Manual The Split Capital Investment Trust Crisis (The Wiley Finance Series)

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Lesson 2 7 Investments in Working Capital

Vandaag voor uur besteld, morgen in huis. Over de auteur Over dit boek Artikelen en interviews Recensies. Samenvatting Rubriek: Financieel management. Trefwoorden: Beleggen. Inhoudsopgave List of Contributors. Lezersrecensies Beoordeel zelf slecht matig voldoende goed zeer goed. Algemene beoordeling slecht matig voldoende goed zeer goed.

Uw recensie. Bedankt voor uw beoordeling Uw reactie is inmiddels op de website geplaatst en zal door onze redactie beoordeeld worden. Bekijk uw recensie. Lezersrecensies 1 Vond u deze recensie nuttig? NaN Vandaag. Aanbevolen bij dit boek Digital Finance. For Citigroup this represented about half the bank's overall assets. Wall Street Journal , SIVs were supposed to be stand-alone institutions that paid service fees to the originating banks, but to which the originating banks had no obligations or commitments.

They borrowed short-term in the commercial paper market and used this money to buy long-term, illiquid but highly profitable securities such as CDOs—a very dangerous game. To enable this commercial paper to receive AAA ratings and thus low interest rates, originating banks had to provide their SIVs with guaranteed lines of credit.

The Split Capital Investment Trust Crisis - PDF

This made the banks vulnerable to problems experienced by their supposedly independent SIVs. This triggered a mass exodus from the asset-backed commercial paper market. With the disappearance of their major source of funding, banks were forced to move these damaged assets to their balance sheets. Contrary to the assumed transparency of financial markets, until SIVs began to collapse very few experienced financial market professionals knew they existed.

The combination of bank write downs on assets held on-balance-sheet combined with devalued SIV assets that had to be moved back onto balance sheets severely eroded bank capital. This in turn forced banks to try to lower their risk by raising interest rates and cutting loans to other financial institutions and to households and nonfinancial businesses. Deregulation allowed financial conglomerates to become so large and complex that neither insiders nor outsiders could accurately evaluate their risk.

The Bank for International Settlement told national regulators to allow banks to evaluate their own risk—and thus set their own capital requirements—through a statistical exercise based on historical data called Value at Risk VAR. Government officials thus ceded to banks, as they had to ratings agencies, crucial aspects of regulatory power.

VAR is an estimate of the highest possible loss in the value of a portfolio of securities over a fixed time interval with a specific statistical confidence level. There are four fundamental flaws in this mode of risk assessment. First, there is no time period in which historical data can be used to generate a reliable estimate of current risk. If firms use data from the past year or less, as is standard practice, then during boom periods such as to mid VAR exercises will show that risk is minimal because defaults and capital losses on securities are low.

Banks thus need to set aside only a small amount of capital against estimated risk, which allows them to aggressively expand leverage, which in turn accelerates security price increases. On the other hand, if data from past decades are used, the existence of past crises will raise estimated risk, but financial markets will have undergone such fundamental change that these estimates will bear no relation whatever to current risk.

Second, VAR models assume that security prices are generated by a normal distribution. Even a 7. Allowing banks to estimate risk and set capital requirements on the assumption that large losses cannot happen left them vulnerable when the crisis erupted. Third, the asset-price correlation matrix is a key determinant of measured VAR. The lower the correlation among security prices, the lower the portfolio's risk. VAR models assume that future asset price correlations will be similar to those of the recent past. However, in crises the historical correlation matrix loses all relation to actual asset price dynamics.

Most prices fall together as investors run for liquidity and safety, and correlations invariably head toward one, as they did in the recent crisis. Again, actual risk is much higher than risk estimates from VAR exercises. Fourth, the trillions of dollars in assets held off balance sheet were not included in VAR calculations Blankfein, Reliance on VAR helped create the current crisis and left banks with woefully inadequate capital reserves when it broke out.

VAR-determined capital requirement are just one of many possible examples of totally ineffective regulatory processes within the NFA. The problems involved in risk management through VAR were apparent to everyone who understood even the outline of the procedure; you do not need specialist knowledge to spot them. I explained the problems associated with VAR in Crotty, , a paper written in , well before the crisis developed. Yet only a few influential financial observers warned against the futility of standard risk management practices prior to the crisis because VAR-based risk assessment maximised bonuses.

