Sub-prime crisis and models

Complex mathematical models that failed miserably in bringing out the risks inherent in financial transactions have been blamed as being primarily responsible for the sub-prime mortgage bubble indiced financial market meltdown.

It is in this context that two IMF economists, Heiko Hesse and Brenda González-Hermosillo, uses Markov regime-switching analysis for a variety of major global market events, and finds evidence to show that the model can detect advance signs of market turbulence emerging. Their model, which uses the VIX, TED spread, and Euro-dollar forex swap rate as proxies for global financial market conditions, indicates the movement towards high volatility state which in turn is a manifestation of systemic risk.

Euro-dollar forex swap rate
The move of the forex swap into the high volatility state on 15 September 2008 coincides with the sharp increase in counterparty risk resulting from Lehman’s failure and a sizeable dollar shortage that occurred with margins and haircuts increasing on most dollar-denominated assets.



Markov switching ARCH model of TED spread
The findings imply a regime change around the sharp Shanghai stock market correction and the first round of ABX (BBB) price declines in late February 2007, which could have been seen as a potential warning signal about the impending fragilities in the global financial system.



Markov switching ARCH model of VIX
During the Bear Stearns rescue, the VIX was more likely to be in the high rather than medium-volatility state. The Lehman failure then triggered a very fast movement of the VIX into the high-volatility regime.


Update 1
Nicholas Bloom uses models of uncertainty to forecast the impact of sub-prime crisis here and here.