Nordic Capital Markets Forum - 26 February 2008 A Risk Managers View on the Credit Crisis

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Nordic Capital Markets Forum - 26 February 2008 A Risk Managers View on the Credit Crisis Morten Weis, Nordea Bank AB. Bunch Market Risk Management

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Disclaimer & affirmations: The material and proclamations displayed here are the individual perspectives of the speaker and does not really speak to the perspectives of Nordea Bank AB. The material and proclamations here are based open data from the media, and my own appearance on these through various examinations with my partners. Any blunders are at fault on me by and by.

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Topics The general point of this introduction is to impart to the group of onlookers my impression of a portion of the instruments that prompts to vast modern banks restating salary weeks in the wake of distributing their budgetary outcomes. I will first discuss bookkeeping principles and after that swing to reflections about how banks perform valuation of complex instruments, in exceptionally broad terms, and utilize the acknowledge showcase for instance to outline some of my announcements.

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Accounting guidelines are essential International bookkeeping rules (IFRS, GAAP) educate banks to report profit and monetary records in light of reasonable esteem . Reasonable esteem is the esteem that a ready and learned partner is prepared to pay/get in an a safe distance exchanges. Reasonable esteem is per definition not the esteem you would get in a troubled deal. In any case, - per definition ought to reasonable esteem join every significant hazard (and dependably credit chance). In Europe and in USA, effectively cited costs ought to dependably be utilized speak to reasonable esteem - when they exist. On the off chance that dynamic markets does not exist for a given instrument - a valuation method must be utilized.

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Accounting A valuation procedure could allude the estimation of another instrument, that is exchanged effectively, to the instrument in core interest. A valuation system can likewise be an advanced scientific model with numerous perplexing suppositions and info parameters, that not be unbiasedly noticeable. In Europe - you are not permitted to perceive an in advance pick up from an exchange, on the off chance that you gauge reasonable incentive by a valuation procedure that depends on undetectable information parameters. [This is changing in US after the presentation of FAS 157].

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Valuation is not a correct science In present day back, the revealed reasonable estimation of a given exchange will be a subjective articulation if no dynamic market exist. Two banks enters a monetary contract: e.g. Bank An offer assurance against default chance on portfolio X to Bank B. Bank A gets a premium from Bank B, that ought to be the reasonable cost of the risk Bank A now have. For both banks the estimation of the exchanges ought to be near zero on day 1. Be that as it may, - there is an undeniable plausibility for both Bank An and Bank B to see the exchange as having a positive incentive on day 1, because of contrasts in the valuation systems they apply. The more mind boggling the instrument is - the bigger the likelihood will be. Furthermore - the partners may work under various bookkeeping rules.

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External partners impact on valuations We have seen a few episodes where outer partners have strengths establishments to adjust valuations. On of the opening demonstrations of the emergency was the disappointment of two Bear Sterns speculative stock investments that caved in after their use suppliers drastically changed their view on the estimation of the benefits posted as security. Bear Stern did not concur, grabbed the advantages in the assets and left speculators with gigantic misfortunes. Later we have seen AIG repeating valuations significantly, pushed by their outside evaluators that focuses to different establishments having made radical compose downs for comparable resources.

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Is absence of liquidity the same as bothered deal? On the off chance that you read the bookkeeping rules - NO. You ought to report the incentive as what might be the "leave cost" on the off chance that you sold the thing today. You are not permitted to slight detectable costs in a dynamic market regardless of the possibility that it is less fluid than typical or in light of the fact that there is a lopsidedness amongst free market activity. In the event that no dynamic market exist - any applicable perceptible value data for comparable instruments must be consolidated in the element's valuation method. The ABX credit subsidiary record for sub-prime home loan bonds is regularly said in this setting since it is detectable.

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Common presumptions behind valuation models Most present day money related valuation systems depend on purported chance nonpartisan models. Models that depend on the presumption that arbitrage is unrealistic and that business sectors are viable. All models depend on two segments: An assurance of the likelihood dissemination for the hidden resource in light of costs of exchanged instruments (choices) identified with the basic resource. Obliged on the likelihood conveyance of today - scientific suppositions on the progression of the hidden depicts how the likelihood dispersion for the basic will advance later on. Note: for the most well-known CDO show - the supposition is really that there is no flow from today until development.

