B9301-125: CRREDIT RIS

SK and FIINANCIAL
L REGULA
ATION 
Spring 2011 
Draft 10/11/10
1  
 
Jacquees ROLFO, Ph.D. 
Adjuncct Profess
sor of Fina
ance 
Uris 21
18 
jr3038@columb bia.edu 
 
 
The top pic of this course is s credit rissk: its ide ntification n and qua antification
from a market participantt’s point of o view; th he role it p played in the 2007--
2009 Great
G Receession; ho ow the 201 10 Financ cial Regula ation Bill intends to o
controll it; wheth her the str ructure th he Bill inteends to pu ut in place e would have
been efffective will
w be ana alyzed. The e course inntends to b be self conttained,
although it does re equire B63302: Capita al Markets.
 
We will review the e way crediit risk measures are d derived fro om market data, the
issues pertaining
p to
t such qua antification
ns, the inte
erweaving b between crredit risk and
liquidity
y risk. We will
w examin ne the limitts to the sp pecificity off credit, an
nd, in
particulaar, how it interrelates
i s with marrket risk. WWe will alsoo discuss th he rating
agencies’ approach to credit rating, and d their role
e in the reccent credit crisis. 
 
We will analyze the instrume ents of creddit risk pro
otection, starting with h insurance e
policies sold by boond insurerrs (aka fina ancial guara antors, or monolines) - as credit
protection on mun nicipal bondds, mortgage insuran nce, then (ttraded) cap pital marke et
Credit Default
D Swa aps (or CDSs) issued by banks and other capital market
participaants includ
ding CDPCs s - static ve
ehicles guaaranteeing CDOs and other capital
market structures - vs (held-to-maturitty) CDSs ssold by monolines on infrastructture
and cap pital market structurees. We will also discusss catastro ophe bonds s, instruments
of risk transfer fro
om insuranc ce compan nies to capiital marketts. 
 
We will analyze the demise of o various institutions
i s looking foor clues to “why them m?”,
starting with LTCM M and Enron, interesting precurssors, then Bear Stearrns, AIG,
Lehman n, bond insurers and mortgage
m insurers.
i For comparison, we w will look at
Goldman Sachs’ approach to o derivative e markets.  
 
We will then summ marize the 2010 Finan ncial Regullation, withh a special focus on
derivatives. We will discuss the Administration's plan to channel derivative
transactions through clearinghouses, distinguishing standard vs.
customized/bespoke contracts and analyzing how clearinghouses intermediate
credit risk. We will also discuss ways to externalize catastrophic risks as a means to
separate extreme risks from normal business risks (e.g., with catastrophe bonds).

We will attempt to quantify the relevance of FinReg by analyzing whether its

existence would have prevented the 2007-2009 credit crisis, or at least dampened
its impact. 
 
We will have 2 or 3 guest speakers discussing real life examples of credit
risk management. 
 
In terms of assignments and grading, quizzes on the guest speaker presentations
and 4-to-6 homeworks will contribute to 30% of the grade, the mid-term for 30%,
and the final exam for 40%. Homework should reflect individual contributions only.
Presence and participation to class are essential.  
 
Office hours will be on Friday mornings in Uris 218. Appointments should be
requested by email at jr3038@columbia.edu. 
 
Required textbook: 
Sundaresan, Suresh ("MSS"): Fixed Income Markets and Their Derivatives,
Academic Press, Third Edition, 2009 
 
Readings will be complemented during the life of the course with handouts and/or
additional references 
 
Session 1: Course Overview of the course; What is credit risk? 
- "MSS": CH 1, 1.4 Risk of Debt Securities 
 
Sessions 2 and 3: Credit risk modeling 
- "MSS": CH 10 Modeling Credit Risk and Corporate Debt Securities, Sections 10.1,
10.3, 10.5 to 10.7 
- Capuano, Christian, et al...: Recent Advances in Credit Modeling, IMF Working
Paper WP/09/162, August 2009 
 
Session 4: The commercial credit services: Credit+; RiskMetrics; KMV 
- “MSS”: CH 10, Section 10.4 Implementing Structural Models: the KMV Approach -
- Handouts 
 
