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Chapter 5 Current Multinational Financial Challenges: The Credit Crisis of
© 2012 Pearson Education, Inc. All rights reserved.5-2 Current Multinational Financial Challenges: The Credit Crisis of 2007 – 2009: Learning Objectives Learn how a variety of economic, regulatory, and social forces led to the real estate market growth and collapse Examine the various dimensions of defining and classifying individual borrowers in terms of their credit quality Consider the role that financial derivatives and securitization played in the formation of the international credit crisis Examine how LIBOR, the most widely used cost of money, reacted to the growing tensions and risk perceptions between international financial institutions during the crisis
© 2012 Pearson Education, Inc. All rights reserved.5-3 Current Multinational Financial Challenges: The Credit Crisis of 2007 – 2009: Learning Objectives Identify the characteristics and components of a number of the instrumental financial derivatives contributing to the spread of the credit crisis including collateralized debt obligations (CDOs), structured investment vehicles (SIVs), and credit default swaps (CDSs) Evaluate the various remedies and prescriptions being pushed forward by a variety of governments and international organizations for the infected global financial organism
© 2012 Pearson Education, Inc. All rights reserved.5-4 The Seeds of Crisis: Subprime Debt The Repeal of Glass-Steagall –1933 legislation that separated commercial from investment banking –FDIC had insured commercial bank deposits –SEC had regulated the riskier investment banks Gramm-Leach-Bliley Financial Services Modernization Act of 1999 –Repealed what remained of Glass-Steagall by allowing commercial and investment banks to engage in activities formerly reserved for the other
© 2012 Pearson Education, Inc. All rights reserved.5-5 The Seeds of Crisis: Subprime Debt The Housing Sector and Mortgage Lending –Many new borrowers now qualified for loans –Prime loans, also known as conventional or conforming loans, meet the requirements for resale to Government Sponsored Enterprises (GSEs) such as Fannie Mae or Freddie Mac –Alt-A loans (Alternative-A paper) are considered low risk but have an initial non-conforming feature –Subprime loans do not meet underwriting criteria and have higher risk of default
© 2012 Pearson Education, Inc. All rights reserved.5-6 The Seeds of Crisis: Subprime Debt Subprime loans continued –Until 1980 most states prevented sale of subprime securities –DIDMCA (1980) supersedes state laws –Tax Reform Act (1986) eliminates the tax deductibility of many types of consumer debt but keeps the tax deductibility of loans associated with real estate including second mortgages and equity lines of credit –By 2008 subprime loans equal approx 8% of outstanding mortgage obligations but are the source of over 65% of bankruptcy filings by U.S. homeowners
© 2012 Pearson Education, Inc. All rights reserved.5-7 The Seeds of Crisis: Subprime Debt Exhibit 5.1 –Shows that from 1960 – late 1980s almost no change in U.S. financial assets as a percentage of GDP –From late 1980s to 2008 financial assets more than doubled from 450% of GDP to over 900% of GDP –Rising housing prices were used as collateral for mortgage- backed assets and encouraged refinancing of mortgages to provide current income Exhibit 5.2 –Debt obligations rose in a variety of countries and was not limited to the United States
© 2012 Pearson Education, Inc. All rights reserved.5-8 Exhibit 5.1 U.S. Credit Market Borrowing,
© 2012 Pearson Education, Inc. All rights reserved.5-9 Exhibit 5.2 Household Debt As A Percent of Disposable Income,
© 2012 Pearson Education, Inc. All rights reserved.5-10 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Liquidity – the ability to turn an asset into cash quickly at a fair market value Securitization –The process of turning an illiquid asset into a liquid salable asset –A form of disintermediation, or bypassing traditional financial intermediaries –Mortgage-backed securities (MSBs) by year-end 2007 had increased five-fold from 1990 to a total of $27 trillion
© 2012 Pearson Education, Inc. All rights reserved.5-11 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Exhibit shows the growth of U.S. securitized loans Securitization continued –Asset-backed securities (ABSs) consist of loans such as second mortgages, equity lines of credit, auto loans, and credit card receivables among others –Securitization allows a disconnect between loan originator and borrower –The practice of “originated-to-distribute” (OTD) decreases the ability and the incentive of the loan originator to monitor borrower behavior
