Dr Kevin Campbell

1. Dr Kevin Campbell CORPORATE FINANCE LECTURE 2: UNDERSTANDING THE FINANCIAL CRISIS March 2011

2. Overview • The causes of the financial crisis • What were the key factors? • Key consequences of the financial crisis • Will future crises be prevented?

3. International financial crises In recent history ... • The US stock market crash of 1987 • The US savings and loans crisis of 1986 -96 • The Japanese property and banking crisis of 1990 -2000 • The EMS crisis in Europe 1992 • The Mexico crisis of 1994-95 • The Asian crisis of 1997-98 • The Russian crisis of 1998 • The dot.com crisis 2000 – 2002 • The Argentina crisis of 2001

4. What is new today? • All previous financial crises were regional or local crises • In all previous financial crises the effects could be contained • The present financial crisis is the first truly global crisis • It affected all stock markets in the world at more or less the same time • It affected all internationally operating banks and institutional investors • There are no safe havens

5. The day the financial world changed: Monday September 15 2008 From credit crunch to financial crisis

6. FINANCIALCRISIS: MAJOR VICTIMS Source: BBC News, Global downturn: In graphics, 19 March 2009, http://news.bbc.co.uk/2/hi/business/7893317.stm

7. FINANCIAL CRISIS: THE COST Source: BBC News, Follow the Money, 10 September 2009, http://news.bbc.co.uk/1/hi/business/8249411.stm

8. FINANCIAL CRISIS: THE COST 3 month annualized growth rate of industrial production Source: The World bank, Global Economic Prospects – Global Headwinds and Recovery, Volume 1, Summer 2010, Washington, D.C., June 2010.

9. The death of the Anglo-American corporate governance model? The nationalisation of Wall Street? or The privatisation of Government? Socialism for the rich? Moral Hazard

10. Moral Hazard

11. Moral Hazard

12. Made in America … September 2007

13. Sources of the crisis 2004 – a critical year • Bush Administration ‘American Dream’ mortgage proposals introduced • helping low-income families to obtain mortgages • Greater capital requirements placed on Fannie Mae and Freddie Mac • Opening up the mortgage market to investment banks • SEC allowed investment banks to increase their leverage ratios ... from 15:1 to 40:1 • ‘consolidated supervised entities program’ • Basel II capital adequacy rules published

14. NINJA = No Income, No Jobs, No Assets Sub-prime • Prime mortgages = A paper • More risky = Alternative A-paper (Alt-A) • Most risky = Sub-prime mortgages • Most common subprime mortgage product = Hybrid Adjustable Rate Mortgage or hybrid ARM (HARM) • EXAMPLE: the 2/28 hybrid • a two-year fixed ‘teaser rate’ followed by a 28-year ARM

15. Why did banks take the risk? U.S. house prices were rising so, if borrowers defaulted, originators repossess houses, sell them and recoup the loan advanced Banks did not keep the loans sold them to investors using the originate and distribute model of securitisation risk was sliced and diced, allowing many of the Asset Backed Securities to be classed as AAA credits Sub-prime

16. Models of credit intermediation • Traditional model • Originate to Hold • Securitised model • Originate to Distribute

17. Securitisation • Securitised forms of credit intermediation have existed since the 1970s • Growth greatly expanded in the late 1990s in both the US and the UK • ... accompanied by growth in complexity of ‘structured products’

18. How do ‘toxic’ loans get AAA ratings? A AAA BBB Equity Assets Liabilities corporate bonds credit card loans auto loans mortgage loans (incl. subprime) Loss • Pass the parcel …. Asset Backed Securities • Pool of assets put into separate legal entity - Structured Investment Vehicle (SIV) • Repackaged into “tranches” • Each tranche has different coupon rate and credit rating • Loss in total pool of assets will hit lowest tranche first • Sold to investors • Approx. 1/4 of Asset Backed Securities (ABS) pool consists of subprime loans AA

19. Double Bubble 600 500 400 300 200 U.S.$ billions 100 0 -100 -200 -300 90 92 94 96 98 00 02 04 06 08 • Bubble in Housing and Securitization S&P/Case-Shiller U.S. Home Price Index Securitized Residential Mortgages Outstanding Quarterly change at annual rates 25 20 15 10 % change year-over-year 5 0 -5 -10 -15 87 89 91 93 95 97 99 01 03 05 07 Source: MacroMarkets LLC Source: Federal Reserve, NBF Financial

20. Foreclosure ... Stockton, California, USA sub-prime mortgage capital of the world • Question: how do you spot a repossessed home? • Answer: by the colour of its front lawn • Whenever you see a brown lawn, it’s a foreclosure

21. Mortgages turn toxic • A, AA and AAA tranches of mortgage-backed securities start to suffer losses • ..... banks restrict credit

22. The sub-prime virus Estimated loss of market value of US sub-prime mortgage-backed securities SOURCE: Bank of England, Financial Stability Report, No. 23, May 2008

23. A credit default swaps (CDS) is financial instrument for swapping the risk of debt default CDS may be used for various classes of bonds (corporate, sovereign) The buyer of a CDS pays a premium for effectively insuring against a debt default receives a lump sum payment if the debt instrument is defaulted. The seller of a CDS receives monthly payments from the buyer If the debt instrument defaults they have to pay the agreed amount to the buyer of the CDS The CDS market functions over-the-counter (OTC) – this offers greater flexibility but lacks the regulatory control of exchange trading Credit Default Swaps

