LO 6.2: Explain how correlation contributed to the global financial crisis o f 2007

LO 6.2: Explain how correlation contributed to the global financial crisis o f 2007 to 2009.
The correlations of assets within and across different sectors and geographical regions were a major contributing factor for the financial crisis of 2007 to 2009. The economic environment, risk attitude, new derivative products, and new copula correlation models all contributed to the crisis.
Investors became more risk averse shortly after the internet bubble that began in the 1990s. The economy and risk environment was recovering with low credit spreads, low interest rates, and low volatility. The overly optimistic housing market led individuals to take on more debt on overvalued properties. New structured products known as collateralized debt obligations (CDOs), constant-proportion debt obligations (CPDOs), and credit default swaps (CDSs) helped encourage more speculation in real estate investments. Rating agencies, risk managers, and regulators overlooked the amount of leverage individuals and financial institutions were taking on. All of these contributing factors helped set the stage for the financial crisis that would be set off initially by defaults in the subprime mortgage market.
Risk managers, financial institutions, and investors did not understand how to properly measure correlation. Risk managers used the newly developed copula correlation model for measuring correlation in structured products. It is common for CDOs to contain up to 125 assets. The copula correlation model was designed to measure [n x (n 1) / 2] assets in structured products. Thus, risk managers of CDOs needed to estimate and manage 7,750 correlations (i.e., 125 x 124 / 2).
CDOs are separated into several tranches based on the degree of default risk. The riskiest tranche is called the equity tranche, and investors in this tranche are typically exposed to the first 3% of defaults. The next tranche is referred to as the mezzanine tranche where investors are typically exposed to the next 4% of defaults (above 3% to 7%). The copula correlation model was trusted to monitor the default correlations across different tranches. A number of large hedge funds were short the CDO equity tranche and long the CDO mezzanine tranche. In other words, potential losses from the equity tranche were thought to be hedged with gains from the mezzanine tranche. Unfortunately, huge losses lead to bankruptcy filings by several large hedge funds because the correlation properties across tranches were not correctly understood.
Correlation played a key role in the bond market for U.S. automobile makers and the CDO market just prior to the financial crisis. A junk bond rating typically leads to major price decreases as pension funds, insurance companies, and other large financial institutions sell their holdings and are not willing to hold non-investment grade bonds. Bonds within specific credit quality levels typically are more highly correlated. Bonds across credit quality levels typically have lower correlations.
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Topic 6 Cross Reference to GARP Assigned Reading – Meissner, Chapter 1
Rating agencies downgraded General Motors and Ford to junk bond status in May of 2005. Following the change in bond ratings for Ford and General Motors, the equity tranche spread increased dramatically. This caused losses for hedge funds that were short the equity tranche (i.e., sold credit protection). At the same time, the correlations decreased for CDOs of investment grade bonds. The lower correlations in the mezzanine tranche led to losses for hedge funds that were long the mezzanine tranche.
The CDO market, comprised primarily of residential mortgages, increased from $64 billion in 2003 to $455 billion in 2006. Liberal lending policies combined with overvalued real estate created the perfect storm in the subprime mortgage market. Housing prices became stagnate in 2006 leading to the first string of mortgage defaults. In 2007, the real estate market collapsed as the number of mortgage defaults increased. The CDO market, which was linked closely to mortgages, collapsed as well. This led to a global crisis as stock and commodities markets collapsed around the world. As a result, correlations in stock markets increased as the U.S. stock market crashed. Default correlations in CDO markets and bond markets also increased as the value of real estate and financial stability of individuals and institutions was highly questionable.
The CDO equity tranche spread typically decreases when default correlations increase. A lower equity tranche spread typically leads to an increase in value of the equity tranche. Unfortunately, the probability of default in the subprime market increased so dramatically in 2007 that it lowered the value of all CDO tranches. Thus, the default correlations across CDO tranches increased. The default rates also increased dramatically for all residential mortgages. Even the highest quality CDO tranches with AAA ratings lost 20% of their value as they were no longer protected from the lower tranches. The losses were even greater for many institutions with excess leverage in the senior tranches that were thought to be safe havens. The leverage in the CDO market caused risk exposures for investors to be 10 to 20 times higher than the investments.
In addition to the rapid growth in the CDO market, the credit default swap (CDS) market grew from $8 trillion to $60 trillion during the 2004 to 2007 time period. As mentioned earlier, CDSs are used to hedge default risk. CDSs are similar to insurance products as the risk exposure in the debt market is transferred to a broader market. The CDS seller must be financially stable enough to protect against losses. The recent financial crisis revealed that American International Group (AIG) was overextended, selling $500 billion in CDSs with little reinsurance. Also, Lehman Brothers had leverage 30.7 times greater than equity in September 2008 leading to its bankruptcy. However, the leverage was much higher considering the large number of derivatives transactions that were also held with 8,000 different counterparties.
Regulators are in the process of developing Basel III in response to the financial crisis. New standards for liquidity and leverage ratios for financial institutions are also being implemented. New correlation models are being developed and implemented such as the Gaussian copula, credit value adjustment (CVA) for correlations in derivatives transactions, and wrong-way risk (WWR) correlation. These new models hope to address correlated defaults in multi-asset portfolios.
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Topic 6 Cross Reference to GARP Assigned Reading – Meissner, Chapter 1
T h e R o l e o f C o r r e l a t i o n R i s k i n O t h e r T y p e s o f R i s k