ERM-615-19: The devil is in the tails: actuarial mathematics and the subprime mortgage crisis



Reading Source:

Topics Covered in this Reading:

  • Introduction
  • The roots of the subprime mortgage crisis
  • Securitization
  • The Gaussian copula model
    • A brief introduction to copulas
    • Two illustrative copulas
    • The Gaussian copula approach to CDO pricing
    • Credit default swaps and synthetic CDOs
  • The drawbacks of the copula-based model in credit risk
    • Inadequate modeling of default clustering
    • Inconsistent implied correlation in tranches and an early warning
    • Ability to do stress-testing
  • The difficulties in valuing CDOs
    • Sensitivities of the mezzanine tranche to default correlation
    • Squaring the difficulty: CDO-squared
  • Alternative approaches to valuing CDOs
  • A failure of risk management: AIG
    • The AIG story
    • Risk management issues
  • Summary