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A.B.C. of The Global Financial Crisis 2008 Making difference & creating inspiration through life changing

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1 A.B.C. of The Global Financial Crisis 2008 Making difference & creating inspiration through life changing

2 Faces of the CRISIS

3 Globalization? Global impact? Global Financial Crises? Why?  Question: What is the truest definition of Globalization?  Answer: Princess Diana's death.  Question: How come?  Answer: An English princess,  with an Egyptian lover,  crashes in a French tunnel,  driving a German car,  with a Dutch engine,  driven by a Belgian who was drunk,  on Scottish whisky,  followed closely by Italian Photographers,  on Japanese motorcycles;  treated by an American doctor,  using Brazilian medicines.  This is being told by a British,  using Bill Gates' technology,  and you're seeing it through a Japanese multimedia projector,  that use Taiwanese chips,  and a Korean lens,  assembled by Bangladeshi workers,  in a Singapore plant,  This is being told in front of Professors,  Educated in USA, UK, Japan and France,  That, my friends, is Globalization

4 Global Financial Crisis Dictionary 2008 Wall Street Crash Financial Tsunami Credit Crunch Lehman Brother AIG Financial Meltdown Housing Bubble Bust Bailout Package PREFERENCE SHARES SECURITISATION Casino Crisis TOXIC DEBT SHORTING Liquidity squeeze Real economy Subprime Write-downs Alan Greenspan Derivatives Black Monday" Money market funds Dowjones Plunge Emergency Economic Stabilization Act of 2008 Merrill Lynch JP Morgan Chase Fannie Mae and Freddie Mac Liquidity crisis Making difference & creating inspiration through life changing

5 20 Steps to the DOOMSDAY 1.In 2001, following a massive stock market and capital spending bubble, Federal Reserve Chairman Alan Greenspan worried that the U.S. faced a severe recession. He began cutting interest rates down to 1% and kept them at that level until 2004, raising them slowly only 0.25% at a time thereafter. 2.With interest rates so low, the financial services industry sensed a lot of money could be made and went all in on real estate, seemingly unaware that low interest rates were masking large risks. 3.Meanwhile, Americans had been anticipating a nasty downturn after the bubble burst. But, they soon realized that money lost in the stock market was more than offset by rising home prices. So, Americans continued to spend freely. Making difference & creating inspiration through life changing

6 4.As Americans spent freely, the U.S. went further into debt with the rest of the world. Foreigners, used their dollar IOUs from these debts to start their own bubbles too. 5.Eventually, things started to unravel in 2006 when those that could least afford to purchase homes -- so called subprime borrowers -- started to default in the U.S., prices having run well out of their range of affordability. 6.In February 2007, HSBC issued the first major warning, a harbinger of things to come, writing down tens of billions in losses from their ill-timed 2002 acquisition of U.S. subprime lender Household International. At first things looked fine and policy makers convinced themselves and the wider public that the problem was contained to subprime.writing down tens of billionsill-timed 2002 acquisition 7.However, when two Bear Stearns hedge funds with exposure to the US housing market blew up in June 2007, people became worried that the risks had been underestimated.Bear Stearns hedge funds 8.It was in August 2007 when BNP Paribas, a large French bank, froze withdrawals in three investment funds that people began to panic. If a bank with zero obvious exposure to the U.S. mortgage sector could have this measure of difficulty, anyone could be hiding untold losses. This marked the official beginning of the credit crisis. The result was mutual distrust amongst large banks operating in the global market for interbank loans which meant credit was hard to come by for many banks.froze withdrawals in three investment funds Making difference & creating inspiration through life changing

7 9.By September, liquidity in the interbank market was so bad that rumors were swirling about various institutions which received most of their funding in wholesale markets. One of these was Northern Rock, an aggressive British mortgage lender. The British public panicked and began lining up to pull their money out of the institution. The Bank of England was forced to bail out the company, subsequently nationalizing it altogether.Bank of England was forced to bail outsubsequently nationalizing it 10.Meanwhile U.S. housing prices continued to decline. The result was massive losses in the alphabet soup of mortgage-related derivative assets held by large global banks. These instruments are called derivatives because their value is derived from the value in underlying assets like mortgages. The first wave of mortgage-related losses were concentrated in these instruments and investing vehicles: RMBSs (Residential Mortgage Backed Securities) CDOs (Collateralized Debt Obligations), and SIVs (Structured Investment Vehicles) and CDOs of CDOs. Merrill Lynch was the first to report a large loss, at $5.5 billion on 5 Oct Only to come back less than three weeks later on 24 Oct 2007 to say that the losses were now over $8 billion. Eventually, losses reached $500 billion a year into the crisis for all global institutions.report a large loss, at $5.5 billionlosses were now over $8 billionlosses reached $500 billion Making difference & creating inspiration through life changing

8 11.The Merrill losses were followed by losses at most of the large global financial institutions. Many CEOs lost their jobs and the companies were forced to raise capital. By August 2008, the amount raised was to reach $350 billion.forced to raise capital 12.The situation seemed to quiet down in early However, in March the failures of hedge funds Peloton and Carlyle Capital put the credit crisis back in full view. Another 2nd period of panic resulted in the sudden collapse of Bear Stearns, America's 5th largest investment bank. The Fed organized a takeover by JP Morgan Chase that was a catastrophic 90% loss for Bear's shareholders.PelotonCarlyle Capitaltakeover by JP Morgan90% loss for Bear's shareholders 13.Eventually the collapse of Bear Stearns faded and, for the third time, we were lulled into a false sense of security that the worst was over. Nevertheless, writedowns continued unabated as did capital raising. When Lehman Brothers announced a massive $3 billion loss 0n 9 Jun 2008, the crisis came into full view yet again -- much as it had when Bear Stearns' hedge funds collapsed the previous June.announced a massive $3 billion loss 14.This time, market fears did not recede and the financial markets remained in a constant state of stress. Things started to unravel very quickly. IndyMac, an aggressive mortgage lender, an American version of Northern Rock, was taken over by the FDIC. And a panic was on for the third time.taken over by the FDIC Making difference & creating inspiration through life changing

