P1.T1.701. Amplifying mechanism and recurring themes in the global financial crisis (Brunnermeier)

[Nicole Seaman]

Learning objectives: Describe how securitized and structured products were used by investor groups and describe the consequences of their increased use. Describe how the financial crisis triggered a series of worldwide financial and economic consequences. Distinguish between funding liquidity and market liquidity and explain how the evaporation of liquidity can lead to a financial crisis. Analyze how an increase in counterparty credit risk can generate additional funding needs and possible systemic risk

Questions:

701.1. Brunnermeier's event logbook is a succinct narrative of the unfolding of the global financial crisis and is organized according to the following ten mini-chapters:

I. Subprime mortgage crisis begins (February 2007): the trigger for the liquidity crisis was an increase in subprime mortgage defaults that was arguably first noticed in the ABX price index
II. Asset-backed commercial paper (ABCP, July 2007): amid widespread concern about how to value structured products and an erosion of confidence in the reliability of ratings, the market for short-term ABCP began to dry up
III. The LIBOR, Repo, and Federal Funds Markets (August 2007): the TED spread, and other related credit spreads, began to surge upward
IV. Central banks step forward (August and September 2007): to alleviate the liquidity crunch, the Federal Reserve reduced the discount rate by half a percentage point to 5.75 percent on August 17, 2007, broadened the type of collateral that banks could post, and lengthened the lending horizon to 30 days; on September 18, the Fed lowered the federal funds rate by half a percentage point (50 basis points) to 4.75 percent and the discount rate to 5.25 percent.
V. Continuing write down of mortgage-related securities (October through November 2007)
VI. Monoline Insurers (January 2018): Fitch downgrades Ambac which has the result of "unnerving worldwide financial markets"
VII. Bear Stearns (March 2008): this financial institution essentially experiences a "bank run"
VIII. Fannie Mae and Freddie Mac (July to September 2008): after making the implicit government guarantee explicit in July, as the stock price of Fannie and Freddie slid further, on September 7th government officials put them into federal conservatorship
IX. Lehman Brothers, Merrill Lynch, and AIG (September 2008 and October 2008)
X. Coordinated Bailout, Stock Market Decline, Washington Mutual, Wachovia, and Citibank (September 2008 to December 2008)

About this particular narrative, which of the following is a TRUE statement?

a. The Federal Reserve failed to take significant actions during 2007 and 2008 to mitigate the crisis
b. The crisis was difficult for anybody to anticipate prior the 4th quarter of 2008 because key credit spreads did not widen until then; even the earlier ABX index price drop was a good omen akin to a lower VIX
c. The crisis was self-contained within financial markets as Wall Street's crisis (in financial markets) did NOT spill over into Main Street (the non-financial economy)
d. While Bear Stearns and AIG were both bailed out and Lehman Brothers was not bailed out, all three firms were highly interconnected to counterparties around the globe


701.2. Brunnermeier's paper is concerned with amplifying mechanisms and liquidity spirals. He asks how liquidity shock(s) can get amplified into a full-blown financial crisis when liquidity evaporates. According to him each of the following is such an amplifying mechanism with the potential to exacerbate (ie., make worse) a crisis or otherwise contribute to systemic risk EXCEPT which is NOT really part of this problem?

a. Low market liquidity risk where market liquidity has three sub-forms of market liquidity: (i) the bid–ask spread, (ii) market depth, and (iii) market resiliency
b. Multilateral netting agreements which tend to create gridlock risk--which is a subclass of liquidity risk--due to network effects especially if a bureaucratic central authority attempts to unrealistically keep track of all positions
c. Low funding liquidity where funding liquidity risk includes three forms, each of which are detrimental when assets can only be sold as fire sale prices: (i) margin/haircut funding risk, (ii) rollover risk, and (iii) redemption risk
d. Precautionary hoarding by lenders who have limited capital and where the risk of such precautionary hoarding increases when either the likelihood of interim shocks increases or when funds are expected to be difficult to obtain.


701.3. Which is the following statements about liquidity is TRUE?

a. After a large price drops, lending haircuts and margins tend to increase
b. Funding liquidity refers to the transfer of the asset with its entire cash flow
c. Market liquidity is like issuing debt, equity, or any other financial contract against a cash flow generated by an asset or trading strategy
d. An investor who wants to maintain a constant leverage ratio (without injecting new equity) when the existing asset value drops rapidly can borrow to purchase additional assets

Answers here:

• In forum

 

[David Harper CFA FRM]

@Nicole Seaman already mentioned elsewhere that we have resumed the weekly practice question discipline. Yay! For those who might be interested, today's question is not my only style but it does reflect one of my qualitative styles and my approach in general to writing FRM questions. I just wanted to share a bit about my approach to writing questions, at least in today's case.

