Day After tomorrow: The Financial Crisis Stephen Y L CHEUNG Professor (Chair) of Finance Dean, School of Business Hong Kong Baptist University

Contents Causes of sub-prime crisis Consequences China and India Policy implications 2018/11/15

Origins Financial crisis derives from the US housing market Causes of sub-prime crisis Consequences China and India Policy implications Financial crisis derives from the US housing market Housing market in US An unparalleled boom in 2007 Negative real interest rates in US Excess liquidity offered by financial innovation High leverage 2018/11/15

Real interest rate Graph Causes of sub-prime crisis Consequences China and India Policy implications Graph 2018/11/15

Financial Innovation Causes of sub-prime crisis Consequences China and India Policy implications Housing loans offered at back loaded teaser interest rates Assuming that borrowers could refinance the sub prime loans through gains in home equity But loan originating banks were smart … 2018/11/15

What is Sub-prime loans? Causes of sub-prime crisis Consequences China and India Policy implications (1) low credit scores (2) No 20% down-payment for a home (3) Disable to fully document their income No Conventional mortgages No Best market interest rates 2018/11/15 6 6

Collateralized Debt Obligations What did the banks do? Causes of sub-prime crisis Consequences China and India Policy implications Offloaded the sub-prime loans through instruments like Collateralized Debt Obligations Modus Operandi of banks (loan originators) Pool together mortgages, including sub prime loans, into CDOs Get top notch credit ratings for senior tranches Retain the highly rated senior derivatives through SIVS Repackage the lower rated derivatives to transform them into synthetic CDOs Investors : Hedge funds, money market and pension funds 2018/11/15

How did the investors buy? Causes of sub-prime crisis Consequences China and India Policy implications Sharp rise in derivatives CDO and CDS issuance CDO Derivatives Industry 2004 - $25 billion 2002 - $ 103 trillion (3 X Global GDP) 2007 - $186 billion 2007 - $ 450 trillion (9 X Global GDP) 2018/11/15

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The boom begins to unravel from 2004 Causes of sub-prime crisis Consequences China and India Policy implications US Fed reacts to rising consumer and asset prices by monetary tightening from second half of 2004 Housing prices begin to fall by end of 2006 Rising interest rates and falling housing prices lead to rise in subprime mortgage delinquencies & foreclosures 2018/11/15

Overloading… Causes of sub-prime crisis Consequences China and India Policy implications 2018/11/15

Suffering… Causes of sub-prime crisis Consequences China and India Policy implications 2018/11/15

“Do you know the true balance sheet of US Investment banks?” Causes of sub-prime crisis Consequences China and India Policy implications “Do you know the true balance sheet of US Investment banks?” There are two sides on the balance sheet: the left side and the right side. On the left side, there is nothing right. and on the right side, there is nothing left. 2018/11/15

Causes of sub-prime crisis Consequences China and India Policy implications 2018/11/15

“but all the while US was selling them toxic investments.” Causes of sub-prime crisis Consequences China and India Policy implications “Yes, it’s true that the Chinese have been selling us toxic toothpaste, toxic pet food, toys with toxic lead paint —” “but all the while US was selling them toxic investments.” 2018/11/15

China and India are the Saver Causes of sub-prime crisis Consequences China and India Policy implications China and India are the Saver 2018/11/15

Policy implications More hazard A new financial order Causes of sub-prime crisis Consequences China and India Policy implications More hazard A new financial order Financial innovations Credit rating agencies Regulatory framework Highly leveraged institutions Regulator quality 2018/11/15

Consequences Liquidity squeeze => Excessive liquidity Asset bubbles; stock and property prices Commodity prices up Inflation? Loose monetary policy is likely to end Interest rates up? 2018/11/15

Consequences Economy not recovered yet Gap between real economy and financial markets Total exports declining High interest rates, negative impact on the fragile economy 2018/11/15

Day after tomorrow: Incentive system; how to compensate senior management? Exit strategy? Financial markets will be different Risk management Corporate governance 2018/11/15

The End 2018/11/15