9 15.Next were the GSEs. The end result of the market panic was a questioning of the viability of Fannie Mae and Freddie Mac, the two largest mortgage lenders in the United States and at the core of the residential property market. Eventually the U.S. Government was forced to take the two companies into conservatorship.take the two companies into conservatorshi 16.Afterwards, all financial shares generally came under assault. The ones considered the weakest came under the heaviest selling pressure, resulting in the collapse of Lehman Brothers. Without government support and unable to close a merger in around-the-clock negotiations at the weekend, the company filed for bankruptcy on Sep. 15.filed for bankruptcy on Sep Merrill Lynch, the venerated US investment bank, sensing trouble, sought and received cover in a takeover by Bank of America that very same weekend.takeover by Bank of America 18. Financial markets smelled blood after Lehman collapsed. Apparently no company was too big to fail. So, the assault on financial service companies continued. Eventually, AIG, the largest insurance company in the world, succumbed to this pressure. The Federal Reserve, citing special considerations, bailed out the non-depositary institution. bailed out the non-depositary institution 19. At this stage, we were in free fall and the entire banking system was on the verge of collapse in the United States. Global shocks had not ended either, as UK institutions were increasingly under attack as well, having been damaged by their own property bubble. At the urging of the British Prime Minister and the UK regulatory authorities, Lloyds TSB bought Britain's largest mortgage lender HBOS, which was in jeopardy of failing.bought Britain's largest mortgage lender HBOS 20. By this time, the Feds had had enough. The time for ad hoc crisis management was at an end. Hank Paulson moved decisively and put forward his $700 billion bailout plan. Which was later approved…. And that's where we stand. Making difference & creating inspiration through life changing

10 Impact of the squeeze??? Here are some startling statistics that make our financial crisis all too real: 2/3 of Americans believe their children will be economically worse off then they are. Profits are at a 40 year high for Fortune 500 companies ($705 billion) nearly 2X previous high. But average wages only up 1% (inflation adjusted) (Bureau of Labor Statistics (BLS)). Median personal income is actually down, below 2000 levels (BLS), and also below 1977 levels in real dollars! The real median income in 1977 was $51,223 (inflation adjusted). In 2006 it was $50,700. (National Center for Education Statistics (NCES)). Virtually all income gains have gone to the richest Americans, the owners of capital and senior management compensation, which is now an incredible 400 times the average employee wage. In USA, out of 300 million people in which the richest 3 million own more than the bottom 256 million. 1% owns more than 90% of us put together! Prices in real terms of housing, education, and health care have risen nearly 300% more in the past 30 years, while individual incomes are stagnant. The amount of monthly income it takes to buy a house today is nearly 23% vs. 17% in People who pay 50% of their income for rent or mortgage payments are at an all time high. Private college tuition and public tuition is up nearly 300% (College Board). The average debt of a college graduate is nearly $20,000+ (College Board). A majority of Baby Boomers expect to work beyond age 65 because they can’t afford not to. 47 million are medically uninsured. Most are in families with at least one full time worker. Medical Insurance Premiums of an average American family exceed $1000 per month. Loan defaults and foreclosures are doubling monthly in many parts of the country. In Cleveland, Ohio nearly 10% of the homes are vacant and abandoned due to foreclosure caused by job loss. Retail sales are declining due to increase costs of gasoline, insurance, and housing. The savings rate for the average American 30 years ago was 9%. Today it is at zero. America has fewer manufacturing jobs (14.3 million) than it did in 1950 with 2 times the population. (In 1950 there were approximately 150 million Americans; today there are approximately 300 million. ) Since 1977, inflation-adjusted medium income for U.S. males has declined 7.5%. U.S. productivity in terms of output ranks 8th behind Norway, Belgium, France, Ireland, Italy, Austria, and Germany (OCED). U.S household debt exceeds $12 trillion. U.S. Federal Deficit is $8.8 trillion! And climbing every second.

11 The Nosedive Making difference & creating inspiration through life changing

12

13 “the elephant in the room”

14 Origin point of the crisis United States, 2007: a price bubble in the housing market bursts… United States, 2007: a price bubble in the housing market bursts… Making difference & creating inspiration through life changing

15 Origin point of the crisis … marking the end of the largest speculative surge of real housing prices in the U.S. in the last 50 years … … marking the end of the largest speculative surge of real housing prices in the U.S. in the last 50 years … Notice the prolongedexponentialgrowth! Making difference & creating inspiration through life changing

16 Origin point of the crisis … and resulting in a surge of loan delinquencies in the residential mortgage loan market … … and resulting in a surge of loan delinquencies in the residential mortgage loan market … Making difference & creating inspiration through life changing

17 Origin point of the crisis … especially among the recent loan vintages on the “subprime” market segment. Vintage 2007 is the worst performing yet… … especially among the recent loan vintages on the “subprime” market segment. Vintage 2007 is the worst performing yet… % of delinquent loans (60+ days) Months from origination Making difference & creating inspiration through life changing

18 Several questions pop up… What has fueled the observed house price bubble? What has fueled the observed house price bubble? U.S. monetary policy? U.S. monetary policy? Global saving glut? Global saving glut? Lack of (other) investment opportunities? Lack of (other) investment opportunities? How can lower house prices increase mortgage loan defaults? How can lower house prices increase mortgage loan defaults? Does the ability to repay mortgage loans depend on the value of the underlying real estate? Does the ability to repay mortgage loans depend on the value of the underlying real estate? Why was the crisis not contained at the point of origin? Why was the crisis not contained at the point of origin? Shouldn’t risks be borne by those who originate them (=mortgage banks) ? Shouldn’t risks be borne by those who originate them (=mortgage banks) ? Can the crisis affect the real economy and the world? Can the crisis affect the real economy and the world? How can problems in a relatively small segment of the U.S. economy affect growth inside and outside of the U.S.? How can problems in a relatively small segment of the U.S. economy affect growth inside and outside of the U.S.? Making difference & creating inspiration through life changing

19 Mortgage loan market in the U.S. – segmentation of the market U.S. mortgage loan market “Prime”LTV<80%FICO>660 “Conforming” Principal < “conforming” limit “Jumbo” Principal > “conforming” limit “Non-prime” “Near-prime”(Alt-A)LTV~80-90%FICO~ “Subprime”LTV>90%FICO<580 Government guarantee and securitization GSEs- Fannie Mae, Freddie Mac… Private securitization market Countrywide financial, Bear Stearns, Lehman Brothers, Bank of America, Wells Fargo, Washington Mutual… Making difference & creating inspiration through life changing