First, the questions are new and original; ie, handcrafted, as they say. Second, I am not trying to game or predict the exam: it's a fool's errand and, to be honest, I do like that we cannot easily predict the FRM exam's exact questions. The reason I like this is because GARP's method seems to consistently imply that the best study strategy is something like genuine familiarity and, in some cases, mastery of the material. As opposed to, say, rote memorization. Related, I have on another forum someone give advice along the lines of "stick tightly to the learning objectives and do not go beyond LOs in the readings." I disagree with such advice, having been engaged with GARP on the significance of the LOs for over ten years now. The LOs are not a prototype (exact technical specification) of the exam; that's sort of a deductive view that might expect the LOs to forecast the exam, in a manner of speaking. But the LOs are part of a broader blueprint, in fact. So I would suggest you view the LOs from an inductive perspective: they are expansions of the Key Concepts. They populate the key concepts into details. Yet the FRM's valid testable domain remains the Key Concepts which are too broad to be actionable from a study perspective and LOs serve the function of translating broad Key Concepts into specific, actionable study hooks.

[Why is it this way? Cynically you could argue that it gives GARP to the freedom to ask questions that, strictly speaking, might not exactly correspond to an LO syllabus item. A bit of air cover-yes?! Okay, but that's not really the reason. GARP is good people and here is the reason: the questions are originated (to use a lending analogy ) from practitioners and from a real-world practitioner orientation. To my knowledge, GARP doesn't originate a question as a first step by going to the reading first; the first step is a real-world practitioner orientation and the questions are then vetted against the readings.]

Third, as the question above shows, personally I am trying to siphon as much relevant knowledge out of the reading as possible. My first question above took me two hours to write, then edit further this morning. This Brunnermeier reading actually gives a really efficient overview of the crisis (although, as you know, there are many different perspectives on the crisis; his perspective is not necessarily anybody's much less GARP's official view. But it's actually mostly just factual, so I like it). So my hidden agenda in question 701.1 is actually just to give the reader a recap (ha!). Then, fourth, you may notice that the question itself is not terribly difficult: I work on calibration a lot. It's easy for me to ask too difficult questions because, geez, I just finished reading and re-reading and re-reading the Brunnermeier paper. So, a typical edit step is for me to dial back the difficulty from a roster of several possibilities. In the case of 701.1, I'd like to think people familiar with the crisis should be able to answer it correctly without having read Brunnermeier in particular. Fifth, each of the false choices is deliberately included to convey information. In this case, the false choices are meant to float themes in the reading; eg, Brunnermeier definitely argues that there were some "early" indicators. A lot of my questions are EXCEPT WHICH questions and the reason is that these are an effective way to reinforce multiple ideas in one question. Finally, paying members can see that we typically put significant effort into the answers. I hope that's interesting insight into how I write a certain style of question. None of these are quantitative really, which is a whole other topic. Thanks!

 

[emilioalzamora1]

Citing @David Harper CFA FRM

'GARP doesn't originate a question as a first step by going to the reading first; the first step is a real-world practitioner orientation and the questions are then vetted against the readings.'

To hammer home the message, listen to B. May from 1:28 onwards (can't copy the link here) Go to: Youtube >
About GARP's FRM Program

 

[David Harper CFA FRM]

Hi @emilioalzamora1 Ah, thank you! This is such a great link to Bill May explaining the practitioner-oriented methodology; eg, reaching out to FRM is practitioner-first.

@Nicole Seaman at the upcoming webinar, can you ask GARP whether this Exam Development method has changed any way? I am including Emilio's link here (did you know you can link to a specific time by appending #t=01m25s). Also, it would be great if we can capture this (just this exam methodology) into a short transcript for the FAQ.

 

[Nicole Seaman]

Hi @emilioalzamora1 Ah, thank you! This is such a great link to Bill May explaining the practitioner-oriented methodology; eg, reaching out to FRM is practitioner-first.

@Nicole Seaman at the upcoming webinar, can you ask GARP whether this Exam Development method has changed any way? I am including Emilio's link here (did you know you can link to a specific time by appending #t=01m25s). Also, it would be great if we can capture this (just this exam methodology) into a short transcript for the FAQ.

@emilioalzamora1 and @David Harper CFA FRM,

I received a response back from our contact at GARP regarding this question. I had asked at the webinar, but they get so many questions during that one hour, that I just don't think they got to answer it. Here is their response:

"No the format has not changed. If anything we have more working professionals from around the world in developing the exam questions and what the topics should be. This is reviewed and updated annually."

I hope this is helpful!

Nicole

 

[David Harper CFA FRM]

@Nicole Seaman Thank you, that is helpful. The implication of this (continues to be) is that Learning Objectives are not necessarily a logically complete recipe for the exam. I think of Learning Objectives as the "bottom up" realization of the topics: they manifest (realize) topics with concrete linkages to the assigned readings. But GARP's exam methodology importantly begins "top down" with risk practitioners in the real world. Of course, they intend that top-down mostly overlaps with bottom-up; or to put this another way, practitioner intent is reconciled with the assigned readings. However, we really are not able to say something like "Such and such is not exactly and literally an LO in the syllabus, so it won't be tested" because that would ignore the top-down, realistic approach of the exam. Similarly, as was always the case, this realty implies that it's not the best strategy to try and "game" the LOs by trying to anticipate too much what exactly GARP will ask for on the exam. Or to worry about how GARP may try and "trick you" (which I've read on another forum). In my experience, GARP does not try to trick you. Instead, the LOs are an expansion of the topics, and the best strategy is to use them as a roadmap to understanding the concepts.