No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

Jeffrey Rosenberg, Bank of America Merrill Lynch

Contents

Introduction to 'Lessons from the Financial Crisis'

1.

The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?

2.

Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

3.

The Shadow Banking System and Hyman Minsky’s Economic Journey

4.

The Collapse of the Icelandic Banking System

5.

The Quant Crunch Experience and the Future of Quantitative Investing

6.

No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

7.

The Re-Emergence of Distressed Exchanges in Corporate Restructurings

8.

Modelling Systemic and Sovereign Risks

9.

Measuring and Managing Risk in Innovative Financial Instruments

10.

Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors

11.

Limits of Implied Credit Correlation Metrics Before and During the Crisis

12.

Another view on the pricing of MBSs, CMOs and CDOs of ABS

13.

Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments

14.

A Practical Guide to Monte Carlo CVA

15.

The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

16.

Market Panics: Correlation Dynamics, Dispersion and Tails

17.

Financial Complexity and Systemic Stability in Trading Markets

18.

The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles

19.

Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

20.

Active Risk Management: A Credit Investor’s Perspective

21.

Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

Bear Stearns, Lehman Brothers and AIG: three key events of the 2007–9 credit crisis were at their core related to troubled mortgage exposure. Derivatives played varying roles in each of these cases and dramatic changes in the structure and economics of the global derivatives markets stand as a consequence of the crisis. During the summer of 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act enshrined the legislative legacy of this era to be followed by the phase of regulatory implementation. While that contributes substantial uncertainty as to the exact impact of these reforms, the broad implications are clear: create greater transparency of the over-the-counter (OTC) market, reduce the counterparty risk of the OTC market through centralised clearing and limit the speculative capacity of derivatives to create systemic risk.

Mortgage Market and Derivatives

The rapidly growing mortgage market, particularly the expansion of the non-agency mortgage market, both fuelled a housing market boom and fed a growing demand from investors for yield. Figure 6.1 highlights this growth. Behind the key events of Bear Stearns, Lehman and AIG (and the Federal National Mortgage

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