The 2007–2008 Credit and Liquidity Crunch: Impact on Structured Credit Markets
We shall begin the second edition of this book with an assessment, and observations, on the 2007–2008 financial crisis and its impact on structured credit markets. This is in two parts: first, we discuss the origins and impact of the crisis, and then we look at specific market events. Before we do this, though, we outline the rationale for credit derivatives and bank credit risk transfer.
BANKS AND CREDIT RISK TRANSFER
Banking institutions have always sought ways of transferring the credit (default) loss risk of their loan portfolios, for two reasons: (i) to remove the risk of expected losses from their balance sheet, due to an expected increase in incidence of loan default; and (ii) to free up capital, which can then be used to support further asset growth (increased lending). The first method of reducing credit risk is selling loans outright. This simply removes the asset from the balance sheet, and is in effect a termination of the transaction. Alternatives to this approach include the following:
- spreading the risk via a syndicated loan, in partnership with other banks;
- securitising the loan, thus removing the asset off the balance sheet and, depending on how the transaction is structured and sold, transferring the credit risk associated with the loan;
- covering the risk of default loss with a credit default swap (CDS) or an index credit default swap;
- transferring the risk of the asset to ...