Session 5: The "fundamental" approach to credit risk: the rating agencies 
- History of Credit Agencies in the United States, F. Warren McFarlan, Tracy Yen
Manty, Background Note, Harvard Business Publishing, 8/9/2007 
- Note: Credit Rating Agencies, William E. Fruhan Jr., Case, Harvard Business
Publishing, 5/18/2009 
- Report on the role and function of the credit rating agencies..., SEC, 2004 
“MSS”: CH 10, Section 10.2 
 
Session 6: Financial Guarantors (or "monolines"); monoline CDSs;
mortgage insurance 
- Global Financial Guaranty Insurance Industry Outlook, Moody's, 12/2006 
- The Changing Business of Financial Guaranty Insurance, Moody's, 11/2008 
- Credit Risks of Mortgage Insurance, Rating Methodology, Moody's, 7/2002 
- Moody's Global Rating Methodology for the Mortgage Insurance Industry, Moody's,
2/2007  
- Credit Derivative Product Companies, Moody's, 3/6/2006 
 
Session 7: Guest speaker on corporate CDOs  
- Presentation document 
“MSS” CH 19 Structured Credit Products: Collateralized Debt Obligations 
 
Session 8: Guest speaker on mortgage cdo and cds 
- Presentation document 
 
Session 9: BIS I and BIS II; Internal models, BIS III 
- S&P articles "The Essentials of Basel II" and "Basel II Evolution Not Revolution"  
- BIS site: www.bis.org and overview of new Basel Accord
www.bis.org/bcbs/cp3ov.pdf and www.bis.org/press/p040511.htm 
-
http://www.riskmanagementmagazine.com.au/articles/39/0C04DA39.asp?Type=12
4&Category=1240 
 
Session 10: Capital Market instruments of credit transfers: capital market CDSs;
market indices 
- "MSS": CH 18 Credit Default Swaps: Single-Name, Portfolio, and Indexes;  
- Emergence of Default Swap Index Products, Darrell Duffie, Harvard Business
Publishing, 10/26/2004, Product Number F268-PDF-ENG 
 
Session 11:IDBs, repo markets 
Lecture Notes  
“MSS”: CH 4 Organization and Transparency of Fixed Income Markets 
“MSS”: CH 5 Financing Debt Securities: Repurchase (Repo) Agreements 
 
Session 12: LTCM and Enron 
- "LTCM", Andre Perold, Case Study, Harvard Business Publishing, 11/5/1999,
Product Number 200009-PDF-ENG 
- Enron and off-balance sheet financing and lessons on credit management 
In complement: "PJ2007", CH 13 and 18, and, for LTCM discussion, "When Genius
Failed", by Roger Lowenstein, Random House, 2000 
 
Session 13: Mid-term 
 
Session 14: Case Study: "Bear Stearns and the Seeds of its Demise", Susan
Chaplinsky, Case Study, Harvard Business Publishing, 10/22/2008 
 
Session 15: Case study: "AIG - Blame for the Bailout", Maureen McNichols,
Nathan T. Blair, Case Study, Harvard Business Publishing, 3/12/2009 
 
Session 16: Lehman 
Lecture Notes 
Repo 105 

Session 17: Goldman Sachs 

Lecture Notes 
Swaps on Greek debt 
Swaps with AIG FP 
 
Session 18: Credit Crisis  
Lecture Notes 
 
Sessions 19 and 20: Financial Regulation 
Lecture Notes 
 
Session 21: Analysis of FinReg from a Bank's Point of View 
- BarCap 
Lecture Notes 
 
Session 22: Derivatives and Clearinghouses 
- The cost of opacity covering the positions of large players in a pure bilateral OTC
market vs its consequence, systemic risk. 
- Consolidation of counter-party credit risk at the level of a clearinghouse or
exchange. 
- Standardized vs bespoke transactions 
- Clearinghouse vs exchange 
 
Session 23: Externalization of Extreme Risk  
- Mandelbrot: The (Mis)Behavior of markets 
Catastrophe bonds 
Hurricane Insurance 
 
Session 24: Final Exam