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The 2007-2008 crisis

Introduction. The paper tries to explain the mechanisms that caused losses in the mortgage market and the threads that can explain the generalised market decline;The US were experiencing low interest rates, large capital inflows (especially from Asia):The FED did not counteract the build-up of the

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The 2007-2008 crisis

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    1. The 2007-2008 crisis Notes for Macrorisks course Universit di Milano Bicocca Based on Brunnermeier 2009 - JEP

    2. Introduction The paper tries to explain the mechanisms that caused losses in the mortgage market and the threads that can explain the generalised market decline; The US were experiencing low interest rates, large capital inflows (especially from Asia): The FED did not counteract the build-up of the housing bubble, while the banking system went through an important evolution towards the originate to distribute model; The creation of new securities (new asset types) facilitated the large capital inflows from abroad (remember Caballero?).

    3. Banking industry trends Instead of holding loans on their balance sheets, banks moved to an originate and distribute model, packaging loans and selling these packages to other financial investors, offloading risks; Banks increasingly financed their assets with short maturity instruments, exposing themselves to maturity mismatch and liquidity risk; To offload risks structured products were created (typically CDOs); CDOs were sliced into different tranches and sold to investors with different risk appetite (super senior, senior, mezzanine, equity or toxic); Buyers of these tranchescould protect themselves through CDS (also on indexes, e.g. CDX or Itraxx).

    4. Maturity mismatch Investors prefer assets with short maturity (focussing on short term performance), but mortgages and other investment projects have long maturities (years); Often (unfortunately) this time mismatch was transferred to a shadow banking system, such as off-balance sheet vehicles and conduits, which raise funds by issuing 90-days notes backed by long term assets, which can be seized and sold by owners in case of default; This practice exposes vehicles to funding liquidity risk, that is solved by banks granting credit lines to their sponsored vehicles; At the end of the day, it is always banks which bear the risk which, however, is hidden away from the balance sheet of banks; Regulatory advantages and infrequent portfolio revaluation.

    5. The unfolding of the crisis The trigger for the liquidity crisis was an increase in subprime mortgage defaults, first noted in February 2007:

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