The Financial Crisis Guide

Discussion in 'Commercial Knowledge Articles' started by Jaysen, Jan 22, 2020.

  1. Jaysen

    Jaysen Legendary Member
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    Our star writer Ginevra Bizzarri is back! This time she breaks down one of the hardest, most complex commercial awareness topics out there: the global financial crisis, all in an easy-to-understand manner.

    You'll learn:
    - The role played by banks, governments and regulators leading up to the crisis
    - How complex financial products developed and their role in amplifying the consequences of the housing collapse
    - How the financial crisis unravelled in 2007 and the rationale for saving particular banks
    - The role of law firms

    And so much more!

    Read here: https://www.thecorporatelawacademy....-on-revisiting-the-financial-inferno-of-2008/
     
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  2. Helena

    Helena Legendary Member
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    This article is brilliantly written, clear and a fantastic round up of the global financial crisis. A must read for all of us! Thank you Ginevra.
     
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  3. Ginevra Bizzarri

    Ginevra Bizzarri Star Member
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    Thank you so much Helena!! Really glad you enjoyed it/ found it useful :))
     
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  4. Helena

    Helena Legendary Member
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    Congratulations on your TC !
     
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  5. Ginevra Bizzarri

    Ginevra Bizzarri Star Member
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    Thank you so much!!! I'm confident this is your year too :)
     
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  6. Jennifer

    Jennifer Distinguished Member

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    I have been reading through the guide (outstandingly written!!) and had a question I am hoping someone could clarify for me.

    The article points out that banks were sitting pretty happy having repackaged and sold off the mortgages as securities, distancing themselves from the risk. Any money paid by the borrowers went to the investors who purchased them as bonds in the secondary market.

    However, later on the article states that when borrowers began to default, 'banks were getting no income from their loan'. This seems contradicting to the above as they weren't receiving any of the income anyway?

    I'd appreciate any help identifying what I have misunderstood somewhere along the way, thanks!
     
  7. Edward J Jones

    Edward J Jones New Member

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    You have identified the most significant part of the events and something which is not very well understood about the crisis. The number of subprime mortgages in existence was actually not large enough to topple the financial system, as Ginevra explains this was enabled by the creation of various classes of ABS. There are different views as to what occurred during the panic, the most convincing is that there was a run in the repo market caused by the hidden risks in structured products. Due to their structuring, the holders of these complex products could not ascertain their risk exposure and potential losses, so they were devalued in response to the defaults on the underlying assets. Their reduction in value caused fire sales and haircuts which amounted to a run on repo. This is what is referred to in the 'Game of Jenga' section of the publication:

    'So what happens when even what is supposed to be the most secure investment in the system turns out to be worthless? Well panic ensues. In turn this means investors and creditors become wary and scared of the financial system and the product it sells.'

    'No one knew what they were holding or who they could trust.'​

    To answer your question:
    Banks rely heavily on the repo market to satisfy many of their funding mismatches. When that market became illiquid and the securities used to obtain funding (ABS) were devalued, the banks could no longer access capital and their maturity mismatches were exposed. Secondly, banks actually retained a number of structured products on their balance sheets and bore direct losses on the products. They used these products as collateral in the repo market to obtain cash, the structured assets were broadly used because the volume of repo transactions outweighed the supply of highly-rated government and corporate bonds. Third, the transfer of risk to off-balance sheet SPVs was incomplete and banks retained a high level of exposure to the risk of default. This is because a bank would, often implicitly, guarantee the losses of an SPV and make payments to investors in the case of default. If you are interested in becoming a structured finance lawyer, the transfer of this risk will be your top priority.

    I have attached an essay which explains the shadow banking system and outlines its role in the crisis. If you look at the footnotes you will find some valuable insight into the issue. Gary Gorton's work, specifically 'The Panic of 2007' <https://www.nber.org/papers/w14358.pdf> is seminal, but 93 pages long... I do not pretend to scratch the surface of that work.

    Commercial awareness:
    Last week the FT published an article about the downgrading of bonds underlying CLOs due to the current pandemic( Financial Times, 'CLOs: ground zero for the next stage of the financial crisis?' <https://www.nber.org/papers/w14358.pdf>). The article itself is an interesting exposition of facts but is a bit lacking in analysis. If you wanted to discuss this issue, it simply isn't adequate to state that downgrading the CLOs will cause a crisis. You must question which parties are heavily invested in these CLOs and what they use these assets for. In 07 these products were widespread in the repo market, causing it to freeze when they were downgraded which arguably set off the whole crisis. What could happen next? If the insurance companies holding 40% of all triple B tranches in the US face downgrades and defaults on their CLOs, would that expose a funding mismatch? If CLOs are downgraded en masse will the investors in these CLOs be downgraded too? Who is invested in these insurance companies, and how are they rated? How is the Fed's role in buying corporate credit supporting CLO prices?

    I do not have the answers to these questions. It seems to me the best starting point should be to explain what a CLO is and why the economic sudden stop has caused some underlying corporate debt to be downgraded. One could then move to discuss the effect of the downgrade of underlying debt on the rating of different CLO tranches, also the impact on the originator (often required to retain an exposure to the assets known as 'skin in the game') and the current investor. When discussing the downgrades, the role of central banks in supporting credit markets should not be neglected. Then explain how these products were used in wholesale funding markets. After that, you could discuss the questions posed above or others you have identified. At this final stage, we are dealing with hypotheticals.


    I hope this is a helpful explanation and provides you with a starting point to read up on if it is something that interests you. It is not a topic which is easily simplified, although perhaps a more knowledgeable person could. As with any other topic, I would not bring this up in discussion/interview unless it is something you are particularly interested in. However, understanding the securitisation process should be quite impressive to any structuring lawyer. On a final note, it should be clarified that all of this explanation fits within the 'A Game of Jenga' section of Ginevra's work. Specifically, where she refers to 'panic'. Hers is a much broader and comprehensive view of the whole crisis.
     

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  8. Jennifer

    Jennifer Distinguished Member

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    @Edward J Jones wow, thank you for that! I did not expect anything nearly as comprehensive, you've given me some things to look into and think about. Thanks again!
     
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  9. D

    D Legendary Member
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    Incredible write-up Edward. One of the best posts I've read on this forum.
     
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  10. Edward J Jones

    Edward J Jones New Member

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    Glad to help and I hope you find it interesting. Too many people take for granted that subprime mortgages and securitisation caused the crisis, but don't pay any thought to how that might occur. Of course, there were many other factors, as outlined in Ginevra's work, which made it a global crisis. Nevertheless, the run on repo appears to be the spark that lit the fire.
     
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  11. Ginevra Bizzarri

    Ginevra Bizzarri Star Member
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    Hi all!

    I agree with everything Edward said. To rephrase it in my own words, the issue was essentially that all the major banks had created these MBS's as well as other very complex securities like CDOs which they sold on to investors (some investors were actually other banks) therefore banks were actually holding these products on their balance sheets. On the other hand, I believe some products were complicated to such a degree (see CDOs in my article) that banks themselves did not even know how toxic they were, and thus kept them on.
    On top of this, these securities were actually perceived by many as valuable (because of the skewed rating system, the fake security around the real estate market and other factors I mention in my article) which allowed banks to use them as collateral in the repo market and the short term note market.

    When banks started to perceive MBS' as less valuable (essentially when people started having problems paying their mortgages and the whole thing started coming down) then these MBS' could no longer be offered as collateral. Once this happened, short term loans and the repo markets dried up leaving banks without liquidity.

    By the way, I am no expert so feel free to correct me if I am wrong! :)
     
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