20 Mortgage loan market in the U.S. – relative size of the “subprime” segment The share of subprime increased by 130% from 2003 to 2005! The share of subprime increased by 130% from 2003 to 2005! The percent of loans securitized increased by 60% from 2001 to 2005! The percent of loans securitized increased by 60% from 2001 to 2005! Share of subprime In total U.S. economy (measured by GDP): 1% (2001), increasing to 5% (2005) Making difference & creating inspiration through life changing

21 Mortgage loan market in the U.S. – types of products Mortgage loans Fixed rate mortgage(FRM) Adjustable rate mortgage(ARM) Common ARM ARM payment option Interest only (I-O) ARM Hybrid ARM Making difference & creating inspiration through life changing

22 Functioning of the mortgage loan market in favorable market conditions Assumptions Rising real estate prices Rising real estate prices Rising income levels Rising income levels Low or falling interest rates Low or falling interest ratesResult Additional real estate equity due to price appreciation Additional real estate equity due to price appreciation Borrowers are able to repay their loans with refinancing. Borrowers are able to repay their loans with refinancing. Example of refinancing: Real estate value:$ Mortgageloan:$ value:$ After 1 year Mortgageloan:$ Repayment of initial loan:$ Cash remaining $ Making difference & creating inspiration through life changing

23 Functioning of the mortgage loan market in strained market conditions Assumptions Stagnating or falling real estate prices. Stagnating or falling real estate prices. Stagnating or falling income levels. Stagnating or falling income levels. High or rising interest rates. High or rising interest rates.Result No new real estate equity. No new real estate equity. Repyment of loans by refinancing not possible. Repyment of loans by refinancing not possible. Borrowers faced with increasing difficulties in servicing real estate debt. Borrowers faced with increasing difficulties in servicing real estate debt. Figure:  Interest rate movements on U.S. mortgage market (hybrid ARM rates). Making difference & creating inspiration through life changing

24 Risk factors contributing to the escalation of the crisis in the U.S. Global capital imbalances: Asia & Middle East – surpluss savings; United States – deficit savings; Europe – mostly balanced. Global capital imbalances: Asia & Middle East – surpluss savings; United States – deficit savings; Europe – mostly balanced. Global demand for higher yields – low rates of return on classical high risk instruments (i.e. shares), in the post dot com era (after 2000). Global demand for higher yields – low rates of return on classical high risk instruments (i.e. shares), in the post dot com era (after 2000). Predatory lending practices among U.S. mortgage banks – Combination of capital abundance in the U.S. due to international inflows and demand for higher yields provides incentives to U.S. banks for aggressive lending. Failure of prudent lending practices – loans made to individuals with poor or no credit histories, no documentation, no regular income! Predatory lending practices among U.S. mortgage banks – Combination of capital abundance in the U.S. due to international inflows and demand for higher yields provides incentives to U.S. banks for aggressive lending. Failure of prudent lending practices – loans made to individuals with poor or no credit histories, no documentation, no regular income! Widespread use of decieving credit products (hybrid ARMs) – Low initial fixed rates marketed to lure high credit risk individuals into borrowing without giving enough consideration to possible subsequent default; upon resetting of interest rates (fixed to floating) debt servicing requirements alone could increase 15-30%! Widespread use of decieving credit products (hybrid ARMs) – Low initial fixed rates marketed to lure high credit risk individuals into borrowing without giving enough consideration to possible subsequent default; upon resetting of interest rates (fixed to floating) debt servicing requirements alone could increase 15-30%! Making difference & creating inspiration through life changing

25 Global financial imbalances U.S. current account deficit recently as high as 6% of U.S. GDP! Financing provided mostly by capital inflows from Asian countires and oil exporters. U.S. current account deficit recently as high as 6% of U.S. GDP! Financing provided mostly by capital inflows from Asian countires and oil exporters. Making difference & creating inspiration through life changing

26 Equity markets Equity markets were not an attractive investment opportunity in the aftermath of the collapse of the dot com bubble. Equity markets were not an attractive investment opportunity in the aftermath of the collapse of the dot com bubble. Making difference & creating inspiration through life changing

27 Interest rates Interest rates in were historically low as a result of expansionary monetary policies by major world central banks. Interest rates in were historically low as a result of expansionary monetary policies by major world central banks. Making difference & creating inspiration through life changing

28 Risk factors revisited: The final touch that puts it all together… 1. G lobal financial imbalances  infusion of liquidity into international financial system, searching for yield 2. L ow yields on equities  incentives to invest into new high risk instruments with adequate risk profile 3. L ow interest rates  incentives to borrow for those who would normally never be able to afford it. Are the owners of global capital really willing to invest into high credit risk U.S. individuals? Probably only in small amounts… …unless the risks can be dispersed!  STRUCTURED FINANCE & SECURITIZATION Making difference & creating inspiration through life changing

29 Structured finance: the first round of securitization (schematic presentation) Mortgageloans Total value: $ Mortgage loan portfolio can be divided into bonds with $100 face falue. Different tranches of bonds carry different levels of risk depending on their seniority/subordination in debt repayment. 1. tranche (low risk) bonds at $100 Coupon rate: 10 % 2. tranche (medium risk) bonds at $100 Coupon rate: 15 % 3. tranche (high risk) bonds at $100 Coupon rate: 20 % Securitization Mortgage backed securities (MBS) Demand:financialinvestors Supply:originators of mortgage loans Making difference & creating inspiration through life changing

30 Structured finance: The key to high (AAA) ratings Credit enhancement facilities External: Bond insurance – monoline insurers; Bond insurance – monoline insurers; Letter of credit – banks. Letter of credit – banks.Internal: Overcollateralization; Overcollateralization; Excess spread; Excess spread; Reserve account; Reserve account; Senior/subordinated debt structure. Senior/subordinated debt structure. Liquidity facilities – sponsor banks Making difference & creating inspiration through life changing

