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Chapter 5. The U.S. and European Financial Crises. The Seeds of Crisis: Sub-Prime Debt. 0. The origins of the current crisis lie within the ashes of the equity bubble and subsequent collapse of the equity markets at the end of the 1990s
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Chapter 5 The U.S. and European Financial Crises
The Seeds of Crisis: Sub-Prime Debt 0 • The origins of the current crisis lie within the ashes of the equity bubble and subsequent collapse of the equity markets at the end of the 1990s • With the collapse of the dot.com bubble, capital began to flow increasingly toward the real estate sectors in the United States • The U.S. banking sector found mortgage lending highly profitable and saw it as a rapidly expanding market
The Seeds of Crisis: Sub-Prime Debt (cont’d) 0 • As a result, investment and speculation in the real estate sector increased rapidly • As prices rose and speculation continued, a growing number of the borrowers were of lower and lower credit quality • These borrowers, and their associated mortgage agreements (sub-prime debt), now carried higher debt service obligations with lower and lower income and cash flow capabilities
Deregulation 0 • Markets were becoming more competitive than ever as a result of a number of deregulation efforts in the United States • The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 completed the repeal of the Glass-Steagall Act of 1933 and eliminated the last barriers between commercial and investment banks, allowing commercial banks to enter areas of more risk • Increased deregulation also put pressure on existing regulators such as the Federal Deposit Insurance Corporation (FDIC) and the Securities and Exchange Commission (SEC)
Mortgage Lending 0 • New market openness and competitiveness allowed many borrowers to qualify for mortgages that they would not have qualified for previously • Structurally, some mortgages re-set to high interest rates after a few years or had substantial step-ups in payments after an initial period of interest-only payments
Credit Quality 0 • Mortgage loans in the U.S. marketplace are normally categorized (in increasing order of riskiness) as: • Prime (or A-paper) • Alt-A (Alternative A-paper) • Sub-prime • The sub-prime category consists of borrowers who do not meet underwriting criteria and have a higher perceived risk of default • With DIDMCA (1980) federal law superseded state usury laws • Tax Reform Act (TRA) of 1986 eliminated tax deductibility of consumer loans, but allowed tax deductibility on interest charges associated with both a primary residence and a second mortgage loan • Exhibit 5.1 illustrates post 2000 run-up and subsequent crash of mortgage and total domestic U.S debt
Credit Quality 0 • Subprime lending was itself the result of deregulation • Growing demand for loans or mortgages from sub-prime borrowers led more and more originators to provide the loans at above market rates • Sub-prime loans became a growing segment of the market by the 2003-2005 period
Asset Values 0 • One of the key financial elements of this growing debt was the value of the assets collateralizing the mortgages – the houses and real estate itself • As the market demands pushed up prices, housing assets rose in market value • The increased values were then used as collateral in re-financings or second mortgages • Many mortgage holders became more indebted and participants in more aggressively constructed loan agreements • Mortgage brokers and loan originators, driven by additional fee income, pushed for continued refinancings
The Transmission Mechanism: Securitization 0 • The transport vehicle for the growing lower quality debt was a combination of securitization and re-packaging provided by a series of new financial derivatives • Securitization, long a force of change in global financial markets, is the process of turning an illiquid asset into a liquid saleable asset. • In finance, a liquid asset is one that can be exchanged for cash, instantly, at fair market value.
Exhibit 5.2 Household Debt as a Percentage of Disposable Income, 1990-2008 0
The Transmission Mechanism: Securitization 0 • The 1980s saw the introduction of securitization in U.S. debt markets, and its growth has been unchecked since. • In its purest form, securitization essentially bypasses the traditional financial intermediaries (typically banks), to go direct to investors in the marketplace to raise funds. • Securitized assets took two major forms, mortgage-backed securities (MBSs) and asset-backed securities (ABSs). • Asset-backed securities included second mortgages and home-equity loans based on mortgages, in addition to credit card receivables, auto loans, and a variety of others. • Growth was rapid. As illustrated in Exhibit 5.3, mortgage-backed securities (MBS) issuances rose dramatically in the post-2000 period. By end of year 2007, just prior to the crisis, MBS totaled $27 trillion and represented 39% of all loans outstanding in the U.S. marketplace.