© 2012 Pearson Education, Inc. All rights reserved.5-12 Exhibit 5.3 Annual Issuances of MBSs,
© 2012 Pearson Education, Inc. All rights reserved.5-13 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Structured Investment Vehicles (SIVs) –Off-balance sheet entity designed to allow banks to invest in long-term higher yielding assets and fund these assets through the sale of commercial paper (CP) –Portfolio theory failed in assessing the risk of SIVs –Banks had guaranteed the backup lines of credit for the CP Exhibit demonstrates how an SIV works
© 2012 Pearson Education, Inc. All rights reserved.5-14 Exhibit 5.4 Structured Investment Vehicles (SIVs)
© 2012 Pearson Education, Inc. All rights reserved.5-15 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Collateralized Debt Obligations (CDOs) –Asset-backed securities packaged and passed to an off- shore entity via a special purpose vehicle (SPV) to be sold in the market by security underwriters –Allowed banks to make loans, collect upfront fees, sell the assets and repeat –CDOs are categories in tranches classified as: Senior – or AAA rated borrowers Mezzanine - AA – BB rated borrowers Equity – or below BB rated borrowers
© 2012 Pearson Education, Inc. All rights reserved.5-16 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Collateralized Debt Obligations (CDOs) Cont. –CDO ratings were hurried and proved to be difficult and ultimately inaccurate –CDO market grows rapidly from 2001 – 2007 thanks to booming real estate markets, slow equity markets, and low interest rates –CDO value driven by cash flows from the original loan and liquidity Exhibit 5.5 illustrates how a CDO works Exhibit 5.6 shows CDO volume from
© 2012 Pearson Education, Inc. All rights reserved.5-17 Exhibit 5.5 The Collateralized Debt Obligation
© 2012 Pearson Education, Inc. All rights reserved.5-18 Exhibit 5.6 Global CDO Issuance, (billions of US dollars)
© 2012 Pearson Education, Inc. All rights reserved.5-19 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Credit Default Swaps (CDSs) –Initially CDSs were designed as insurance against payment default for purchasers of corporate debt –Subsequently mutated to a form of speculation betting on the ability, or lack thereof, of the debt issuer’s ability to repay –Purchaser of a CDS did not have to have ownership of the underlying asset, nor were there limits on how many speculative contracts could be sold on a particular asset, nor was the market publicly regulated –The CDS market grew to $62 trillion – far larger than the corresponding underlying assets
© 2012 Pearson Education, Inc. All rights reserved.5-20 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Exhibit 5.7 explains how CDSs work Exhibit 5.8 charts the growth of CDSs Credit Enhancement –Making investments more attractive to investors by reducing their perceived risk –Commonly, ABSs were insured to appear safer –Exhibit 5.9 shows how in the 1990s credit enhancement was provided in the form of subordination
© 2012 Pearson Education, Inc. All rights reserved.5-21 Exhibit 5.7 Cash Flows Under a Credit Default Swap
© 2012 Pearson Education, Inc. All rights reserved.5-22 Exhibit 5.8 Credit Default Swap Market Growth
© 2012 Pearson Education, Inc. All rights reserved.5-23 Exhibit 5.9 CDO Construction and Credit Enhancement
© 2012 Pearson Education, Inc. All rights reserved.5-24 The Fallout: The Crisis of The housing market slows in 2005 and crashes in the spring of 2007 in several countries Two hedge funds at Bear Stearns fail in July 2007 Northern Rock Bank is bailed out by the Bank of England September 2007 sees several bank runs around the globe Commodity prices skyrocket in 2008 with crude oil peaking at $147/barrel in July
© 2012 Pearson Education, Inc. All rights reserved.5-25 The Fallout: The Crisis of US Government places Fannie Mae and Fredie Mac into conservatorship on September 7, 2008 Lehman Brothers fails on September 14, 2008 Equity markets plunge on September 15 AIG rescued with an $85 billion bailout September 16
