The Sub Prime Crisis And Liquidity Risk

The sub perfect crisis was as much about liquidity as about insolvency. Many banks suffered during the sub prime problems because of a capital framework that relied too heavily on personal debt. ’ net worth much faster than their gross value. The total amount that they can sharply borrow falls. 100 million worth of assets on ten percent margin.

5 million of capital remaining. 45 million of property must be sold. Which sale may happen exactly when the price is low. These sales will depress the purchase price further, inducing more selling and so forth. This loss spiral are certain to get aggravated if various other potential buyers with experience may face similar constraints at the same time. The spiral will also get amplified if other audience find it more profitable to hold back out losing spiral before reentering the marketplace. Indeed, investors might even engage in “predatory trading, ” forcing others to liquidate their positions at fire-sale prices deliberately. The margin/haircut spiral reinforces losing spiral.

As margins or haircuts rise, the trader must sell assets to reduce the leverage percentage. Haircuts and Margins spike in times of large price drops, leading to an over-all tightening of lending. A vicious cycle emerges, where higher margins and haircuts pressure de-leveraging and more sales, which increase margins further and push more sales, leading to the possibility of multiple equilibria. A rise in counterparty credit risk can create additional funding needs and potential systemic risk.

Brunnermeir has illustrated this by an example related to the Bear Stearns problems in March 2008. Imagine a hedge account that had mortgage loan swap contract with Goldman Sachs. Say the hedge finance offset its obligation through another swap with Bear Stearns. In the lack of counterparty credit risk, the two swap contracts would collectively be looked at as just a single one between Goldman and Carry Stearns essentially. However, it might be unwise for Goldman to renew the contract if it feared that Bear might default on its commitment.

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Goldman was asked to increase its direct exposure to Bear following the trading hours on March 11, 2008 when Bear was approaching personal bankruptcy. Goldman did renew the agreement in the morning of March 12. However the delay in response was mistakenly interpreted as a hesitation on Goldman’s behalf and fear that Bear Stearns might be in trouble. This misinterpretation was leaked to the press and appears to have added to the run on Bear Stearns. Indeed, a rise in recognized counterparty credit risk can be self-fulfilling and create additional financing needs. Guess that Bear Stearns had an offsetting swap agreement with a private equity fund, which offset its exposure with Goldman Sachs.

All parties, used together, are hedged fully. However, each party appreciates only of its own contractual agreements. So it might not know the full situation and therefore become concerned about counterparty credit risk. If the investment banks won’t let the hedge fund and private equity fund net their offsetting positions, both funds have to either set up additional liquidity, or insure each other against counterparty credit risk by buying credit default swaps. This happened in the week after Lehman’s personal bankruptcy. All major investment banks were worried that their counterparties might default.

So they bought credit default swap protection against each other. The already high prices on credit default swaps of the major investment banking institutions almost doubled. The price tag on credit default swaps for AIG was strike the most severe. It more than doubled within two trading days. Such problems are easier overcome when there is a central clearinghouse which understands who owes what things to whom. Indeed, many economists have argued highly in favour of moving away from OTC to central clearing preparations for most if not all derivatives.

3. Creditors can argue that forces of visit strengthen Jack’s ownership interest to a level that makes trust possessions reachable. Given these arguments, how can a grantor mitigate the risk that unwanted parties will gain access to irrevocable trust possessions? Ultimately, protecting those assets is the estate planning attorney’s responsibility. But your clients’ understanding of the following procedures can help protect the possessions they hope to transfer to heirs.

Powers of appointment. These provisions permit the beneficiary to mention new beneficiaries to his or her share of the property. In general, the higher the powers of appointment, the higher the chance that trust assets will be exposed. 1. Power of session can expose trust possessions to a divorce proceeding or lenders potentially.

2. The courts differ in the way they treat this concern, so it can be an essential aspect in trust design. Beneficiary as trustee. It’s not unusual for a grantor to name the beneficiary as the trustee. By doing so, possessions become susceptible to divorce debts and contracts settlements. 1. If the trustee has discretion to make distributions to the beneficiary (himself or herself), maybe it’s difficult to claim that is not outright possession.

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