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Common components of valuation models Per development - the normal models will return you the costs that you find in the market. In any case, - just on the "standard instruments" that have a dynamic market. Bank utilize the models to esteem complex instruments that are not exchanged a dynamic markets and where there is pretty much nothing, assuming any, immediate value straightforwardness. What's more, banks may need to "extrapolate" the discernible information or gauge inconspicuous parameters required by the model. Tomorrow - the banks will recalibrate their model to the new costs in the market for "standard instruments" - I.e. they will state there is another likelihood conveyance for the fundamental resource and they will express another incentive for the mind boggling instrument. In some sense you can state that banks just trust their models for one day at the time.

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How to check whether the esteem is right? The models gauge of the estimation of a mind boggling subsidiary ought to speaks to the hypothetical fence cost of the instrument until development of the agreement. I figure that few banks can confirm if that holds. The model may be changed commonly before development of the exchange (it is normal to exchange 10 - 30 years contracts in business sectors that have existed in significantly less time). You can just test if the esteem is right, in the event that you exchange the instrument. There is progressively concentrate on agreement estimating administrations, yet there are blended signs from the bookkeepers if these when all is said in done fill in as speaking to "tradable costs".

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What can happen if the model isn't right? At the point when an outrageous occasion happens that is not anticipated by the model - one ought not expect any from your model. Chance figures in view of the model won't anticipate what happens. The "rules" in the commercial center can change drastically after an extraordinary occasion. It don't should be a transitory change. In the event that it is an aggregate model blunder over the business a few items may vanish from the scene. An element can confront absence of capital in light of the fact that the evaluated interest for capital depended on figures from a model that did not foresee a repricing of hazard.

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Why banks pick the valuation they do Consensus frequently emerge on the grounds that the general population that assemble models talk together - they commonly think a similar way (they are all physicist) - and the model clients have comparable business and motivating forces. Administration need models that empowers them to offer new items (i.e. items that have higher edges). Rivalry is cruel. Merchants shares this motivation and obviously they additionally need models that measures the dangers in the item on an everyday premise, with the end goal that they can deal with their positions. Chance chiefs need models that can disclose everyday value moves - and models that appears to be "sensible". Controllers need banks to apply "best practice" models.

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Credit subsidiaries - models All models value subordinates by demonstrating the hidden procedure - here the likelihood of default of one or a few backers. Be that as it may, - the market is not in adjust! The credit subordinate market is approx. 20 times bigger than the hidden corporate security showcase. My claim: The subordinate market "controls" the basic market - not the inverse. "Current" Itraxx IG 5Y spread level relates to 7% misfortune in 5 years among the 125 most fluid speculation review firms in Europe. Liquidity, free market activity, and numerous other "certifiable" elements are not demonstrated!

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Itraxx speculation review S8 5Y, 12%-22%

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Is reasonable esteem the right esteem? In the event that the entire market isn't right - then it is correct… If it is regular to disregard certain hazard components in the valuation of an item - then it will be reasonable esteem, since the esteem other market members will exchange at. Valuation alterations serves to adjust the yields of models that are to basic, in a journey to acquire reasonable esteem levels. At the point when the market's view on hazard changes quickly - you don't get new valuation models overnight - and you have to have a go at monitoring the valuation vulnerability through valuation modification. The outline of valuation alterations is a vital hazard administration undertaking.

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The reasonable esteem theory You begin seeing individuals scrutinizing requesting "reasonable esteem" revealing for things that is not exchanged. The reasoning in the US is by all accounts that expanded revelation about exposures and valuations ought to make a market teach between banks, if valuations depend on inconspicuous info. The making of fluid files was a stage from driving banks to make a reference outline for valuation of bespoke exchanges to decrease the instability in valuations and to make reasonable evaluating of hazard. Presently - a few banks will most likely question if the fluid records are a gift or a

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