The Transmission Mechanism: Securitization 0 • The credit crisis of 2007-2008 renewed much of the debate over the use of securitization. • Securitization had historically been viewed as a successful device for creating liquid markets for many loans and other debt instruments. • However, securitization may ultimately degrade credit quality as lenders or originators of loans would not be held accountable for the borrower’s ultimate capability to repay the loans. • Critics of securitization argue that securitization provides incentives for rapid and possibly sloppy credit quality assessment.
Structured Investment Vehicles 0 • The structured investment vehicle (SIV) was the ultimate financial intermediation device, filling the market niche as buyer for much of the securitized non-conforming debt. • The funding of the typical SIV was fairly simple: using minimal equity, the SIV borrowed very short (commercial paper, interbank or medium-term notes). • SIV’s used these proceeds to purchase portfolio’s of higher yielding securities which held investment grade credit ratings (generating an interest margin, acting as middleman)
Collateralized Debt Obligations 0 • One of the key instruments in the growing market of securitized products was the collateralized debt obligation or CDO. • Banks originating mortgage loans, and corporate loans and bonds, could now create a portfolio of these debt instruments and package them as an asset-backed security. • Once packaged, the bank passed the security to a special purpose vehicle (SPV). • From there, the CDO was sold into a growing market through underwriters freeing up the bank’s financial resources to originate more and more loans, earning a variety of fees.
Collateralized Debt Obligations 0 • CDOs were sold to the market in categories representing the credit quality of the borrowers in the mortgages – senior tranches (rated AAA), mezzanine or middle tranches (AA down to BB), and equity tranches (below BB or junk status). • The actual marketing and sales of the CDOs was done by the major investment banking houses. • CDOs would be rated by rating agencies, often without undertaking the typical ground-up credit analysis themselves. • Further, combinations of bonds were able to achieve higher ratings than any of the individual bonds – Really?! • The actual value of the CDO was no better or worse than its two primary value drivers. The first was the performance of the debt collateral it held, the ongoing payments made by borrowers; the second was the willingness of institutions to make a market in CDOs. • Exhibit 5.4 illustrates how in 2007 the CDO market collapsed.
Exhibit 5.4 Global CDO Issuance, 2004-2008 (billions of U.S. dollars)
Credit Default Swaps 0 • The credit default swap (CDS) is a contract, a derivative, which derived its value from the credit quality and performance of any specified asset. • Invented in 1997, the CDS was designed to shift the risk of default to a third-party. • In short, it was a way to bet whether a specific mortgage or security would either fail to pay on time or fail to pay at all. • For hedging, it provided insurance against the possibility that a borrower might not pay. • It was also a way in which a speculator could bet against the increasingly risky securities (like the CDO) to hold their value.
Credit Default Swaps 0 • The CDS was completely outside the regulatory boundaries. • Participants in the market, protection buyers and protection sellers, do not have to have any actual holdings or interest in the credit instruments at the center of the protection. • Participants simply have to have a viewpoint. • CDSs actually allow banks to sever their links to their borrowers, reducing incentives to screen and monitor the ability of borrowers to repay. • Exhibit 5.5 shows how the CDS market grew to many times larger than the value of the underlying securities.
Credit Default Swaps 0 • A buyer of a credit default swap makes regular nominal premium payments to the seller for the length of the contract. • If there is no significant negative credit event during the term of the contract, the protection seller earns its premiums over time, never having to payoff a significant claim. • If a credit event occurs however, the protection seller must fulfill its obligation to make a settlement payment to the protection buyer.