© 2012 Pearson Education, Inc. All rights reserved.5-26 The Fallout: The Crisis of September 2008 – Spring 2009 corporate lending markets demonstrate the following: –Risky investment banking activities overwhelmed commercial banking activities –Corporate indebtedness was tiered –Corporate balance sheets seem to have predicted the crisis with low levels of debt and high levels of cash and marketable securities –Even low risk marketable securities were now failing –Credit lines and lending was sharply reduced
© 2012 Pearson Education, Inc. All rights reserved.5-27 The Fallout: The Crisis of September 2008 – Spring 2009 corporate lending markets demonstrate the following: Continued –Commercial paper markets almost stopped operating in September and October of 2008 –Traditional commercial bank lending for operating capital was squeezed out by huge investment banking losses Exhibit 5.10 illustrates a timeline of economic events and the impact on interest rates
© 2012 Pearson Education, Inc. All rights reserved.5-28 Exhibit 5.10 USD & JPY LIBOR Rates (September-October 2008)
© 2012 Pearson Education, Inc. All rights reserved.5-29 The Fallout: The Crisis of Global Contagion –The collapse of mortgage-backed security markets in the U.S. spread globally –Capital fled from equity markets world wide cash in traditionally stable currencies such as yen, euro, and U.S. dollars –Exhibit 5.11 highlights the fall of equity markets in select countries in September and October of 2008
© 2012 Pearson Education, Inc. All rights reserved.5-30 Exhibit 5.11 Selected Stock Markets During the Crisis
© 2012 Pearson Education, Inc. All rights reserved.5-31 The Fallout: The Crisis of Global Contagion continued –In spring 2009 mortgage delinquency rates reach record highs –Domestic firms were favored over MNEs by rating agencies, financial institutions, and government agencies –Credit crisis progresses from the failure of specific mortgage-backed securities to great risk put on commercial and investment banks, to a credit-induced global recession with the potential of a global recession and all that entails
© 2012 Pearson Education, Inc. All rights reserved.5-32 The Fallout: The Crisis of LIBOR – The London Interbank Offered Rate –Has always traded as a “no-name” market with no differential credit risk among participating institutions –As mortgages and derivatives failed and CDOs started suffering losses, individual banks were treated as risks in themselves –LIBOR was estimated to be used in the pricing of over $350 trillion of assets globally –Dramatic fluctuations and increases in LIBOR were a major course of concern for all
© 2012 Pearson Education, Inc. All rights reserved.5-33 Exhibit 5-12 LIBOR and the Crisis in Lending
© 2012 Pearson Education, Inc. All rights reserved.5-34 The Fallout: The Crisis of LIBOR – The London Interbank Offered Rate, cont. –July and August 2008 the TED spread is approximately 80 basis points (where the TED spread is the difference between the U.S Treasury Bill rate and the Eurodollar futures market) –The TED spread leapt to 359 basis points at times during the next two months before the market somewhat returned to more normal differences
© 2012 Pearson Education, Inc. All rights reserved.5-35 The Remedy: Prescriptions for an Infected Global Financial Organism Debt – originate-to-distribute behavior combined with poor credit assessment but be addressed Securitization – risk assessment is not properly evaluated by portfolio theory Derivatives – some became so complex they were difficult to evaluate and were outside the oversight of regulators Deregulation – new legislation is already in effect but the proof is in the implementation
© 2012 Pearson Education, Inc. All rights reserved.5-36 The Remedy: Prescriptions for an Infected Global Financial Organism Capital Mobility – greater openness will result in greater opportunity and more and bigger crises Illiquid Markets – without liquidity markets soon fail Troubled Asset Recovery Plan (TARP) - $700 billion to bail-out banks and other entities deemed “too big to fail”. Much of these funds have already been repaid Liquidity vs. Capital – as asset values fell due to loan defaults banks suffered massive equity losses
© 2012 Pearson Education, Inc. All rights reserved.5-37 The Remedy: Prescriptions for an Infected Global Financial Organism Golden Parachutes – top executives resigned but were well-compensated due to earlier termination agreements Financial Reform Law of 2010 – Key Features: –Established an Office of Financial Research –FDIC insurance increased to $250,000 per account –SEC can sue professionals who knew about deceptive acts even if they did not instigate the acts –Treasury to modernize and monitor state insurance regulators –Institutions must disclose the amount of short selling in each stock
