Credit Crisis: Actions Taken and Lessons Learned

Credit Crisis: Actions Taken and Lessons Learned

Thursday, November 6, 2008

The New York Academy of Sciences

Presented By


Endorsed by the International Association of Financial Engineers

The credit crisis has had a significant impact on the financial markets as well as the global economy. At this meeting, we will hear from two prominent presenters their insights and experiences on this topic.This event will build on the discussion began at the Spring 2008 meeting examining the market crisis and the resulting credit crunch.

Quantitative Finance is part of a new initiative launched in physical sciences and engineering. Given the Academy's new location at 7 World Trade Center and the number of scientists who work in finance, the goal of this symposium is to build community by creating collaborations and developing professional networks between the science and finance communities.

Moderator: Petter Kolm, Courant Institute, NYU.

An Overview of the Current Financial Crisis and Some Ideas for Resolving It
Stephen Figlewski, Stern School of Business, NYU

  • Derivatives are zero-sum contracts with two sides. If the party on one side loses $1, that $1 is a gain to the counterparty. The whole financial system consists of such contracts, making it possible to abstract from the intricate details and view it as a single zero-sum entity, as if you were 20,000 up.
  • From that height, one can see that the financial system is currently being battered by huge losses and extreme uncertainty that are arising in the real estate sector of the real economy, and it is breaking down.
  • Solution: Disconnect the financial system from the risk that is too big for it to handle. The Federal government could take over bearing this risk quite easily, just by guaranteeing that all mortgage payments would henceforth be made to the lender as scheduled.
  • The financial markets would stabilize because all mortgage-backed securities, no matter how complicated, would immediately become as safe and as marketable as US Treasury bonds.
  • The government would then work with homeowners to restructure their monthly payments so they can afford to stay in their homes. Defaults and foreclosures would go down sharply.
  • This type of approach is much more cost effective than others that have been proposed.
  • Turning the "approach" into a workable plan involves many details. A key principle is that the plan should be widely felt to be "fair" to all parties. Some suggestions on how to do that will be discussed.

The Credit Crunch in Pictures
Bjorn Flesaker, Bloomberg

This brief talk highlights three economic time series and seeks to explain their relevance to the credit crunch. First, we look at the outstanding balances of asset backed commercial paper, whose rapid growth raised half a trillion dollars worth of low risk, short term investments which were partially funneled via CDOs and mortgage backed securities into long term, high risk subprime mortgages, in a multi-stage financial engineering process that was heavily dependent on credit ratings. Next, we will examine the size of the balance sheet of the Fed, comparing the scale of their response to the current crisis to other events over the last two decades. Finally, we will show the historical results of a hypothetical investment in a particular "hedge fund replication strategy" that seeks to take advantage of predictable differences between implied and realized volatility in the S&P 500 index. We speculate that forced unwinds of positions held by hedge funds and other leveraged trading desks due to the credit crunch is likely to have played a role in the catastrophic breakdown of a historically stable relationship in the equity market.