31 Structured finance: The players in securitization Originator End borrowers Conduit/trust/SPV/SPE/SIV Investment bank (underwriter) Rating agency Institutionalinvestor End lenders Insurancecompany Broker Servicer $ $ $ $ $ Mortgages Mortgages MBS I&P ($) MBS, I&P ($) Financial returns ($) LEGEND KEY O&G – interest and principal SPV – special purpose vehicle SPE – special purpose enterprise SIV – special investment vehicle MBS – mortgage backed securities Founder: loan originator or investment bank Purpose: transfering ownerhship of claims (loans) and collateral (mortgages) in order to issue mortgage backed securities (bonds). Exposure of founder: implicit guarantee in case of large losses. Assigns credit rating to issued MBSs. Organizes issuing of MBSs and places MBSs to investors in financial markets. Broker places mortgage loans to borrowers for fee Manages the flow of interests and principal (I&P); usually, but not necessarilly the Originator Typically a specialized mortgage bank Mutual funds, pension funds, hedge funds… Can assume part of risks (insurance of mortgage loans, insurance of MBS returns). Making difference & creating inspiration through life changing

32 Structured finance: The second round of securitization Mortgage bonds Rating: AAA/Aaa Mortgage bonds Rating: AA/Aa2 Mortgage bonds Rating: A/A2 Mortgage bonds Rating: BBB/Baa2 Mortgage bonds Rating: BB/Ba2 Mortgage bonds Rating: B/B2 “Equity” tranche Mortgage backed securities (MBS) Investmentgrade Speculativegrade CDO Ratings: AAA/Aaa – BBB/Baa2 CDO Ratings: less than BBB/Baa2 Collateralized debt obligations (CDO) Investmentgrade MBS Otherclaims Making difference & creating inspiration through life changing

33 Structured finance: The third round of securitization… A mil. $ question: if I am a sponsor bank of the SIV that issued CDO2, what is my risk exposure? Making difference & creating inspiration through life changing

34 Structured finance: Instruments and volumes RMBS – residential mortgage backed securities RMBS – residential mortgage backed securities CMBS – commercial mortgage backed securities CMBS – commercial mortgage backed securities MBS – mortgage backed securities MBS – mortgage backed securities ABS – asset backed securities ABS – asset backed securities CDO – collateralized debt obligations CDO – collateralized debt obligations CDS – credit default swaps CDS – credit default swaps Making difference & creating inspiration through life changing

35 Structured finance: ratings of issued securities and types of claims for SIVs Making difference & creating inspiration through life changing

36 Structured finance: funding profile of SIVs and claims of ABCP conduits

37 International transmission of the crisis – institutional investors (1) Key question Why has a crisis in a relatively narrow segment of the U.S. financial system send such strong shockwaves through the U.S. and international financial environment? Why has a crisis in a relatively narrow segment of the U.S. financial system send such strong shockwaves through the U.S. and international financial environment?Explanations Investor miopia – excessive focus on yield and insufficient focus on risk due to benign international financial environment. Investor miopia – excessive focus on yield and insufficient focus on risk due to benign international financial environment. Difficulties in estimating risks – failure of risk assessment models for structured finance instruments, which are not actively traded in the secondary markets (such as CDO and CDO2). Difficulties in estimating risks – failure of risk assessment models for structured finance instruments, which are not actively traded in the secondary markets (such as CDO and CDO2).

38 International transmission of the crisis – institutional investors (2) Over reliance on credit rating agencies – systematic large downgrades of MBS credit ratings since July 2007 cause panic among investors and subsequent “flight to quality”  repricing of risk! Over reliance on credit rating agencies – systematic large downgrades of MBS credit ratings since July 2007 cause panic among investors and subsequent “flight to quality”  repricing of risk! Contagion effect – a lack of confidence spread from the narrow MBS segment to the wider ABS segment, which is based on a much broader pool of claims, including corporate bonds, student loans, car leases, credit card payments etc. Contagion effect – a lack of confidence spread from the narrow MBS segment to the wider ABS segment, which is based on a much broader pool of claims, including corporate bonds, student loans, car leases, credit card payments etc. Self-fulfilling negative spirals – investors’ lack of condifence  fire sales of structured finance instruments  stressed liquidation of SIV/SPV/SPE assets  falling prices of illiquid structured finance instruments  further lack of confidence  accelerated fire sales of structured finance instruments… Self-fulfilling negative spirals – investors’ lack of condifence  fire sales of structured finance instruments  stressed liquidation of SIV/SPV/SPE assets  falling prices of illiquid structured finance instruments  further lack of confidence  accelerated fire sales of structured finance instruments…

39 Unreliable ratings of rating agencies in the MBS market

40 Transmission of risk aversion (1): From the RMBS to the CMBS segment… Record drops in prices Record increases in risk premiums Making difference & creating inspiration through life changing

41 Transmission of risk aversion (2): …from MBS to the entire ABS market… Making difference & creating inspiration through life changing

42 Transmission of risk aversion (3): …and even to corporate debt markets Making difference & creating inspiration through life changing

43 International transmission of the crisis –the interbank money market (1) Key question How has the crisis jumped from institutional investors to the interbank market? How has the crisis jumped from institutional investors to the interbank market?Explanations Realization of contingent liabilities of banks to various investment vehicles Realization of contingent liabilities of banks to various investment vehicles Important role of ABCP (asset backed commercial papers) with partial exposure to U.S. subprime market in transmission of the crisis! Important role of ABCP (asset backed commercial papers) with partial exposure to U.S. subprime market in transmission of the crisis! Conduits issuing ABCPs were established & sponsored by several european banks. Problems at German banks IKB and Sachsen LB and french BNP Paribas. Conduits issuing ABCPs were established & sponsored by several european banks. Problems at German banks IKB and Sachsen LB and french BNP Paribas. Making difference & creating inspiration through life changing