© 2012 Pearson Education, Inc. All rights reserved.5-38 Exhibit 5-13 The U.S. Dollar TED Spread (July 2008–January 2009)
© 2012 Pearson Education, Inc. All rights reserved.5-39 The Future Exhibit 5.14 shows how cross-border capital flow fell by more than 80% due to the crisis Questions remain about how long until and how capital will return to international markets
© 2012 Pearson Education, Inc. All rights reserved.5-40 Exhibit 5.14 The Global Financial Crash
© 2012 Pearson Education, Inc. All rights reserved.5-41 Summary of Learning Objectives The seeds of the credit crisis were sown in the deregulation of the commercial and investment banking sectors in the 1990s. The flow of capital into the real estate sector in thepost-2000 period reflected changes in social and economic forces in the U.S. economy. Mortgage loans in the U.S. marketplace are normally categorized as prime (A-paper), Alt-A Alternative-A paper), and subprime, in increasing order of riskiness.
© 2012 Pearson Education, Inc. All rights reserved.5-42 Summary of Learning Objectives Subprime borrowers, historically not considered creditworthy for mortgages, became an acceptable credit risk as a result of major deregulation initiatives. The transport vehicle for the growing distribution of lower- quality debt was a combination of securitization and re- packaging provided by a series of new financial derivatives. Securitization allowed the re-packaging of different combinations of credit-quality mortgages in order to make them more attractive for resale to other financial institutions; derivative construction increased the liquidity in the market for these securities.
© 2012 Pearson Education, Inc. All rights reserved.5-43 Summary of Learning Objectives The structured investment vehicle (SIV) was the ultimate financial intermediation device: It borrowed short and invested long. The SIV was an off-balance sheet entity designed to allow a bank to create an investment entity that would invest in long-term and higher yielding assets such as speculative grade bonds, mortgage-backed seucrities (MBSs) and collateralized debt obligations (CDOs), while funding itself through commercial paper (CP) issuances.
© 2012 Pearson Education, Inc. All rights reserved.5-44 Summary of Learning Objectives The CDO, collateralized debt obligation, is a portfolio of debt instruments—mortgages—which are re-packaged as an asset-backed security. Once packaged, the bank passes the security to a special purpose vehicle (SPV). The credit default swap (CDS) is a contract, a derivative, which derived its value from the credit quality and performance of any specified asset. The CDS was designed to shift the risk of default to a third-party. In short, it was a way to bet whether a specific mortgage or security would either fail to pay on time or fail to pay at all.
© 2012 Pearson Education, Inc. All rights reserved.5-45 Summary of Learning Objectives LIBOR, although only one of several key interest rates in the global marketplace, plays a critical role in the interbank market as the basis for all floating rate debt instruments of all kinds. This includes mortgages, corporate loans, industrial development loans, and the multitudes of financial derivatives sold throughout the global marketplace.
© 2012 Pearson Education, Inc. All rights reserved.5-46 Summary of Learning Objectives With the onset of the credit crisis in September 2008, LIBOR rates skyrocketed between major international banks, indicating a growing fear of counterparty default in a market historically considered the highest quality and most liquid in the world. The U.S. Congress passed the Troubled Asset Recovery Plan (TARP), which authorized the U.S. government to use up to $700 billion to bail out the riskiest large banks.
© 2012 Pearson Education, Inc. All rights reserved.5-47 Summary of Learning Objectives The U.S. Federal Reserve purchased billions in mortgage-backed securities, CDOs, in the months following the credit crisis in an attempt to inject liquidity into the credit markets. As a result of the massive write-offs of failed mortgages by the largest banks, the banks suffered weakened equity capital positions, making it necessary for the private sector and the government to inject new equity capital into the riskiest banks and insurers.
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