In the summer of 2007, the world financial markets entered into a severe liquidity crisis. On August 9, 2007, France’s largest bank BNP Paribas announced that it was having difficulties because two of its off-balance-sheet funds had loaded up on securities based on American subprime mortgages. But Paribas was not alone in its troubles: a month before, the German bank IKB announced similar difficulties, and the Paribas announcement was followed the next day by Northern Rock’s revelation that it had only had enough reserve cash to last until the end of the month. These and other similar announcements lead to a freeze of the credit markets as banks lost faith in each other’s balance sheets.
The situation was particular surprising considering the market conditions shortly before the crisis began. At the beginning of 2007, financial markets were liquidity unconstrained and credit spreads were at historical lows. Even as late as May 2007, it would have been hard to predict the magnitude of the response that the losses on subprime mortgages had generated. Compared to the total value of financial instruments traded worldwide, the subprime losses were relatively small: even the worst-case estimates put them at around USD 250 billion . Further, for investors familiar with the instruments, the losses were not unexpected. By definition, the subprime mortgages were part of the riskiest segment of the mortgage market, so it was hardly surprising some borrowers would default on the loans. Yet, despite their predictability, the defaults had precipitated the current liquidity crisis that spread between the credit markets.
As Caballero and Krishnamurthy [2008a] argue, the crisis was primarily caused by the rise in ambiguity that followed the subprime defaults. That is, although the value of the underlying assets did not necessarily change, the credit market participants were taken by surprise at how the complex credit derivatives were reacting and became uncertain about the quality of their investments. A prime example is the behavior of the credit default spreads (CDS) and the CDX index. Before July 2007, the popular copula models of defaults were able to price both the CDS spreads on the securities that compose the CDX index and the tranches of the index it self.
Starting with July 2007, the copula pricing model failed. In fact, Bear Stearns announced in June 2007 that it no longer understood how to price mortgage backed securities. The rise of the complex credit derivatives in the previous five years proliferated the problem. Because investors had no prior experience with how these instruments would behave in a time of crisis, they did not know how to interpret the securities’ response to mortgage failure. The complexity of the instruments involved made it almost impossible to calculate the proper response to changes in the underlying. Thus, when even AAA-rated subprime tranches suffered losses, the resulting increase in ambiguity about the quality of investments in place lead market participants to make decisions based on their perceived worst-case scenario. The revelations by major banks about their exposure to subprime mortgages through off-balance sheet funds only served to reinforce the increase in ambiguity about signals from the major market participants.
