1. Michael Burry (Scion Capital) and CVA (Credit Valuation Adjustment)
- Scenario: Michael Burry, managing Scion Capital, bought CDS (Credit Default Swaps) to insure against CDOs (Collateralized Debt Obligations) based on subprime mortgages. He recognized that these mortgages were inherently risky and likely to default.
- Real-world issue: At the time, banks did not fully account for CVA in pricing CDOs. They assumed that counterparty default risk was negligible, which led to the overvaluation of CDOs.
- If CVA had been applied: Proper CVA adjustments would have significantly lowered the valuation of CDOs, reflecting the high counterparty risk. Burry might have paid higher premiums for CDS, but it would have exposed the risks earlier, potentially discouraging the issuance of risky CDOs.
2. Mark Baum (FrontPoint Partners) and KVA (Capital Valuation Adjustment)
- Scenario: Mark Baum and his team discovered that many CDOs were falsely rated as AAA, even though they were backed by subprime loans. They decided to short the housing market by purchasing CDS.
- Real-world issue: Banks did not factor in KVA, the cost of capital needed to support the risks of CDOs. This allowed financial institutions to issue large volumes of CDOs without holding sufficient capital to cover potential losses.
- If KVA had been applied: Banks would have been required to reserve additional capital to cover credit risks, reducing the profitability of issuing CDOs. This could have prevented the rapid expansion of subprime mortgage-backed securities and might have curbed the crisis at an earlier stage.
3. Jared Vennett (Deutsche Bank) and FVA (Funding Valuation Adjustment)
- Scenario: Jared Vennett, a bond salesman at Deutsche Bank, saw an opportunity to profit from market ignorance. He sold CDS to investors betting against the housing market collapse.
- Real-world issue: Banks issuing CDS did not account for FVA, the funding costs required to maintain derivative positions throughout their life. When the market collapsed, funding costs skyrocketed, but the banks had not prepared for this.
- If FVA had been applied: CDS prices would have included funding costs, making them more expensive for buyers like Vennett's clients. Higher CDS costs could have reduced the volume of speculative trades, limiting the proliferation of risky derivatives.
4. Credit Rating Agencies (Standard & Poor’s, Moody’s) and XVA in Credit Ratings
- Scenario: Credit rating agencies assigned AAA ratings to CDOs based on flawed data, misleading investors into believing these products were low-risk.
- Real-world issue: The lack of CVA and FVA considerations in the valuation of CDOs meant that these ratings failed to account for counterparty credit risk and funding costs.
- If XVA had been applied: Proper CVA calculations would have revealed the significant default risks in subprime mortgages, leading to lower credit ratings. Incorporating FVA would have shown the high funding costs of maintaining such products, discouraging their overissuance.
5. Investment Banks and DVA (Debt Valuation Adjustment)
- Scenario: Large investment banks like Lehman Brothers issued and insured derivatives without fully considering their own risk of default, which became apparent during the crisis.
- Real-world issue: Banks did not account for DVA, which measures the impact of their own potential default on the value of their liabilities.
- If DVA had been applied: Banks would have recognized the systemic risk posed by their overleveraged positions and adjusted their exposure accordingly. This could have encouraged greater caution in the issuance and trading of risky derivatives.
How XVA Could Have Prevented the 2008 Crisis
The financial crisis of 2008 was exacerbated by the failure to account for the true risks embedded in derivatives like CDOs and CDS. Proper application of XVA could have addressed these issues:
- CVA (Credit Valuation Adjustment): Identifies and prices in counterparty default risk. Could have lowered the valuation of risky derivatives, deterring their issuance.
- KVA (Capital Valuation Adjustment): Ensures adequate capital reserves for risky positions. Would have limited the excessive growth of the subprime mortgage market.
- FVA (Funding Valuation Adjustment): Reflects the cost of funding derivatives. Could have increased the cost of speculative derivatives, reducing demand.
- DVA (Debt Valuation Adjustment): Captures the risk of the institution's own default. Encourages financial institutions to recognize their vulnerability in a crisis.
- MVA (Margin Valuation Adjustment): Accounts for the cost of collateral requirements. Would have forced institutions to maintain more liquidity, improving resilience.
Lessons from "The Big Short"
The failure to integrate XVA into risk assessment and pricing allowed banks, investors, and rating agencies to ignore the true costs and risks of financial products. If XVA had been used, it could have:
- Increased transparency in the valuation of complex derivatives.
- Prevented the overissuance of risky financial products like CDOs.
- Reduced systemic risk by ensuring better capital and funding management.
In summary, XVA provides a comprehensive framework for measuring and managing financial risk. Its adoption could have changed the trajectory of events depicted in "The Big Short" and might have mitigated or even prevented the 2008 financial crisis.
?Dam Van Vi - Quantitative Finance.
My two-cent opinion is that the whole system was relying on ratings that proved to be flawed. Products with a triple AAA were much riskier indeed. They found it by unpacking the products, looking at the single positions, and exploiting the flaw. It was a system failure, not a methodology failure.