44 International transmission of the crisis –the interbank money market (2) Non-functioning of the securitization market – banks can no longer transfer risks off their balance sheets (problems with pending LBOs). Unwanted claims put pressure on banks’ capital adequacy. Non-functioning of the securitization market – banks can no longer transfer risks off their balance sheets (problems with pending LBOs). Unwanted claims put pressure on banks’ capital adequacy. Larger liquidity requirements at banks – due to increased risks of realization of additional contingent liabilities. Larger liquidity requirements at banks – due to increased risks of realization of additional contingent liabilities. Crisis of confidence between banks – problem of adverse selection creates a dangerous liquidity squeeze in the interbank money market. Banks respond by toughening lending standards. Crisis of confidence between banks – problem of adverse selection creates a dangerous liquidity squeeze in the interbank money market. Banks respond by toughening lending standards. Increased liquidity requirements of nonfinancial companies – Due to stressed liquidity conditions, companies try to secure cash, creating further liquidity pressures for banks. Increased liquidity requirements of nonfinancial companies – Due to stressed liquidity conditions, companies try to secure cash, creating further liquidity pressures for banks. Making difference & creating inspiration through life changing

45 Transmission of the crisis to the interbank market – increase in credit and liquidity risks Making difference & creating inspiration through life changing

46 Countermeasures (1) Infusion of liquidity to the interbank market (Fed, ECB and other central banks) – liquidity provided in exchange for securities that “nobody else wants”. Infusion of liquidity to the interbank market (Fed, ECB and other central banks) – liquidity provided in exchange for securities that “nobody else wants”. Lowering interest rates (Fed) – with the objective to prevent a sharp recession in the U.S. and to ease conditions in the mortgage markets Lowering interest rates (Fed) – with the objective to prevent a sharp recession in the U.S. and to ease conditions in the mortgage markets Balance sheet clean-up and recapitalization of large, systemically important banks – substantial role of the so called sovereign wealth funds. Balance sheet clean-up and recapitalization of large, systemically important banks – substantial role of the so called sovereign wealth funds. Making difference & creating inspiration through life changing

47 Countermeasures (2) Bailouts of failed banks – nationalization in case of Northern Rock, takeover (by JP Morgan Chase) in case of Bear Stearns, with the objective to contain systemic risks – problem of moral hazard! Bailouts of failed banks – nationalization in case of Northern Rock, takeover (by JP Morgan Chase) in case of Bear Stearns, with the objective to contain systemic risks – problem of moral hazard! Measures to improve the conditions in the mortgage market (U.S.) – moratorium on loan repayments, increased authority for intervention by government sponsored enterprises (GSEs) both in granting guarantees and securitization, fiscal stimulation. Measures to improve the conditions in the mortgage market (U.S.) – moratorium on loan repayments, increased authority for intervention by government sponsored enterprises (GSEs) both in granting guarantees and securitization, fiscal stimulation. Reconsidering the role of regulation and supervision of nonbank financial institutions and off balance sheet conduits and investment vehicles. Reconsidering the role of regulation and supervision of nonbank financial institutions and off balance sheet conduits and investment vehicles. Making difference & creating inspiration through life changing

48 Bank capital write-downs and recapitalizations Making difference & creating inspiration through life changing

49 What are the costs of the crisis? Current estimates of potential losses from the crisis are $945 bil. (IMF). Current estimates of potential losses from the crisis are $945 bil. (IMF). Of this, $ 225 bil. is due to estimated losses on outstanding loans, $ 720 bil. due to estimated losses on securities. Of this, $ 225 bil. is due to estimated losses on outstanding loans, $ 720 bil. due to estimated losses on securities. About $ bil. losses expected in banks, $ bil. losses in insurance, $ bil. in pensions/savings, $ bil. in GSEs and government and $ bil. in other institutions (including hedge funds). About $ bil. losses expected in banks, $ bil. losses in insurance, $ bil. in pensions/savings, $ bil. in GSEs and government and $ bil. in other institutions (including hedge funds). Making difference & creating inspiration through life changing

50 How will the crisis evolve in the future? Problems in the U.S. mortgage market are far from over which implies more potential for realization of contingent liabilities in financial institutions Problems in the U.S. mortgage market are far from over which implies more potential for realization of contingent liabilities in financial institutions Delinquencies and defaults expected to continue; Delinquencies and defaults expected to continue; Write-downs in financial institutions expected to continue. Write-downs in financial institutions expected to continue. Signs of cooling housing markets accross Europe Signs of cooling housing markets accross Europe United Kingdom, Ireland, Spain… United Kingdom, Ireland, Spain… Could there be a mini subprime case in Europe? Could there be a mini subprime case in Europe? Making difference & creating inspiration through life changing

51 How will the crisis evolve in the future? Impact of the crisis on credit risk premiums Impact of the crisis on credit risk premiums Implications of the “flight to quality”: repricing of risk – significantlly higher required yields for riskier investments than until recently. Implications of the “flight to quality”: repricing of risk – significantlly higher required yields for riskier investments than until recently. Danger of global growth slow down, if the crisis turns into a credit crunch and threatens smooth borrowing of nonfinancial enterprises. Danger of global growth slow down, if the crisis turns into a credit crunch and threatens smooth borrowing of nonfinancial enterprises. Making difference & creating inspiration through life changing

52 Conclusion: systemic risks in international financial system have increased Making difference & creating inspiration through life changing

53 Sub-prime lending Sub-prime lending had spread from inner-city areas right across the US by By then, one in five mortgages were sub-prime, and they were particularly popular among recent immigrants trying to buy a home for the first time, and the poor. House prices were high, and it was difficult to become an owner-occupier. But these mortgages had a much higher rate of repossession than conventional mortgages (and thus much riskier) because they were adjustable rate mortgages (ARMs). Payments were fixed for two years, and then became higher and linked to Fed interest rates, which also rose substantially. Making difference & creating inspiration through life changing

54 Subprime 2 A wave of repossessions is sweeping America as many of these mortgages reset to higher rates. By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust, acting for of bondholders, was the largest property owner in the city. As many as two million families will be evicted from their homes as their cases make their way through the courts. The Bush administration is pushing the industry to renegotiate, but mortgage companies are being overwhelmed by a tidal wave of cases. Making difference & creating inspiration through life changing

55 Scale and Spread Collapse of the government backed mortgage system in the USA (Fannie and Freddie) followed by meltdown of major investment banks (Lehman, Bear, Merrill) exposed to mortgage market Mark-to-market asset pricing effects on balance sheets and cumulative liquidity retraction due to rising risk aversion; Now affecting Insurance (AIG) ; and pensions funds next? Making difference & creating inspiration through life changing

