Financial Risk Management: Models, History, and Institutions

CHAPTER 9

Structured Credit Risk

This chapter focuses on a class of credit-risky securities called securitizations and structured credit products. These securities play an important role in contemporary finance, and had a major role in the subprime crisis of 2007 and after. As described in Chapter 1, these securities have been in existence for some time, and their issuance and trading volumes were quite large up until the onset of the crisis. They have also had a crucial impact on the development of the financial system, particularly on the formation of the market-based or “shadow banking system” of financial intermediation.

In this chapter, we look at structured products in more detail, with the goal of understanding both the challenges they present to risk management by traders and investors, and their impact on the financial system before and during the crisis. These products are complex, so we'll employ an extended example to convey how they work. They are also issued in many variations, so the example will differ from any extant structured product, but capture the key features that recur across all variants. A grasp of structured credit products will also help readers understand the story, told in Chapters 12, 14 and 15, of the growth of leverage in the financial system and its role in the subprime crisis.

9.1 STRUCTURED CREDIT BASICS

We begin by sketching the major types of securitizations and structured credit products, sometimes collectively called portfolio credit products ...