.

• Mortgage-backed security (MBS) – A security that derives its cash flows from principal and
interest payments on pooled mortgage loans. MBSs can be backed by residential mortgage
loans or loans on commercial properties.

• Mutual fund – A professionally managed type of collective investment scheme that pools
money from many investors and invests it in stocks, bonds, short-term money market instru-
ments, and/or other securities.

• Originate-to-distribute model – A business model of financial intermediation, under which

financial institutions originate loans such as mortgages, repackage them into securitized prod-
ucts, and then sell them to investors.

• Prime mortgage – the home owner puts up 20% of the home value and has a good credit
rating.

• Quantitative analyst (quant) – A person that uses numerical or quantitative techniques to

develop financial instruments and manage risk.

• A Repurchase or REPO agreement is a short term loan with a security used as collateral on
the loan.

• Savings and Loan association (S & L) – A financial institution that specializes in accepting
savings deposits and making mortgage loans.

• Structured investment vehicle (SIV) – A legal entity whose assets consist of asset-backed
securities and various (SIV) types of loans and receivables. An SIVs funding liabilities are
usually short- and medium-term debt;

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• Subprime mortgage – A mortgage to borrowers with impaired or limited credit histories, who
typically have low credit scores.

• Commercial banks – A corporation that accepts deposits and makes loans, as well as other
fee based services.
The federal takeover of Fannie Mae and Freddie Mac refers to the placing into conservatorship
of government sponsored enterprises Fannie Mae and Freddie Mac by the US Treasury in
September 2008. It was one financial event among many in the ongoing Subprime mortgage
crisis.

References
• IMF Global Financial Stability Report, October 2008.

• Wikipedia, The Free Encyclopedia.

• Monetary Policy and the Financial Crisis of 2007 − 2008 by Stephen G. Cecchetti, Center for
Economic Policy Research, POLICY INSIGHT No. 21. April 2008

• The Subprime Crisis in the United States by Adolfo Barajas, IMF Institute, 2008.

• The Subprime Panic by Gary Gorton, NBER working paper 14398, October 2008.

• Securitized Banking and the Run on the Repo Market by Gary Gorton and Andrew Metrick,
Yale ICF working paper 09-14, November 2009.

• In Fed We Trust: Ben Bernanke’s War on the Great Panic by David Wessel, Crown Business
Publishing 2009.

• The Credit Crisis: Conjectures about Causes and Remedies by D. W. Diamond and R. G.
Rajan, University of Chicago working paper 2009.

• U.S. Commercial Bank Behavior in the Wake of the 2007-2009 Financial Crisis by Adolfo
Barajas, Ralph Chami, Thomas Cosimano, Dalia Hakura, IMF working paper 2010.

• Liquidity Risk, Credit Risk, and the Federal Reserve’s Responses to the Crisis by Asani Sarkar,
Federal Reserve Bank of New York, Staff Report no. 389 2009.

• Understanding Fiscal and Monetary Policy in 2008-2009 by John Cochrane. University of

Chicago working paper 2009.

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