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The Credit Crisis of 2007

4 important questions on The Credit Crisis of 2007

What were the largest mistakes?

- Wrong incentives (agency theory)
- Correlations tend to increase during crises (reliance on historical data)
- BBB abs is not equal to corporate BBB (as the size of tranch is thin), also called cliff risk. The probability that BBB tranch would lose everything is much larger than a corporate bond of BBB losing everything.
- No tranparency - - > dry-up of liquidity (inter-bank market)
- Too much reliance on credit raters (who were new to complex ABS)
- Irrational exuberance (behavior of investors)
- Assumption that house price would increase forever.

What about regulatory arbitrage?

Bank originated mortgages but bought most of it as well, why? Because of regulatory arbitrage. Mortgages are kept in banking book, while ABS is MtM and therefore in the trading book. Capital requirements on the trading book were low.

What about the incentives/agency costs?

Clearly, the interest of two parties in a business relationship are not perfectly aligned if we look at the crisis:
- Originator (transfer risk)
- Property assessor (want to be hired again, so pleasing)
- Homeowner (put-option)
- Rating agencies (paid by ABS creators)
- Employee compensation (no downside, so bet on anther house increasing year)
- Financial institutions hire people that are tremendously good in losing money

What was a trading opportunity?

Selling BBB+ and buying BBB-, chances that they will be safe or wiped out are almost the same as tranches are very thin. So basically selling senior ABS CDO and buying junior ABS CDO.