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JJ Mois Année Oct 2007 Risk Management Implications of Recent Market Turbulence and Liquidity Conditions, Including Managing Credit and Market Risk Institute.

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Presentation on theme: "JJ Mois Année Oct 2007 Risk Management Implications of Recent Market Turbulence and Liquidity Conditions, Including Managing Credit and Market Risk Institute."— Presentation transcript:

1 JJ Mois Année Oct 2007 Risk Management Implications of Recent Market Turbulence and Liquidity Conditions, Including Managing Credit and Market Risk Institute of International Bankers Seminar on Regulatory Examination, Risk Management and Compliance Issues Affecting International Banks October 29, 2007

2 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Risk Management Implications of Recent Market Turbulence and Liquidity Conditions Pre-Crisis Environment Structural vulnerabilities What Happened? Impact on Risk Management Activities

3 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT The Pre-Crisis Environment

4 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Commercial and Industrial Loans held by US Banks – Delinquencies Source: Federal Financial Institutions Examination Council (FFIEC) Consolidated Reports of Condition and Income (FFIEC 031 through 034 for period from ; FFIEC 031 & 041 thereafter) Overall, the quality of C&I Loans continued to improve through the second half of 2007  Delinquency levels continue below 20 year lows. Note: Delinquent loans are those past due thirty days or more and still accruing interest as well as those in nonaccrual status. They are measured as a percentage of end-of-period loans; Banks are insured U.S.-chartered commercial banks. Key drivers – distressed LBO financings, real estate lending Key drivers – Technology, merchant energy Corporate delinquency rates at very low levels

5 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Structured issuance provides liquidity for leveraged transactions of all types Average annual growth of 72% Source: Moody’s

6 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT A period of low delinquency feeds subprime origination RMBS securities market is hot, driven by cyclically low delinquency and default rates and investor demand Historical Prime, Sub prime Mortgage Delinquency Rates (source UBS and SG estimates) (source Mortgage Banker’s Assoc.) Subprime RMBS Issuance

7 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT US loan market issuance and pricing trends – through 1H 2007 Source for all data: Loan Pricing Corporation Loan Connector Database Loan market volumes continued to set records in 1H 07, despite small reduction in investment grade issuance. Spread compression remained a constant across ratings categories, with spreads reaching absolute and relative lows Average investment grade A / BBB risk premium is bps vs bps in 1H07 Average leveraged BB / B risk premium is 68.5 bps vs bps in 1H07 Corporate loan market is also hot with heavy issuance, compressed spreads and weak structural protections All figures are $ in billions Refinancing New Money since 2002

8 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Structural Vulnerabilities

9 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Timeline of Adjustable Rate Mortgage Price Re-settings TO INSERT Source: Bianco Research LLC The ARM Reset Wave (a train wreck in slow motion)

10 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Federal Reserve Funds Target Rate Resetting of ARMs into an increasing interest rate enviornment

11 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT US Home Price Appreciation Source: National Association of Home Builders Median Sales Price of Existing Single-Family Homes for Metropolitan Areas Home price (de)appreciation is both cause and effect of the bursting housing bubble (RHS)

12 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Aggregate delinquency rates trending upward Delinquent loans are those past due thirty days or more and still accruing interest as well as those in nonaccrual status. They are measured as a percentage of end-of-period loans Source: US Federal Reserve Rising mortgage delinquency rates

13 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT A sharp rise in sub-prime delinquencies were the main driver Sub prime Loans 60 or more Delinquent, Foreclosure or REO (source:Moodys)

14 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Deterioration in Underlying Assets and Market Psyche Reflected in Index Prices ABX-HE-BBB ABX-HE-AAA 06-2 ABX-HE-AAA 07-1 ABX-HE-BBB- 07-1

15 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT What Happened?

16 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Chronology of a Liquidity Crisis Late 2006: ABX index begins to decline after a pickup in early default payments on 2006 originations; sharp drop in profitability of sub-prime mortgage originators which accelerates consolidation in the sector (Merrill Lynch purchases First Franklin for 1,3G USD; Morgan Stanley buys Saxon for 706M USD). Some early closures/bankruptcies (Sebring Capital; Ownit Mortgage). Early 2007: Many small sub-prime mortgage originators are shutting down after delinquencies rise and early payment defaults (EPD) accelerate sharply; some larger originators are closing down their sub- prime lending operations (Fremont Financial). investors begin pulling out of the market. Early February 2007: New Century Financial Corp. announces delay in Q4 earnings due to reclassification of treatment of EPDs and loan repurchases (Market Capitalization of approx. 1.1 B USD) February 27, 2007: Sub-prime concerns trigger re-pricing of risk in mortgage markets. March 2007: ABX index stabilizes, markets recover in belief the worst is over. April 2007: New Century files for bankruptcy. June 1: First Data launches 16B USD loan (part of total 25B USD LBO financing), the largest “covenant lite” transaction seen yet, and immediately meets investor resistance. Mid June: Sub-prime concerns re-emerge after surge in long term rates; ABX slide deepens. June 15: Two Bear Sterns sponsored hedge funds concentrated in RMBS are forced to liquidate assets after sub-prime losses. Sources: SG Eco Insight | The 2007 crisis in confidence and liquidity, AKA the sub-prime crisis ; SG Risk Management

