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Credit Risk Measurement In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms, Third Edition by Linda Allen, Anthony Saunders

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CHAPTER 2
The Three Phases of the Credit Crisis

INTRODUCTION

In Chapter 1, we described how credit risk built up in the financial system over the decade prior to 2007. Although this period was certainly not free of crises (e.g., the 1997 East Asian currency crisis; the summer 1998 Russian default and Long Term Capital Management insolvency; the March 2000 bursting of the tech bubble; and the September 11, 2001, World Trade Center attack), it was generally a period of historically low credit risk and defaults. Global equity markets grew over this period as credit markets expanded in size and complexity, and both consumers and corporations took leverage to historically high levels. In this chapter, we discuss the bursting of the credit bubble and the contagious transmission of the crisis from the subprime mortgage market to the financial system as a whole.

BURSTING OF THE CREDIT BUBBLE

While it is difficult to date the beginning of the post-2007 global financial crisis, the preconditions for such a crisis were building from 2001, and in particular after the terrorist attacks on 9/11. In fact, the immediate response to the terrorist attacks by regulators was to create stability in the financial markets by providing liquidity to banks and other financial institutions alike. For example, the Federal Reserve lowered the short-term money market rate that banks and other financial institutions pay in the federal funds market, the market for overnight borrowings among major banks, ...

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