56 Global mortgage boom and bust Making difference & creating inspiration through life changing

57 The end of the stock market boom Making difference & creating inspiration through life changing

58 Financial Times, 20 Sept 2008 “… bank boards and bank executives have failed to understand complex mortgage-backed banking products, as have central bankers, regulators and credit rating agencies.” “…a reward system that has granted huge bonuses to those who peddled toxic mortgage-related products….” “Almost as absurd has been the degree of leverage racked up by investment banks.” Making difference & creating inspiration through life changing

59 Policy reactions “There are no atheists in foxholes and no ideologues in financial crises,” Mr. Bernanke told colleagues…(NYT ) Freddie Mae and Freddie Mac (re)nationalised; Merrill sold to BankAmerica; Lehman to Barclays; Goldman and Morgan become banks again; US govt $700bn purchase of bad debt; G3 central banks support world banking. Expansionary monetary policy (to avoid recession like 1930s) and scale of US Govt (and G3) bailouts will have large repercussions, yet to be evaluated [lessons of Mexico etc?] Making difference & creating inspiration through life changing

60 Scale of the potential bailout (already up to $850bn) Making difference & creating inspiration through life changing

61 Growth and trade World GDP growth already projected by IMF to slow down by 2 % points (from 5 to 3 for 2008 and 09); probably more. So with 2% world growth; global GDP per capita falls Asia probably most resilient (though exports to US will fall); LA will slow down, Africa recession? Commodity prices declining already; volumes too. Natural resource exporters will be hit; food and oil importers to benefit. Making difference & creating inspiration through life changing

62 World growth will slow, reducing trade expansion etc. Making difference & creating inspiration through life changing

63 An end to the commodity boom? Making difference & creating inspiration through life changing

64

65 Investment and aid International investment (bonds, FDI) will slow down; as will emerging market stocks; as global confidence declines Sovereign spreads will rise due to rising risk premium (default probability x risk aversion): already up to 4%. Aid flows already under pressure; will be hurt by fiscal overload in G3. Making difference & creating inspiration through life changing

66 Unsurprisingly, G3 market expectations are bad Making difference & creating inspiration through life changing

67 US now HIRC? Making difference & creating inspiration through life changing

68 Recent ODA rise will be difficult to sustain Making difference & creating inspiration through life changing

69 Poverty and human development MDG goals even less likely to be met (growth and aid are main drivers) Limitations of family support (Asia), few universal benefits (LA) and narrow safety nets (Africa): effect on poor Previous crises increased inequality, which remains even when growth recovers Commodity price reverse will change lottery of winners and losers Making difference & creating inspiration through life changing

70 Proactive macroeconomic policy Countercyclical monetary policy and real exchange rate management (inc. capital controls) necessary: MICs with forex reserves already do this; but LICs constrained by IMF. Support domestic banks (esp for agriculture and SMEs), underwrite longterm investment lending; keep real interest rates low. Raise tax pressure (not rates) to maintain fiscal balance and reduce public borrowing. Making difference & creating inspiration through life changing

71 HD strategy for difficult times Evidence (UNICEF) that for children employment stability more important than wages; implications for e.g. inflation policy Essential to ringfence budgets (in real terms) for education and health; extend schemes for (simple) universal benefits. Focus on inequality (especially horizontal) rather than just poverty; to reduce conflict and increase social cohesion. Making difference & creating inspiration through life changing

72 International action and the “duty to protect” Essential to moderate G8 policy shifts (e.g. bank regulation, interest rates, exchange rates) from viewpoint of impact on world poor. Need for UN to speak in a clear, timely and credible fashion on these issues (TDR08 good, UN/DESA etc silent) Regional arrangements for mutual currency support etc are vital (Asia progressing; LA talking; Africa nothing). Role for sovereign wealth funds? Making difference & creating inspiration through life changing

73 Main points The US real estate market downturn, the associated global financial crisis, and the surge in commodity prices has pushed the probability of a world economic recession to its highest level since Neither Europe nor Japan is in a position to fill the gap left by weaker US demand. Moreover, commodity exporting and emerging market countries are likely to offset only part of the effects of the US slowdown. Hence, global growth is likely to fall to its lowest level since Euroland is unlikely to de-couple from the US, as the ECB expects. Hence, the ECB in our view is “falling behind the curve”. Making difference & creating inspiration through life changing

74 Transatlantic recession risks: 1. A real estate bubble Housing prices adjusted for inflation (GDP weighted averages for Euroland ) Source: OECD, DB Global Markets Research 74

75 Housing markets in the US and Europe: some similarities in valuation developments Price-to-rent ratio Price-to-income ratio 75 Source: OECD, DB Global Markets Research

76 Euroland’s key housing markets: Hot, except in Germany Housing prices adjusted for inflation Source: OECD, DB Global Markets Research Making difference & creating inspiration through life changing

77 Adjustment is under way Source: OECD, DB Global Markets Research Making difference & creating inspiration through life changing

78 The power of real estate Source: ECB, Haver, DB Global Markets Research The cooling real estate market is likely to exert a drag on construction investment and consumption Making difference & creating inspiration through life changing

79 …and credit… Source: Bloomberg, DB Global Markets Research Transatlantic recession risks: 2. Financial crisis Making difference & creating inspiration through life changing

80 …leading to a tightening of lending standards… Sources: Fed, ECB, GM Research Transatlantic recession risks: 2. Financial crisis Making difference & creating inspiration through life changing

81 Transatlantic recession risks: 2. Financial crisis …and in Euroland to an increase in bank lending rates Consumer credit MortgagesSmall corporations Large corporations Feb 07 – Feb bp+0.25bp Lending rates on new loans with 1-5 year fixed rates Sources: ECB, GM Research Making difference & creating inspiration through life changing

82 Transatlantic recession risks: 2. Financial crisis Hunt for collateral widens Euroland sovereign spreads… Source: Bloomberg, DB Global Markets Research bp Making difference & creating inspiration through life changing

83 Transatlantic recession risks: 2. Financial crisis Source: Bloomberg, DB Global Markets Research …while policy divergence is creating exchange rate tensions Making difference & creating inspiration through life changing

84 Europe as vulnerable to the financial crisis as US Making difference & creating inspiration through life changing

85 Credit and banking crisis likely to dampen business investment growth Despite rising profits, firms need credit to fund their growth Source: Haver, Bloomberg, DB Global Markets Research Making difference & creating inspiration through life changing