17 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Chronology of a Liquidity Crisis Late June: US Foodservice 4B USD LBO financing pulled from market after unsuccessful revisions to bond and loan deals. Alliance Boots £9B LBO financing is launched and also meets significant investor resistance. July 10: Ratings agencies downgrade a large pool of RMBS deals, revise ratings criteria for new deals. July 18-20: Contagion spreads to other parts of the credit markets; credit markets begin to shut down, CDS spreads widen sharply. July 20: Financial stocks begin a slide after $20 bln Chrysler LBO offering fails to attract investors. Attention is then focused on LBO market including distribution failure of other mega-LBO’s such as First Data, US Foodservice, Alliance Boots,TXU. July 24/25: Sale of Chrysler debt is postponed, banks forced to absorb the loans on their balance sheets; financial shares slide. Alliance Boots syndication is postponed. July 30: German banks IKB and Commerzbank warn that exposure to sub-prime loans would hurt results. August 1: Citigroup research report estimates 300B USD of LBO financings in the pipeline in the US and another 100B USD in Europe; allocates exposures amongst major underwriting banks. August 2: IKB sub-prime positions are taken over by a state-owned German bank in a first bailout. Sources: SG Eco Insight | The 2007 crisis in confidence and liquidity, AKA the sub-prime crisis ; SG Risk Management

18 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Chronology of a Liquidity Crisis August 7-8: CP spreads widen after American Home Mortgage, Luminent Mortgage and Alladin Capital exercise extension options on CP. Traditional conduit funding is already becoming difficult, with investors demanding higher rates and extremely short maturities. August 9: BNP Paribas halts redemptions in two asset-backed funds due to inability to price securities. August 9/10: Interbank rates under pressure; ECB, Fed and others offer temporary liquidity injections. ABS markets in general globally have seized up. Interbank funding becomes more and more difficult. August 13: Coventree declares a general market disruption event in Canadian ABCP market, to induce funding under liquidity lines as they are unable to roll ABCP. Certain banks are reluctant to fund, triggering a liquidity crisis in the Canadian markets. Goldman Sachs announces a 3B USD investment in its Global Equity Opportunities Fund after it lost 30% of value in the prior week. Goldman also acknowledges its Global Alpha fund has lost 27% ytd. Mid-August: Bankruptcy of American Home Mortgage; Countrywide bankruptcy rumors emerge after company experiences funding difficulty. Countrywide taps $11.5 bln backup credit facility after funding problems in CP; Citigroup research estimates JP Morgan LBO loan loss exposure at 1.4B USD. August 16: Fed report shows a $91 bln drop in commercial paper, implying 4.2% of total CP outstanding could not be rolled over. August 17: Fed cuts discount rate by 50 bps and eases lending terms at the discount window. August 20: Investors begin to shun money market funds fearing sub-prime exposure via CP and CDOs. August 23: Lehman Brothers shuts down its subprime lending unit (BNC Mortgage), purchased in 2004, bringing the total of mortgage companies that have halted operations, sought buyers or filed for bankruptcy protection since the start of 2006 to at least 100. Sources: SG Eco Insight | The 2007 crisis in confidence and liquidity, AKA the sub-prime crisis ; SG Risk Management

19 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Impact on Risk Management Activities

20 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT Impact on Risk Management Activities Market Risk Credit Risk (Corporate Banking & Structured Finance) Credit Risk (Capital Markets) Risk Operations & Control

21 IIB Seminar on Regulatory Examination, Risk Management and Compliance Issues OCT What have we learned (or been reminded of) so far? Market risk can quickly transform into credit risk. Products need to be evaluated not only for their sensitivity to market risk, but credit risk in the event of illiquidity. As we have brought a market discipline to some credit products, we need to bring a credit risk evaluation to market products. Portfolio Concentration Limits do matter (and help in times of stress). When interim warehousing turns to permanent financing. Renewed sensitivity to financing long term assets with short term liabilities. Can we still be comfortable relying on “market terms” and conditions (i.e. the least common denominator)? Need to keep regulators in the loop as market conditions evolve.


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