An Analysis of the Financial Crisis of.docx
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AnAnalysisoftheFinancialCrisisof
AnAnalysisoftheFinancialCrisisof2008:
CausesandSolutions*
Abstract
Thisresearchevaluatesthefundamentalcausesofthecurrentfinancialcrisis.Close
financialanalysisindicatesthattheoreticalmodelingbasedonunrealisticassumptionsled
toseriousproblemsinmispricinginthemassiveunregulatedmarketforcreditdefault
swapsthatexplodeduponcatalyticrisesinresidentialmortgagedefaults.Recent
academicresearchimpliessolutionstothecrisisthatareappraisedtobefarlesscostly
thanabailoutofinvestorswhomadepoorfinancialdecisionswithrespecttocredit
analysis.JEL:
G11,G12,G13,G14
________________________________________________________________________
*byAustinMurphy,ProfessorofFinance,OaklandUniversity,SBA,Rochester,MI
48309-4493(248-370-2125;jamurphy@oakland.edu).
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AnAnalysisoftheFinancialCrisisof2008:
CausesandSolutions
Thefinancialcrisisin2008isofsuchepicproportionsthatevenastronomical
amountsspenttoaddresstheproblemhavesofarbeeninsufficienttoresolveit.Besides
thewell-publicized$700billionapprovedbyCongress,theFederalReservehas
attemptedtobailoutinstitutionsandmarketswithabout$1.3trillionininvestmentsin
variousriskyassets,includingloanstootherwisebankruptinstitutionsandcollateralized
debtobligationslikethosebackedbysubprimemortgagesthataredefaultingatrapid
rates(Morris,2008).Afurther$900billionisbeingproposedinlendingtolarge
corporations(Aversa,2008),makingatotalofnearly$3trillioninbailoutmoneysofar,
withoutevencountingthemassivesumofcorporatedebtsguaranteedbytheU.S.
governmentinthelastyear.Ananalysisofthefundamentalcausesofthis“colossal
failure”thathasput“theentirefinancialsystem…atrisk”(WoellertandKopecki,2008)
iswarrantedinordertobothsolvetheproblemandavoidsucheventsinthefuture.
RootCauseoftheCrisis:
MispricingintheMassiveCreditDefaultSwapsMarket
Manyblamedefaultingmortgagesforthecurrentfinancialcrisis,butthismassive
tragedyisonlyacomponentandsymptomofthedeeperproblem.Thepricingofcredit
defaultswaps,whoseprincipalamounthasbeenestimatedtobe$55bytheSecuritiesand
ExchangeCommission(SEC)andmayactuallyexceed$60trillion(orover4timesthe
publiclytradedcorporateandmortgageU.S.debttheyaresupposedtoinsure),aretotally
unregulated,andhaveoftenbeencontractedoverthephonewithoutdocumentation
2
(Simon,2008),istheprimaryfundamentalissuefromwhichalltheotherproblemsofthe
crisisemanate.
Creditdefaultswapsareactuallyrathersimpleinstrumentsinconcept,merely
mandatingthatonepartypayingaperiodicfeetoanothertoinsurethedebtsofsome
entity(suchasaspecifiedcorporation)againstdefaultforaparticularamountoftimelike
5years.Theyareeffectivelydebtinsurancepoliciesthatarelabeledotherwisetoavoid
theregulationthatnormallyisimposedoninsurancecontracts.Thisunregulatedmarket
grewastronomicallyfrom$900billionattheturnofthemillenniumtoover$50trillion
in2008afterCongressenactedalawexemptingthemfromstategaminglawsin2000
(PIAConnection,2008)..
Anyinvestmentinadebtrequirescompensationnotonlyforthetimevalueof
moneybutalsoapremiumforthecreditriskofthedebt.Compensationforthetimevalue
ofmoneyisusuallyprovidedbythedebtpromising,ataminimum,ayieldequaltothat
oftherateavailableondefault-freegovernmentsecuritieslikeU.S.Treasurybonds.The
creditriskpremiumabovethatratemustcompensateinvestorsfornotonlytheexpected
valueofdefaultlossesbutalsoforthesystematicriskrelatingtothedebt,aswellasfor
anyembeddedoptions(Murphy,1988).
Inacreditdefaultswaporbondinsurancecontract,thereisnoinitialinvestment
inthedebtbytheinsuringparty,andsoonlyacreditriskpremiumisrequired.This
premiummust,however,includeboththedefaultriskpremiumandthesystematicrisk
premium.Appropriateappraisalmethodsforestimatingthosepremiumshavelongbeen
known(CallaghanandMurphy,1998).
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However,manypractitionerstodayapplypuremathematicaltheoriestoevaluate
creditriskandestimatecreditriskpremiumstoberequired(GlantzandMun,2008).The
modelsofsuch“’quants’whohavewieldedsomuchinfluenceovermodernbanking”are
often“worsethanuseless”(NewScientist,2008b).Someinvestorsindebtsecuritieslook
onlyatthecreditratingsprovidedbyafewratingagenciessuchasMoody’sand
Standard&Poors(S&P),whichthemselvesevaluatecreditusingsuchmodels.Those
models,whichusestatisticstouncoverpastrelationshipsbetweendebtdefaultsandafew
variables,asintheseminalAltman(1968)study,canignoreveryimportantfactorsand
possibilities(WoellertandKopecki,2008).Whilesomehavesuggestedthatthemodels
onlyneedtobeimproved(NewScientist,2008b),allstatisticalmodelsaresubjecttothe
problemsofspuriouscorrelationsbetweenvariablesthataremagnifiedasthenumberof
variablesareincreased,andsoitisquestionablewhethercreditanalysiscaneverbe
conductedwithoutsomehumanjudgment.