No one wanted to kill the goose that was laying golden eggs. It gave firms a false sense of complacency, because it ignored certain risks and relied heavily on past price movements. In some markets, VAR actually increased risk, because every trader assessed risk in the same flawed way. Partnoy, , p.

The Split Capital Investment Trust Crisis

It was claimed that in the NFA, complex derivatives would allow the risk associated with securities to be divided into its component parts, such as interest rate and counter-party risk. Investors could buy only those risk segments they felt comfortable holding. Since markets price risk correctly, no one would be fooled into holding excessive risk, so systemic risk would be minimised.

There are major flaws in this argument. First, and perhaps most important, it implicitly assumed that the NFA would not generate more total risk than the previous tightly-regulated bank-based regime, but only spread a given system-wide risk across more investors. However, the degree of system-wide risk associated with any financial regime is endogenous. The effect of regime change on systemic risk depends on the amount of real and financial risk it creates and the way it disperses that risk, factors strongly affected by the mode of regulation.

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The structure of the NFA inevitably created excessive risk. Second, derivatives can be used to speculate as well as to hedge.

In the boom, hedging via derivatives is relatively inexpensive, but financial institutions guided by perverse incentives do not want to accept the deductions from profit and the bonus pool that full hedging entails. Conversely, after serious trouble hits financial markets, agents would like to hedge risk, but the cost becomes prohibitive. Moreover, a rise in the cost of hedging can occur quickly and unexpectedly.

Ironically, while the ability to hedge via derivatives can make an individual investor safer, it can simultaneously make the system riskier. For example, hedging often involves dynamic derivative trading strategies that rely on liquid continuous markets with low to moderate transactions costs. A typical dynamic hedge involves shorting the risky asset held and investing in a risk-free asset. The hedge adjusts whenever the asset price, interest rate or volatility changes, which they do continuously.

When problems hit, price falls and volatility rises. Institutions with dynamic hedges must sell their risky assets, which accelerates the rate of price decrease, which in turn forces more hedged-asset sales.

If many investors have made similar dynamic hedges and are selling, liquidity dries up and prices can free-fall. Insurers such as AIG piled up immense commitments to pay in the event of defaults or capital losses with little capital to back these commitments. When losses hit security markets AIG could not pay off its contracts; it became insolvent.

Ultimately, CDSs made the system more fragile because they facilitated excessive risk-taking. Third, the narrative insists that derivatives unbundle risk, dividing it into simpler segments. But in fact, sophisticated derivatives such as CDOs re-bundle risk in the most complicated and non-transparent ways: this is what financial engineering and structured derivative products do. Fourth, the celebratory NFA narrative applauded globalisation of financial markets because it created channels of risk dispersion.

But securitisation and funding via tightly integrated global capital markets simultaneously created channels of contagion in which a crisis that originated in one product in one location US subprime mortgages quickly spread to other products US prime mortgages, MBSs, CDOs, home equity loans, loans to residential construction companies, credit cards, auto loans, monoline insurance and auction rate securities and throughout the world. Weber, As noted, structural flaws in the NFA created dangerous leverage throughout the financial system.

Annual borrowing by US financial institutions as a percent of gross domestic product GDP jumped from 6. However, in , under pressure from Goldman Sachs chairman and later Treasury Secretary Henry Paulson, it raised the acceptable leverage ratio to 40 times capital and made compliance voluntary Wall Street Watch , , p. This allowed large investment banks to generate asset-to-equity ratios in the mid to upper 30s just before the crisis, with at least half of their borrowing in the form of overnight repos, money that could flee at the first hint of trouble.

Commercial banks appeared to be adequately capitalised, but only because they over-estimated the value of on-balance-sheet assets while holding a high percentage of their most vulnerable assets hidden off-balance-sheet. In fact, they were excessively leveraged, as the crisis revealed.


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Many European banks had leverage ratios of 50 or more before the crisis Goodhart, , while Citibank's and Bank of America's ratios were even higher Ferguson, By the end of many large banks had seen their equity position evaporate to the brink of insolvency and beyond. Rising leverage was facilitated in part by the easy money policies of the Fed. To avoid a deep financial crisis following the collapse of the late s stock market and internet booms, the Fed began to cut short-term interest rates in late and continued to hold them at record lows through to mid Financial firms were thus able to borrow cheaply, which, under different circumstances, might have fueled a boom in productive capital investment.