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Describe how the crisis built up and which factors were important in that build-up.

FRM® Part I · Foundations of Risk Management · Anatomy of the Great Financial Crisis of 2007-2009 · FRM1.FR.10.b

The idea

The build-up rested on several reinforcing factors. After the 2001 recession the Federal Reserve held rates very low, at 1 percent from mid-2003 to mid-2004. Large foreign savings kept long-term yields down, so credit was cheap and investors searched for yield. House prices rose for years, which taught lenders and investors that mortgage losses were rare. Originate-to-distribute securitisation let lenders sell loans on, so underwriting standards fell. Banks held little capital against off-balance-sheet vehicles, and bonuses rewarded short-term volume. Leverage magnified everything. A bank with 5 percent equity is wiped out by a 5 percent fall in asset values. Exam questions ask you to name the factors and how they reinforced each other. No single cause is the right answer.

A practice question

From the question bank, with the reason each wrong option is wrong.

The Federal Reserve held its policy rate at 1 percent from mid-2003 to mid-2004. Which build-up effect is most directly linked to such a low-rate environment?

  1. Higher funding costs for securitisation conduits pushed banks to hold mortgages on their balance sheetsWhy not: Reverses the effect: low rates cut funding costs and encouraged securitisation, not holding.
  2. Falling house prices that exposed subprime borrowers earlyWhy not: House prices rose during this period; they only turned down around 2006.
  3. Cheap credit fuelled borrowing, house price gains and a search for yield by investors - correct
  4. Rising inflation that forced the Federal Reserve to tighten sharply in 2003Why not: The Fed did not tighten in 2003; it held rates at 1 percent and began raising them only in mid-2004.

Low policy rates and strong foreign demand for US securities kept borrowing cheap. That supported house prices and pushed investors toward higher-yielding structured products, both key elements of the build-up.

A harder one

A bank buys USD 100 million of AAA-rated structured securities yielding 5.0 percent. It funds 95 percent in the repo market at 4.2 percent and the rest with equity. Ignoring all other costs, its return on equity is closest to:

  1. 16.0%Why not: Charges the 4.2% repo cost on the whole 100 instead of only the 95 borrowed.
  2. 5.0%Why not: Reports the asset yield as the return on equity, ignoring both leverage and funding cost.
  3. 1.0%Why not: Computes profit as a percentage of assets (1.01 on 100) rather than dividing by the 5 of equity.
  4. 20.2% - correct

Income 5.0 - funding cost 0.042 x 95 = 3.99 gives 1.01 profit. Dividing by equity of 5 gives 20.2%. A 0.8 point spread is magnified about twentyfold by leverage, which is why leverage drove risk-taking in the build-up.

The hardest tier

A bank has USD 100 billion of assets and USD 5 billion of equity. Marked-to-market losses of 3 percent on its assets occur. It wants to restore its original leverage (assets / equity) without raising capital, by selling assets at current prices. How much must it sell?

  1. USD 60 billionWhy not: Targets assets of 40 against the original 100 and ignores that the 3 of losses already shrank assets to 97.
  2. USD 55 billionWhy not: Treats the leverage of 20 as debt-to-equity rather than assets-to-equity, giving target assets of 42.
  3. USD 57 billion - correct
  4. USD 3 billionWhy not: Sells only the amount of the loss, which leaves leverage at 97 / 2 = 48.5, far above the original 20.

Losses cut equity to 2 and assets to 97. Leverage of 20 allows assets of 20 x 2 = 40, so the bank must sell 97 - 40 = 57 billion. Leverage amplifies a 3 percent loss into forced selling of well over half the balance sheet, a driver of the build-up and the spirals that followed.

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