Existingmathematicalcreditriskmodelshave“atendencytounderestimatethe
likelihoodofsuddenlargeevents”(Buchanan,2008)thatareespeciallyimportantinthe
creditmarketswherethetailofadistributioniskeyinpredictingthedefaultsthat
typicallyhavealowprobabilityofoccurrence(Murphy,2000).Themathematicalmodels
typicallyfailtoconsiderinter-relatedsystematicrisks(Jameson,2008),andtheytendto
makeunrealisticassumptionssuchasmarketsalwaysbeinginequilibrium(NewScientist,
2008a).Despitetheir“poorriskmodeling”inactuality(Jameson,2008),thestatistical
accuracyofthemodelsinpredictingbackwardintothepast(usinghistoricdata)resulted
inthemathematicalmodelersdevelopingsucha“faithintheirmodels”inforecastingthe
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futurethattheybeganto“toignorewhatwashappeningintherealworld”(NewScientist,
2008b).
Inaddition,withouthumanjudgment,financialmodelsofcreditriskaresubjectto
manipulation,bothlegallyandfraudulently.Justforinstance,themodelingpredictionsat
theratingagencieshave,atleastrecently,beenbiasedtowardgrantinghigherratingsthan
meritedinordertocompeteforrevenuesfromthedebtorswhopaytoberatedandarea
“colossalfailure”(Burns,2008).Theresulthasbeenthatalargeportionofthecredit
defaultswapsweremispriced.
Themortgagecrisisitselfmayhavelargelybeencausedbythemispricingof
creditdefaultswaps.Amajorcontributortothelackofsubjectivejudgmentand
verificationofthemodelinputswasthefactthatmortgagebrokersweremotivatedby
loanoriginationcommissionstojustmaximizethevolumeofissuedmortgagesthatoften
requirednomoneydownandnoproofofincomebecausetherisksassociatedwithsuch
lendingpolicieswere“blurred”tothefinalinvestorswhotookpositionsinthemthrough
collateralizeddebtobligationsorCDOs(Buchanan,2008).OnefactorcausingCDO
investorstoacceptsuchuncertaintiesmayverywellhavebeenthatsuchmortgagebacked
securitieswerewidelyinsuredagainstlossesfromdefaultbyinsurerslikeAIG,
whichitselfplaced“blindfaithinfinancialriskmodels”andtheirsmallelitestaffof
modelerswhoinitiallygeneratedlargeincomeforthefirmthatlaterturnedinto
decimatinglosses(Morgenson,2008).AIG’smodelerslikelyjustifiedtheirpricingby
applyingpurelystatisticalcreditscoringproceduresusingalimitednumberoffactorsthat
didn’tincorporatetheeffectsofrequiringnodocumentationfortheinputstothemodels
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andhavingnohumancreditanalysttoprovideasubjectivejudgment.Inmanycases,the
unverifiedinputstothemodelswereevenwidelyrecognizedtobefalseormisleading.1
Inaddition,manyofthemoresophisticatedmathematicalmodelsofdebt
instrumentswerebasedontheoriesthatimpliedthesystematicrisksofdebtscouldbe
hedgedordiversifiedaway(Duffee,1999).Asaresult,manymodelersquestionedthe
needtorequireanyyieldcompensationforsystematicrisks(Elton,Gruber,Agrawal,and
Mann,2001)thatdebtinvestorsnormallyreceivebecausetherisksofdebtinvestments
can’tbefullydiversifiedaway(Murphy,2000).Unfortunately,thetheoriesthatindicate
debtinvestorsonlyneedtochargesufficientinteresttocoverexpecteddefaultlossesare
basedonunrealisticassumptions,suchasnotransactioncostsandacontinuous
distributionofreturns(Merton,1974).Asaresult,theirconclusionsareinvaliddespite
theaccuracyoftheirmathematics.
Suchmodelingproceduresresultedinmanycreditdefaultswapsbeingpricedto
havetheperiodicpaymentcompensatetheinsuringpartyforaveragedefaultlosses.
Withouttheextrayieldcushionthatnormallyisrequiredtocoverthesystematically
above-averagedefaultlossesthatinevitablyoccurinsomeyears,debtinvestorshadset
themselvesupforlargelossesatsomepoint.Withmanyoftheinsuringpartiesofcredit
defaultswapsbeingbanksandotherfinancialinstitutionsthatwerehighlyleveragedwith
largecurrentobligations,sufferinglossescreatedtheriskoftheseinsurersdefaultingon
theirownobligationsunderthecreditdefaultswaps,2leadingtoapotentialdominoeffect
ontheirswapcounterpartiesandasystematiccascadeofdefaults.
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Compoundingtheproblemoffailingtochargeasystematicriskpremiuminthe
creditdefaultswapswasthepreviouslymentionedproblemofunderestimatingeven
averagedefaultlossesbecauseofthefailuretoutilizesubjec
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