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The Advantage of Innovative Thinking

The Advantage of Innovative Thinking. Sub-prime Crisis A Structural View & Implications. 2 nd Annual CAACM Conference St. Lucia – June 24, 2008 Presenter: Eric Guichard GRAVITAS Capital. Sub-prime Impact to date….

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The Advantage of Innovative Thinking

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  1. The Advantage of Innovative Thinking

  2. Sub-prime CrisisA Structural View & Implications 2nd Annual CAACM Conference St. Lucia – June 24, 2008 Presenter: Eric Guichard GRAVITAS Capital

  3. Sub-prime Impact to date… • Citigroup has declared about $30+ billion in value wiped out from its balance sheet • Merrill Lynch has declared in excess of $25+ billion lost in value • In total to date about $600+ billion lost (hedge funds, insurance companies, pension funds, endowments…) • Foreclosure rates are at historical highs • Global impact…Why?

  4. What is sub-prime? • In 90s big push to increase homeownership in US. • Freddie Mac and Fannie Mae (GSEs) push with new ways to provide loans to the needy (people with substandard credit quality) • Private sector banks balk at market share grab by GSEs • Congress allows Banks and other private financiers to enter market • Current market is about 5% - 10% of total mortgages outstanding.

  5. House = Household Wealth Bank Bank 2 (Equity Loan) Mortgage 2 Equity = Collateral Mortgage $$ Loan Consumer Goods/Services NB: Equity grows over time

  6. Housing pulls Economy Hardware Jobs $ Home Purchase Electronics $ Jobs $ Utilities Jobs

  7. Old days of Relationship Banking Bank (Owns Mortgage) Homeowner Mortgage Loan NB: Bank owns loan and knows client – is part of community

  8. The Mortgage Market Today (A) Key Attraction: Steady Cashflows + Valuable Collateral HH Loan Lender Packager (Securitization) Rating Agencies HH Loan Pensions Insurances Endowments Investment Guidelines

  9. Securitization Process (A) Detroit Bank Low Yield Bonds Exotic Loans Pool A: 30%D 30%H 40%F Insurance Pensions Banks Wall Street Investment Bank (Packager) Hollywood Bank Exotic Structures Pool B: 70%D 10%H 10%F Insurance Pensions Banks Florida Bank High Yield Bonds (Sub-prime) Selling/Buying Mortgages

  10. Securitization Process (B) Pool A Investors AAA Banks High Credit AA Pensions Mid Credit Insurance BB Sub-Credit Exotic Structures CCC Hedge Funds Hi Risk Rating Agencies

  11. Workings of Mortgage Market • All mortgage originators (Countrywide) sell their loans (cash flows) to packagers • Packagers (Merrill & Citi) securitize them and sell the securities backed by mortgages to investors (pensions, insurances, endowments, hedge funds…) • Some investors (hedge funds) believing in the collateral mantra purchase these bonds with leveraged funds.

  12. The Mortgage Market (B) (Credit Worthiness?) (Due Diligence?) HH Loan (Pressures?) (Due Diligence?) Lender Packager (Securitization) Rating Agencies HH Loan Pensions Insurances Banks Collateral (Value?) (Due Diligence?)

  13. Audit Committees Role? • Could Audit Committees of respective players have caught on? How? • Can an over-reliance on process be at issue? • Is auditing as stringent in good times as it is in bad? • What about the impact of incentives on behavior?

  14. What are incentives? • $160 Trillion in Global Liquidity • Only $51 Trillion in available stock investment • Pressure on Investment Banks to create new investment vehicles = Pressure on Banks to originate • Bankers get paid irrespective of quality of loans • Rating agencies sell their ratings to investment banks.

  15. Pressure = Origination Fraud • Incentives create dislocation and loss of accountability • Documentation is suspect and loan practices are misleading. No one pays attention • Ripple effect ensues as sub-prime borrowers default on their loans due to reset clauses (yield) and drop in housing prices (assumption).

  16. Fraud = mistrust = credit squeeze • Corporate lending in short term market which is based on trust is shut out due to poor quality of collateral • Lack of transparency leads to mistrust and collapse of short term liquidity • This leads to credit squeeze • Central bank in dilemma…

  17. Implications for the System? • Revive Accountability • Apply Existing Fraud Regulation • Realign Incentives • Strengthen Role of Incentive Audits • Loan performance ratios as part of reporting • Governance at Banks • Global liquidity still a challenge

  18. In Conclusion • Mix of inexperience, poor incentives, greed, booming global liquidity pressures and oversight dislocations lead to sub-prime collapse • Sub-prime collapse leads to credit squeeze as mistrust sets in • Sub-prime still a good idea to help alleviate poverty • Accountability, Transparency and Incentives are key as challenges remain…

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