1. Chapter Ten Financial Crisis

2. Introduction From 2007 to mid-2009, global financial markets and systems have been in the grip of the worst financial crisis since the Depression era of the late 1920s. Major banks in the U.S., the U.K. and Europe have collapsed and been bailed out by state aid The crisis has had a massive adverse impact on global banking systems. The International Monetary Fund’s Global Financial Stability Report (IMF, 2009) reports an estimate of $2.7 trillion for write-downs of U.S.-originated assets by banks and other financial sector institutions between 2007 to 2010

3. What Went Wrong? Macroeconomic factors Global financial imbalances Long period of low real interest rates Microeconomic Factors Consumers failed to watch out for themselves Managers of financial firms increased returns by boosting leverage Manager compensation schemes further encouraged risk- taking Skewed incentives of the rating agencies Limitations of risk measurement, management and regulation

4. Stages of The Crisis Stage 1: Losses in the U.S. subprime market starting in the summer of 2007 to June 2007 up to mid-March 2008 Stage 2: Events leading up to the Lehman Brothers bankruptcy, mid-March to mid-September 2008 Stage 3: Global loss of confidence, 15 September to late October 2008 Stage 4: Investors focus on the global economic downturn, late October 2008 to mid-March 2009 Stage 5: Signs of stabilization, from mid-March 2009

5. The Role Of Securitization The rapid growth in securitization was a major cause of the crisis. This activity has had a major impact on the funding of residential property markets but also on the flexibility with which banks can manage their loan books The collapse of subprime mortgage lending in the U.S. and related securitized products is seen by many as the start of the credit crisis

6. The Role Of Securitization (cont.) Securitization involves the process where banks find borrowers, originate loans but then sell the loans (repackaged as securities) on to investors. This is known as the originate-to-distribute model in contrast to the traditional originate and hold approach Securitization relates to the pooling of credit-risky assets, traditionally residential mortgage loans (but nowadays also includes other types of credits such as car loans, credit card receivables or any credit generating some form of predictable cash flow), and their subsequent sale to a special purpose vehicle (SPV), which then issues securities to finance the purchase of the assets

7. The Role Of Securitization (cont.) Subprime loans refer to loans to higher risk borrowers – those that are not prime borrowers. The use of subprime loans in the underlying collateral allowed mortgage-backed securities (MBS) and collateralized debt obligation (CDO) packagers to enhance their profit margins while offering competitive returns on their securitizations

8. The Role Of Securitization (cont.) Most securities issued by SPVs were rated by credit rating agencies to make them more attractive to investors The risks of the portfolio could further be improved by various credit enhancement techniques such as third-party guarantees (insurance from monoline insurers to protect the value of assets), overcollateralization (holding a larger pool of assets than securities issued) and by something known as excess spread (originators, namely banks, inject cash into the SPV that will bear certain early losses)

9. Impact of the Crisis The credit crisis spread rapidly, having a particularly disastrous impact on the financial systems of the U.S., U.K., Ireland and Iceland No major European system was immune from its effects as banks failed or had to be supported via capital and liquidity injections Japanese banks appeared less affected by the crisis than most, although they have had a poorly performing domestic economy to worry about for over a decade

10. Regulation Governments and various international organizations have proposed major reforms to the financial system covering: The cleansing of bank balance sheets Increased capital and liquidity requirements Increased oversight and regulation of securitization business, hedge funds and credit rating agencies See details of the Dodd Frank Act (2010) in the US and the Vickers Commission Report (2011) for the UK on reform to the system. (Details in Chapter 6) (Also see Liikanen Report, June 2012) on EU reform)