Presentation on theme: "Chapter 5 Current Multinational Financial Challenges: The Credit Crisis of 2007 - 2009."— Presentation transcript:
1 Chapter 5Current Multinational Financial Challenges: The Credit Crisis of
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 collapseExamine the various dimensions of defining and classifying individual borrowers in terms of their credit qualityConsider the role that financial derivatives and securitization played in the formation of the international credit crisisExamine how LIBOR, the most widely used cost of money, reacted to the growing tensions and risk perceptions between international financial institutions during the crisis
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
4 The Seeds of Crisis: Subprime Debt The Repeal of Glass-Steagall1933 legislation that separated commercial from investment bankingFDIC had insured commercial bank depositsSEC had regulated the riskier investment banksGramm-Leach-Bliley Financial Services Modernization Act of 1999Repealed what remained of Glass-Steagall by allowing commercial and investment banks to engage in activities formerly reserved for the other
5 The Seeds of Crisis: Subprime Debt The Housing Sector and Mortgage LendingMany new borrowers now qualified for loansPrime loans, also known as conventional or conforming loans, meet the requirements for resale to Government Sponsored Enterprises (GSEs) such as Fannie Mae or Freddie MacAlt-A loans (Alternative-A paper) are considered low risk but have an initial non-conforming featureSubprime loans do not meet underwriting criteria and have higher risk of default
6 The Seeds of Crisis: Subprime Debt Subprime loans continuedUntil 1980 most states prevented sale of subprime securitiesDIDMCA (1980) supersedes state lawsTax 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 creditBy 2008 subprime loans equal approx 8% of outstanding mortgage obligations but are the source of over 65% of bankruptcy filings by U.S. homeowners
7 The Seeds of Crisis: Subprime Debt Exhibit 5.1Shows that from 1960 – late 1980s almost no change in U.S. financial assets as a percentage of GDPFrom late 1980s to 2008 financial assets more than doubled from 450% of GDP to over 900% of GDPRising housing prices were used as collateral for mortgage-backed assets and encouraged refinancing of mortgages to provide current incomeExhibit 5.2Debt obligations rose in a variety of countries and was not limited to the United States
8 Exhibit 5.1 U.S. Credit Market Borrowing, 1995-2010
9 Exhibit 5.2 Household Debt As A Percent of Disposable Income, 1990-2008
10 The Transmission Mechanism: Securitization and Derivatives of Securitized Debt Liquidity – the ability to turn an asset into cash quickly at a fair market valueSecuritizationThe process of turning an illiquid asset into a liquid salable assetA form of disintermediation, or bypassing traditional financial intermediariesMortgage-backed securities (MSBs) by year-end 2007 had increased five-fold from 1990 to a total of $27 trillion
11 Exhibit 5.3 - shows the growth of U.S. securitized loans The Transmission Mechanism: Securitization and Derivatives of Securitized DebtExhibit shows the growth of U.S. securitized loansSecuritization continuedAsset-backed securities (ABSs) consist of loans such as second mortgages, equity lines of credit, auto loans, and credit card receivables among othersSecuritization allows a disconnect between loan originator and borrowerThe practice of “originated-to-distribute” (OTD) decreases the ability and the incentive of the loan originator to monitor borrower behavior
12 Exhibit 5.3 Annual Issuances of MBSs, 1995-2009
13 Structured Investment Vehicles (SIVs) The Transmission Mechanism: Securitization and Derivatives of Securitized DebtStructured 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 SIVsBanks had guaranteed the backup lines of credit for the CPExhibit demonstrates how an SIV works
15 Collateralized Debt Obligations (CDOs) The Transmission Mechanism: Securitization and Derivatives of Securitized DebtCollateralized 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 underwritersAllowed banks to make loans, collect upfront fees, sell the assets and repeatCDOs are categories in tranches classified as:Senior – or AAA rated borrowersMezzanine - AA – BB rated borrowersEquity – or below BB rated borrowers
16 Collateralized Debt Obligations (CDOs) Cont. The Transmission Mechanism: Securitization and Derivatives of Securitized DebtCollateralized Debt Obligations (CDOs) Cont.CDO ratings were hurried and proved to be difficult and ultimately inaccurateCDO market grows rapidly from 2001 – 2007 thanks to booming real estate markets, slow equity markets, and low interest ratesCDO value driven by cash flows from the original loan and liquidityExhibit 5.5 illustrates how a CDO worksExhibit 5.6 shows CDO volume from
18 Exhibit 5.6 Global CDO Issuance, 2004-2008 (billions of US dollars)
19 Credit Default Swaps (CDSs) The Transmission Mechanism: Securitization and Derivatives of Securitized DebtCredit Default Swaps (CDSs)Initially CDSs were designed as insurance against payment default for purchasers of corporate debtSubsequently mutated to a form of speculation betting on the ability, or lack thereof, of the debt issuer’s ability to repayPurchaser 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 regulatedThe CDS market grew to $62 trillion – far larger than the corresponding underlying assets