24. EXAMPLE Agreed CDS rate is 5% Amount of referenced debt is USD 100 million The annual protection fee is USD 5 million In the event that the named borrower, say Greece, defaults on its debt, the seller of protection then gives the buyer of protection the difference between the referenced amount of debt and the market value of the defaulted debt For example, if the referenced USD 100 million in debt defaults and as a result has a market value of only USD 30 million, then the buyer of protection would collect USD 70 million from the seller of protection Credit Default Swaps

25. The Monster That Ate Wall Street CDS were invented in the mid 1990s by JP Morgan The Problem: JP Morgan client Exxon needed to open a line of credit to cover potential damages of five billion dollars (later reduced to one billion) resulting from the 1989 Exxon Valdez oil spill The deal would tie up a lot of JP Morgan’s reserve cash to provide for the risk of the loans going bad under the Basel capital adequacy rules: banks were required to hold eight per cent of their capital in reserve against the risk of outstanding loans But, if the risk of the loans could be sold, it logically followed that the loans were now risk-free; and, if that were the case, what would have been the reserve cash could now be freely loaned out The Solution: the first CDS The credit risk was sold to the European Bank of Reconstruction and Development (EBRD) which received a fee in return from J. P. Morgan Thus: Exxon got its credit line, J. P. Morgan got to honour its client relationship with Exxon but also to keep its credit lines intact for other activities Credit Default Swaps

26. Naked CDS vs covered CDS A naked CDS is a CDS in which the buyer does not own the underlying debt Estimated to be up to 80% of the CDS market Critics argue that naked CDS should be banned – analagous to buying fire insurance on your neighbour’s house … which creates a huge incentive for arson There are concerns about the size of the CDS market - there is no limit to how many CDS can be sold The gross amount of CDS far exceeds all “real” bonds and loans outstanding As a result, the risk of default is magnified leading to concerns about systemic risk Credit Default Swaps

27. Size of the CDS Market By 1998, the total size of the credit default swap market was a relatively small $180 billion The credit default swap market has grown enormously since then, although there is no definitive measure of how much Total notional amount of the CDS market $6 trillion in 2004 $57 trillion by June 2008 $41 trillion by the end of 2008 Based on survey data from the Bank for International Settlements (BIS) at http://www.bis.org/statistics/derstats.htm Credit Default Swaps

28. Post-crisis regulation of CDS The Dodd-Frank Wall Street Reform & Consumer Protection Act (2010) does not ban naked CDS but does require the central clearing of CDS and thus significantly reduces counterparty risk Similar measures have been proposed in Europe, under the aegis of the European Commission and its recently formed European Securities and Markets Authority (ESMA) Credit Default Swaps

29. The Greek Question ... • Criticism of the role of hedge funds and investment banks during the EU Sovereign debt crises • Argument: creation of a downward spiral due to CDS trading • EXAMPLE: Bets against Greek bonds made the country’s situation appear worse than it really was, creating fear • This in turn made the CDS market more nervous about Greece, with more people buying insurance against the possibility of a Greek default • This made it even harder for Greece to raise money in the bond market, exacerbating the problem further • On March 7 2011 the European Parliament's economic and monetary affairs committee approved a measure which could lead to an EU-wide ban on uncovered shorting of CDS on sovereign debt of EU member states • Under the measure as currently drafted, investors would be permitted to short a "naked" sovereign CDS if it held a proxy "asset or portfolio of assets" whose prices have a "high correlation" with government bond prices • But Italy, Britain, Sweden, the Netherlands, Spain are against the ban …

30. Almost all banks are interwoven with CDS If default should occur the institution issuing the CDS will have to make good on the difference but may not have the pool of capital assets necessary to back up a systemic wave of defaults Lehman Brothers was a key player in the CDS market and its demise triggered a whole set of obligated payments leading to the bailout of AIG, the world’s largest insurance company The Lehman bankruptcy also triggered a series of national crises in countries whose banks had overextended during the boom times Credit Default Swaps

31. Recommended reading

32. Recommended reading

33. kevin.campbell@stirling.ac.uk Koniec Dziękuję za Uwagę!

34. Homework Exercise The Financial Crisis: who was responsible? SOURCE: The Observer, Sunday 6 March 2011

35. Homework Exercise The Financial Crisis: who was responsible? • Background • The Financial Crisis Inquiry Commission • Established by the U.S. Congress and President in May 2009 to "examine the causes, domestic and global, of the current financial and economic crisis in the United States." • It comprised 10 members - private citizens with experience in areas such as housing, economics, finance, market regulation, banking and consumer protection • Six members were appointed by the Democratic leadership of Congress and four by the Republican leadership • In January 2011 the Commission delivered its report to the President, Congress and the American people

36. Homework Exercise The Financial Crisis: who was responsible? Task: Review the materials available on the website of the Financial Crisis Inquiry Commission (FCIC) at http://www.fcic.gov/ and answer the following questions: QUESTIONS: • What were the main conclusions of the six Democrat-appointed members of the FCIC? • What were the main conclusions of the three Republican-appointed Dissenters Keith Hennessey, Douglas Holtz-Eakin and Bill Thomas • What were the main conclusions of the Republican-appointed Dissenter Peter J. Wallison