Credit Default Swaps 0 • As a result of the CDS market growth in a completely deregulated segment, there was no real record or registry of issuances, no requirement on writers and sellers that they had adequate capital to assure contractual fulfillment, and no real market for assuring liquidity – depending on one-to-one counterparty settlement. • New proposals for regulation have centered first on requiring participants to have an actual exposure to a credit instrument or obligation, eliminating outside speculators, and the formation of some type of clearinghouse to provide systematic trading and valuation of all CDS positions at all times.
Credit Enhancement 0 • A final element quietly at work in credit markets beginning in the late 1990s was the process of credit enhancement. • Credit enhancement is the method of making investment more attractive to prospective buyers by reducing their perceived risk. • Bond insurance agencies were utilized as guarantors in the case of default. • Beginning in 1998 a more innovative approach to credit enhancement was introduced in the form of subordination. • This was the process of combining different asset pools of differing credit quality into different tranches by credit quality.
Credit Crisis 0 • The housing market began to falter in late 2005, with the bubble finally bursting in 2007. • Global in scope, a domino effect ensued with collapsing loans and securities being followed by the funds and institutions which were their holders. • Starting with hedge funds at Bear Stearns and the rescue of Northern Rock, the global financial markets slid toward near panic. • 2008 proved even more volatile, with oil and commodity prices peaking, then plummeting.
Credit Crisis 0 • In September 2008, the US government announced it was placing Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) into conservatorship. • Over the following week, Lehman Brothers, one of the oldest investment banks on Wall Street struggled to survive, eventually filing for the largest single bankruptcy in American history on September 14. • Exhibit 5.6 shows LIBOR market reaction to the perception of financial collapse by U.S. financial institutions.
Credit Crisis 0 • The following day, equity markets plunged and US dollar LIBOR rates shot skywards as a result of the growing international perception of financial collapse by US banking institutions. • The following day, American International Group (AIG), who had extensive credit default swap exposure, received an $85 billion injection from the US Federal Reserve in exchange for an 80% equity interest. • Periods of collapse and calm followed with the credit crisis beginning in full force as the world’s credit markets – lending of all kinds – nearly stopped.
Global Contagion 0 • Although it is difficult to ascribe causality, the rapid collapse of the mortgage-backed securities markets in the United States definitely spread to the global marketplace. • Capital invested in equity and debt instruments in all major financial markets fled not only for cash, but for cash in traditional safe-haven countries and markets. • Equity markets fell worldwide, emerging markets were hit particularly hard. • Currencies of the more financially open emerging markets felt a significant impact.
Global Contagion 0 • By January 2009, the credit crisis was having additionally complex impacts on global markets – and global firms. • The crisis, which began in the summer of 2007 had now moved to a third stage, that of potential global recession of depression-like depths. • Exhibit 5.7 illustrates clearly how markets fell in September and October 2008, and how they remained volatile in the months that followed. • Constricted lending had impacted borrowing and importantly investing. • Prospects for investment returns of all types were dim; corporations failed to see returns on investments. • As a result there was widespread retrenchment among industrialized nations as corporations slashed budgets and headcount.
What’s Wrong with LIBOR? 0 • The global financial markets have always depended upon commercial banks for their core business activity. • The banks in turn have depended on the interbank market for liquidity which had historically operated on a “no-names” basis but rather a tiered basis with respect to individual banks. • In the summer of 2007 however, much of this changed, increasing focus on each individual institution and its particular credit risk profile.
LIBOR’s Role 0 • The global financial markets have always depended upon commercial banks for their core business activity. See Exhibit 5.8 • The banks in turn have depended on the interbank market for liquidity which had historically operated on a “no-names” basis but rather a tiered basis with respect to individual banks. • In the summer of 2007 however, much of this changed, increasing focus on each individual institution and its particular credit risk profile.