20 Exhibit 5.7 explains how CDSs work The Transmission Mechanism: Securitization and Derivatives of Securitized DebtExhibit 5.7 explains how CDSs workExhibit 5.8 charts the growth of CDSsCredit EnhancementMaking investments more attractive to investors by reducing their perceived riskCommonly, ABSs were insured to appear saferExhibit 5.9 shows how in the 1990s credit enhancement was provided in the form of subordination
21 Exhibit 5.7 Cash Flows Under a Credit Default Swap
23 Exhibit 5.9 CDO Construction and Credit Enhancement
24 The Fallout: The Crisis of 2007 - 2009 The housing market slows in 2005 and crashes in the spring of 2007 in several countriesTwo hedge funds at Bear Stearns fail in July 2007Northern Rock Bank is bailed out by the Bank of EnglandSeptember 2007 sees several bank runs around the globeCommodity prices skyrocket in 2008 with crude oil peaking at $147/barrel in July
25 The Fallout: The Crisis of 2007 - 2009 US Government places Fannie Mae and Fredie Mac into conservatorship on September 7, 2008Lehman Brothers fails on September 14, 2008Equity markets plunge on September 15AIG rescued with an $85 billion bailout September 16
26 The Fallout: The Crisis of 2007 - 2009 September 2008 – Spring 2009 corporate lending markets demonstrate the following:Risky investment banking activities overwhelmed commercial banking activitiesCorporate indebtedness was tieredCorporate balance sheets seem to have predicted the crisis with low levels of debt and high levels of cash and marketable securitiesEven low risk marketable securities were now failingCredit lines and lending was sharply reduced
27 The Fallout: The Crisis of 2007 - 2009 September 2008 – Spring 2009 corporate lending markets demonstrate the following: ContinuedCommercial paper markets almost stopped operating in September and October of 2008Traditional commercial bank lending for operating capital was squeezed out by huge investment banking lossesExhibit 5.10 illustrates a timeline of economic events and the impact on interest rates
29 The Fallout: The Crisis of 2007 - 2009 Global ContagionThe collapse of mortgage-backed security markets in the U.S. spread globallyCapital fled from equity markets world wide cash in traditionally stable currencies such as yen, euro, and U.S. dollarsExhibit 5.11 highlights the fall of equity markets in select countries in September and October of 2008
30 Exhibit 5.11 Selected Stock Markets During the Crisis
31 The Fallout: The Crisis of 2007 - 2009 Global Contagion continuedIn spring 2009 mortgage delinquency rates reach record highsDomestic firms were favored over MNEs by rating agencies, financial institutions, and government agenciesCredit 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
32 The Fallout: The Crisis of 2007 - 2009 LIBOR – The London Interbank Offered RateHas always traded as a “no-name” market with no differential credit risk among participating institutionsAs mortgages and derivatives failed and CDOs started suffering losses, individual banks were treated as risks in themselvesLIBOR was estimated to be used in the pricing of over $350 trillion of assets globallyDramatic fluctuations and increases in LIBOR were a major course of concern for all
34 The Fallout: The Crisis of 2007 - 2009 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
35 The Remedy: Prescriptions for an Infected Global Financial Organism Debt – originate-to-distribute behavior combined with poor credit assessment but be addressedSecuritization – risk assessment is not properly evaluated by portfolio theoryDerivatives – some became so complex they were difficult to evaluate and were outside the oversight of regulatorsDeregulation – new legislation is already in effect but the proof is in the implementation
36 The Remedy: Prescriptions for an Infected Global Financial Organism Capital Mobility – greater openness will result in greater opportunity and more and bigger crisesIlliquid Markets – without liquidity markets soon failTroubled 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 repaidLiquidity vs. Capital – as asset values fell due to loan defaults banks suffered massive equity losses
37 The Remedy: Prescriptions for an Infected Global Financial Organism Golden Parachutes – top executives resigned but were well-compensated due to earlier termination agreementsFinancial Reform Law of 2010 – Key Features:Established an Office of Financial ResearchFDIC insurance increased to $250,000 per accountSEC can sue professionals who knew about deceptive acts even if they did not instigate the actsTreasury to modernize and monitor state insurance regulatorsInstitutions must disclose the amount of short selling in each stock
38 Exhibit 5-13 The U.S. Dollar TED Spread (July 2008–January 2009)
39 The FutureExhibit 5.14 shows how cross-border capital flow fell by more than 80% due to the crisisQuestions remain about how long until and how capital will return to international markets
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.
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.
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.
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.
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.
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.
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.