86 Source: Eurostat, Haver, DB Global Markets Research Investment has benefited from buoyant export growth Making difference & creating inspiration through life changing

87 Rise of the euro to slow export growth, reinforcing the dampening effect from tighter credit on business investment Source: Eurostat, Haver, DB Global Markets Research Recursive eur regressions suggest no major changes in coefficient Making difference & creating inspiration through life changing

88 Investment growth to be squeezed Source: ECB, Haver, DB Global Markets Research Making difference & creating inspiration through life changing

89 Transatlantic recession risk: 3. Rising oil and commodity prices First-round impact on trade balance of the oil price surge since September 2007 Sources: IMF, DB Global Markets Research Making difference & creating inspiration through life changing

90 Transatlantic recession risk: 3. Rising oil and commodity prices Falling terms of trade hurting consumer Source: Haver, DB Global Markets Research Making difference & creating inspiration through life changing

91 Consumers retrenching Retail sales plunge as surging food and energy prices tax consumers Source: Haver, DB Global Markets Research Making difference & creating inspiration through life changing

92 Slower growth likely to reduce inflationary pressures Source: ECB, OECD, Haver, DB Global Markets Research Headline inflation boosted by food and energy Wage inflation remaining contained 92

93 Conclusion: a cooler world economy… Source: DB Global Markets Research 93

94 …and shifting sources of growth Source: DB Global Markets Research 94

95 Hypotheses about the Origin of the Current Financial Turmoil Highly expansive monetary policy in industrial countries. The persistence of global macroeconomic imbalances. Technological developments in financial markets, which led to the creation of complex instruments. Insufficient transparency of non-bank entities’ operations and off-balance sheet bank operations. Inadequate regulation for the current sophisticated financial and equity markets. Making difference & creating inspiration through life changing

96 Hypotheses about the Origin of the Current Financial Turmoil ALL the advanced hypotheses are part of the problem. But there is one more: A not-yet learned lesson: capital markets complement, not substitute the banking system. All financial crisis are characterized by the presence of incentives for excessive risk taking.

97 The Crisis: Policies and Incentives Excepting the period , monetary policy has remained expansive in industrial countries (with periods of negative real interest rates). Making difference & creating inspiration through life changing

98 The Crisis: Policies and Incentives The main reasons that prevented a restrictive monetary policy in the US: The vulnerability of the economic recovery after the 2001 recession, especially in the context of geopolitical risks. Low inflation expectations. Making difference & creating inspiration through life changing

99 The Crisis: Policies and Incentives Despite the stock markets crash in 2001, monetary policy stabilized real consumption growth in the period , through its effects on the consumers’ wealth. This was possible because of the large increase in housing prices associated with low interest rates. Over the last decade, consumption has offset declines in investments. This responds to the consumers’ perception of greater wealth, through the value of stocks at first and then through the value of real state. Making difference & creating inspiration through life changing

100 The Crisis: Policies and Incentives The large global liquidity (low interest rates) created incentives for: The aggressive expansion of financial non-bank intermediaries (mortgage lenders, hedge funds) with increasing demand for high-yield assets. The use of financial products that “saved” capital for banks through “securitization”. (Under Basel I, mortgages held on banks’ balance sheets are subject to a 50% capital charge. There is no capital charge when mortgages are sold to a SIV.) The use of housing equity to get individual funding (home equity loans). In contrast to the 2001 crisis, in 2008 the American consumer is highly indebted. Making difference & creating inspiration through life changing

101 The Crisis: Policies and Incentives The Mortgage Loans Expansion in the Industrial World Before: Traditional Relationship between Borrower and Creditor Bank Borrower - Pays interest and principal - Lends money - Manages delinquencies Making difference & creating inspiration through life changing

102 The Crisis: Policies and Incentives The system, though complex, can work if risks are correctly assessed. The problem is that under conditions of large liquidity, the quest for “returns” encourages excessive risk taking and exposes the system’s vulnerabilities: Market participants that work for fees (mortgage brokers, payments receivers) don’t have incentives to monitor the quality of loans, only to increase the quantity of loans. The same thing happens with the credit rating agencies which supply “ratings” for the structured products and do not face any financial responsibility to cover losses from their mistakes. Regulatory Arbitrage: different financial institutions undertaking similar activities face different regulations (especially capital requirements). Principal-Agent Problem: huge disparity in traders’ maximum loss (zero bonus) vs. investors’ losses (the full capital invested). Making difference & creating inspiration through life changing

103 The Crisis: Policies and Incentives But the largest problem is that, if an adverse shock to the system occurs (in this case, the generalized fall of housing prices), all the involved financial institutions lose capital. Because banks provide liquidity to capital markets and hold structured products as assets, a complex system in crisis might collapse to the simple system: bank-borrower. This trend is already happening: Banks have absorbed many SIVs into their books. Banks faced pressures from authorities to finance insurers (monolines). Many mortgage brokers have declared bankruptcy. Making difference & creating inspiration through life changing

104 Would Basel II Helped Prevent the Crisis? Most likely not! Under the “Standardized Approach” Basel II emphasizes the reliance on external credit ratings. The current crisis has seriously questioned the credibility of these agencies for the adequate assessment of risks. For large and sophisticated banks, Basel II relies on the banks’ internal risk models for assessing credit risk. During the current crisis, large banks were heavily affected using their own internal models! Because of the large demand from investors for mortgage- backed structured products, a reduction in capital charges (from 50 to 35 percent in Basel II for mortgage held on banks’ balance sheets) would not have prevented excessive securitization. Basel II does not properly take into account liquidity risk. Funding for SIVs collapsed when doubts about the quality of their assets emerged. Under huge liquidity constraints, many SIVs were forced to sell their assets at very low prices. Making difference & creating inspiration through life changing

105 And Moving Forward? Under current circumstances, when the value of the fundamentals is adjusting (the decrease in housing prices)… Making difference & creating inspiration through life changing

106 And Moving Forward? … The system’s equilibrium involves a lower size of the banking system (according to the available capital)… … And that’s already happening. Making difference & creating inspiration through life changing