LIBOR’s Role 0 • The British Bankers Association, the organization charged with the daily tabulation and publication of LIBOR Rates, became worried about the validity of its own published rate. • The growing stress in the financial markets had actually created incentives for banks surveyed for LIBOR calculation to report lower rates than they were actually paying. • As the crisis deepened, many corporate borrowers began to publicly argue the LIBOR rates published were in fact understating their problems. • In its role as the basis for all floating rate debt instruments of all kinds, LIBOR rates have the potential to cause significant disruptions when they skyrocket as they did in September 2008. • Exhibit 5.9 shows this disruption via the TED spread in October 2008
Exhibit 5.9 The U.S. Dollar TED Spread (July 2008–January 2009) 0
U.S. Credit Crisis Resolution 0 • Market solutions are preferred by U.S. Treasury and Federal Reserve • Immediate market solutions include mergers and bankruptcy • Government aid came in the form of the Troubled Asset Recovery Plan (TARP) 2008 • $700 billion to support financial institutions and insurers deemed too big to fail
U.S. Credit Crisis Resolution 0 • Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 • Establish an Office of Financial Research • FDIC insurance increased from $100,000 to $250,000 per account • Institutions must disclose amount of short selling
The European Debt Crisis of 2009-2012 • Most governments today run budget deficits – European countries are no exception • Late 2009 the global financial crisis is winding down but it fostered two realities • Money was cheaper than ever • Banks sharply reduced lending thus slowing economies that needed growth to repay existing debt levels
Sovereign Debt • Government (sovereign) debt typically considered to be of the highest quality due to ability to manage fiscal (tax) policy and monetary policy • Eurozone members control fiscal policy for their own countries but not monetary policy • Different levels of debt are incurred by each of the eurozone countries as seen in Exhibit 5.10 • Greece with a debt/GDP ratio of 166% is the highest
The European Debt Crisis of 2009-2012 • October 2009 the newly elected Greek government discovers the previous administration has systematically under-reported the government debt • Greek financial instruments are down graded • Financial markets fear Greek default and financial contagion to other financially weak eurozone countries • March 2010 the IMF helps establish a plan to stabilize the Greek economy
The European Financial Stability Facility (EFSF) • EFSF designed to raise €500 billion to extend credit to distressed member states • Ireland: • Unlike Greece, their problems are similar to those in the U.S., a property bubble and the failure of the banking system • Portugal • Problems may actually be contagion as their financial problems did not appear to be as serious as Greece or Ireland
Transmission • Greek, Irish, and Portuguese government debt was held by many European banks • These banks were considered too big to fail • The risky sovereign debt was trading at deep discounts and with high yields • Further bailouts of Greece and others were becoming necessary • Exhibit 5.11 illustrates what happened to interest rates • Who would buy such risky debt? See Exhibit 5.12
Moving Ahead in Europe • How much money is needed in the coming years for eurozone countries? Exhibit 5.13 • Solutions to the debt crisis • Greece needed immediate capital to manage debt obligations and run their government • European banks needed to be protected from the plunging value of the sovereign debt of Greece, Ireland, Portugal and the like • Address the long-term fundamental issues of government deficits with ...in some cases austerity measures
Alternative Solution to the Eurozone Debt Crisis • The Brussels Agreement - a failed attempt to write down sovereign debt values, increase funds in the EFSF, and increase required bank equity capital – contingent upon Greek acceptance of new austerity measures, but the Greeks hesitated • Debt-to-Equity Swaps – these come at a cost as the debt value is trimmed before conversion to equity • Stability Bonds – Issued with the full backing of every eurozone country rather than individual sovereign debt – resisted by the stronger countries
Currency Confusion • Has the sovereign debt crisis put the euro at risk? • YES • Too much euro-denominated sovereign debt could raise significantly the cost of financing as could the failure of eurozone countries to meet convergence standards • No • Bad sovereign debt should affect each country more than the group of euro nations • Very little empirical evidence thus far that the crisis has really devalued the currency
