Systemic Financial Turmoil : Inside the Subprime and the Eurozone Crises Quantitative Architecture and Empirics

The paper investigates the Subprime and the European sovereign debt crises through the prism of a novel methodology for portfolio credit derivatives analytics - a dynamic top-down HJM setting. Interestingly, the eurozone resembles a giant CDO in its financial construct which makes such an approach viable. Common currency imposed on a union lacking common treasury and fiscal policy produces a special waterfall for the losses on the overall community's sovereign debt. Rather than having the extremes, on one hand, of complete proportional loss sharing, and, on the other hand, each country to rely only on its means for debt service, an intermediate implicit priority rule becomes operative. Namely, the debt becomes a tranche structure reflecting the country's paid-in capital with ECB with priority going from the bearing highest spread country (equity) to the lowest spread one (super-senior). In both crises situations, it becomes important to well understand what factors drive the risky spreads and how they can be properly divided between systemic and idiosyncratic ones. We employ suitable calibration and estimation techniques and control appropriately for the market price of risk. The empirical results allow to dissect the turmoil by novel financial engineering techniques with policy and industrial implications