107 And Moving Forward? With a lower lending capacity to corporations (affecting investment) and with a poorer consumer (decrease in wealth), the chances of a prolonged US slowdown or recession are very high. Making difference & creating inspiration through life changing

108 Effects of the Current Financial Turmoil on Emerging Markets Up to now, the effects of the financial turmoil in industrial countries on emerging markets have been: Mild and mostly limited to financial variables Different between regions and between countries HAVE NOT BEEN AN OBSTACLE TO THE CONDUCT OF FISCAL AND MONETARY POLICY Making difference & creating inspiration through life changing

109 Effects of the Current Financial Turmoil on Emerging Markets A most important current feature of many emerging markets is their ability to tighten monetary policy -increase interest rates- in the presence of inflationary pressures. Source: Central Banks and IFS-IMF

110 Effects of the Current Financial Turmoil on Emerging Markets This contrasts with monetary policy in industrialized countries where fears of a significant slowdown in economic growth are keeping interest rates low and decreasing… … in spite of expectations of higher inflation. Making difference & creating inspiration through life changing

111 What Factors might weaken the Performance of Emerging Markets? Severe and protracted recession in the US / Banking crisis (a mild recession is already priced in). High inflation leading to increases in industrial countries interest rates (more relevant in 2009). The China factor and the sustainability of high commodity prices. Making difference & creating inspiration through life changing

112 The External Risks affecting Emerging Markets 1. US Recession / Banking Crisis Without doubt the worst case scenario for global growth and emerging markets performance is a systemic banking crisis in the US. This worst case scenario can only materialize if the US enters in a vicious circle where: severe decline in the value of banks’ assets loss of bank capital credit crunch financing problems in corporations and non- bank financial institutions recession increase in severity of bad banks’ assets banking crisis prolonged recession This is still a relatively low probability scenario, however, because the Fed and the Treasury are currently aligned to prevent its occurrence. Making difference & creating inspiration through life changing

113 The External Risks affecting Emerging Markets 1. US Recession / Banking Crisis While a mild US recession would find emerging markets in good standing, a severe and prolonged recession would increase risk aversion, hurting investment inflows to emerging markets. Foreign direct investment tend to decline sharply in the face of global slowdowns. Making difference & creating inspiration through life changing

114 The External Risks affecting Emerging Markets 1. US Recession / Banking Crisis Trade flows would also be affected, especially if the US financial troubles expand to other industrial countries, particularly Europe (some markets estimations calculate that UK residential properties are 30% overvalued). Export growth has suffered the most in periods of global slowdowns. Re-emerging calls for trade protectionism in the US exports are also a potential threat for emerging markets exports. Making difference & creating inspiration through life changing

115 The External Risks affecting Emerging Markets 2. The Costs of Preventing a US Financial Meltdown: Inflation Concerns about inflation are keeping long-term interest rates high. A medium-term risk (2009 onwards) is a sudden increase in interest rates in industrial countries to contain inflation. This risk, which will affect emerging markets financing costs, has a low probability under current circumstances, when fears of a prolonged recession in the US is the main driver of monetary policy. Making difference & creating inspiration through life changing

116 The External Risks affecting Emerging Markets 3. A Decline in Commodity Prices? Although, as stated before, global exports are at risk in the face of a US-led global slowdown, the sustainability of high commodity prices is less risky in the short and medium-term due to two factors: A. Cyclical There is an inverse correlation between the value of the dollar and the price of commodities. This is because commodities (especially oil and gold and food, more recently) are perceived as a hedge against dollar weakness and the risk of inflation.

117 The External Risks affecting Emerging Markets 3. A Decline in Commodity Prices? A. Cyclical … and the dollar is expected to depreciate further, especially with respect to Asian currencies. Recent policy signals by the Chinese authorities to control inflation point towards further increases in interest rates in China and further appreciation of the RMB against the US dollar.

118 The External Risks affecting Emerging Markets 3. A Decline in Commodity Prices? B. Structural Factors China, a major importer of many commodities -second importer of oil-, will continue a strong path of growth in the coming years. Supply problems in the precious and industrial metals are a long-term issue, especially given South Africa’s power crisis (SA produces 69% of platinum, 30% of palladium and 18% of world’s supply of gold). Supply problems of aluminum are also large. Land and water constraints supporting high prices for agricultural commodities.

119 The External Risks affecting Emerging Markets 3. A Decline in Commodity Prices? B. Structural Factors And the markets are forecasting a continuation in the upward trend of major commodities prices. Making difference & creating inspiration through life changing

120 The External Risks affecting Emerging Markets 3. A Decline in Commodity Prices? Also oil prices will remain high, supported by: (a) China’s strong demand, (b) ageing infrastructure leading to unplanned outages and (c) climate change leading to extreme weather conditions. Future prices anticipate a modest decline, but these prices have not been effective predictors of oil returns in the past.

121 Sign of Economic Recovery 121 Real GDP growth Making difference & creating inspiration through life changing

122 122 What not to do Fed has effectively underwritten balance sheet (not equity) of entire US banking system (large banks) without any material conditionality or pain for the banks Massive moral hazard (future reckless lending) Massive adverse selection (pricing of collateral at range of new facilities for Primary Dealers). Fed uses risk-free rate cuts to target illiquidity and help banks to recapitalise themselves Making difference & creating inspiration through life changing

123 123 What more is there to come? Further shake-out globally in banking system from subprime & alt-A exposures Other eruptions of previously underpriced default risk & other risk Other secured credit to households (car loans and ABS backed by pools of car loans) Unsecured credit to households (e.g. ABS secured by credit card receivables Non-sovereign risk in emerging markets, especially exposure to EM private sector & SOEs where rule of law is weak (China, Russia, Kazakhstan) Sovereign risk with the usual suspects Argentina Turkey Philippines Ecuador Venezuela South Africa Making difference & creating inspiration through life changing

124 124 What more is there to come? Non-sovereign default risk & market risk in overheating EMs: Baltics, Bulgaria, Romania. Sectoral risks in advanced industrial countries. Housing & commercial property: US, UK, Spain, Ireland Liquidity risks for any complex structures Longevity risks for pension funds Interesting times indeed! Making difference & creating inspiration through life changing

125 125 Thanks Making difference & creating inspiration through life changing


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