Abc Of Global Financial Crisis 2008

A.B.C.of The Global Financial Crisis 2008

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Faces of the CRISIS

Globalization? Global impact? Global Financial Crises? Why? Question: What is the truest definition of Globalization? Answer: Princess Diana's death. Question: How come? Answer: An English princess, with an Egyptian lover, crashes in a French tunnel, driving a German car, with a Dutch engine, driven by a Belgian who was drunk, on Scottish whisky, followed closely by Italian Photographers, on Japanese motorcycles; treated by an American doctor, using Brazilian medicines. This is being told by a British, using Bill Gates' technology, and you're seeing it through a Japanese multimedia projector, that use Taiwanese chips, and a Korean lens, assembled by Bangladeshi workers, in a Singapore plant, This is being told in front of Professors, Educated in USA, UK, Japan and France, That, my friends, is Globalization

Global Financial Crisis Dictionary 2008


20 Steps to the DOOMSDAY1. In 2001, following a massive stock market and

capital spending bubble, Federal Reserve Chairman Alan Greenspan worried that the U.S. faced a severe recession. He began cutting interest rates down to 1% and kept them at that level until 2004, raising them slowly only 0.25% at a time thereafter.

2. With interest rates so low, the financial services industry sensed a lot of money could be made and went all in on real estate, seemingly unaware that low interest rates were masking large risks.

3. Meanwhile, Americans had been anticipating a nasty downturn after the bubble burst. But, they soon realized that money lost in the stock market was more than offset by rising home prices. So, Americans continued to spend freely.


4. As Americans spent freely, the U.S. went further into debt with the rest of the world. Foreigners, used their dollar IOUs from these debts to start their own bubbles too.

5. Eventually, things started to unravel in 2006 when those that could least afford to purchase homes -- so called subprime borrowers -- started to default in the U.S., prices having run well out of their range of affordability.

6. In February 2007, HSBC issued the first major warning, a harbinger of things to come, writing down tens of billions in losses from their ill-timed 2002 acquisition of U.S. subprime lender Household International. At first things looked fine and policy makers convinced themselves and the wider public that the problem was contained to subprime.

7. However, when two Bear Stearns hedge funds with exposure to the US housing market blew up in June 2007, people became worried that the risks had been underestimated.

8. It was in August 2007 when BNP Paribas, a large French bank, froze withdrawals in three investment funds that people began to panic. If a bank with zero obvious exposure to the U.S. mortgage sector could have this measure of difficulty, anyone could be hiding untold losses. This marked the official beginning of the credit crisis. The result was mutual distrust amongst large banks operating in the global market for interbank loans which meant credit was hard to come by for many banks.


9.By September, liquidity in the interbank market was so bad that rumors were swirling about various institutions which received most of their funding in wholesale markets. One of these was Northern Rock, an aggressive British mortgage lender. The British public panicked and began lining up to pull their money out of the institution. The Bank of England was forced to bail out the company, subsequently nationalizing it altogether.

10.Meanwhile U.S. housing prices continued to decline. The result was massive losses in the alphabet soup of mortgage-related derivative assets held by large global banks. These instruments are called derivatives because their value is derived from the value in underlying assets like mortgages. The first wave of mortgage-related losses were concentrated in these instruments and investing vehicles: RMBSs (Residential Mortgage Backed Securities) CDOs (Collateralized Debt Obligations), and SIVs (Structured Investment Vehicles) and CDOs of CDOs. Merrill Lynch was the first to report a large loss, at $5.5 billion on 5 Oct 2007. Only to come back less than three weeks later on 24 Oct 2007 to say that the losses were now over $8 billion. Eventually, losses reached $500 billion a year into the crisis for all global institutions.


11. The Merrill losses were followed by losses at most of the large global financial institutions. Many CEOs lost their jobs and the companies were forced to raise capital. By August 2008, the amount raised was to reach $350 billion.

12. The situation seemed to quiet down in early 2008. However, in March the failures of hedge funds Peloton and Carlyle Capital put the credit crisis back in full view. Another 2nd period of panic resulted in the sudden collapse of Bear Stearns, America's 5th largest investment bank. The Fed organized a takeover by JP Morgan Chase that was a catastrophic 90% loss for Bear's shareholders.

13. Eventually the collapse of Bear Stearns faded and, for the third time, we were lulled into a false sense of security that the worst was over. Nevertheless, writedowns continued unabated as did capital raising. When Lehman Brothers announced a massive $3 billion loss 0n 9 Jun 2008, the crisis came into full view yet again -- much as it had when Bear Stearns' hedge funds collapsed the previous June.

14.This time, market fears did not recede and the financial markets remained in a constant state of stress. Things started to unravel very quickly. IndyMac, an aggressive mortgage lender, an American version of Northern Rock, was taken over by the FDIC. And a panic was on for the third time.


15. Next were the GSEs. The end result of the market panic was a questioning of the viability of Fannie Mae and Freddie Mac, the two largest mortgage lenders in the United States and at the core of the residential property market. Eventually the U.S. Government was forced to take the two companies into conservatorship.

16.Afterwards, all financial shares generally came under assault. The ones considered the weakest came under the heaviest selling pressure, resulting in the collapse of Lehman Brothers. Without government support and unable to close a merger in around-the-clock negotiations at the weekend, the company filed for bankruptcy on Sep. 15.

17. Merrill Lynch, the venerated US investment bank, sensing trouble, sought and received cover in a takeover by Bank of America that very same weekend.

18. Financial markets smelled blood after Lehman collapsed. Apparently no company was too big to fail. So, the assault on financial service companies continued. Eventually, AIG, the largest insurance company in the world, succumbed to this pressure. The Federal Reserve, citing special considerations, bailed out the non-depositary institution.

19. At this stage, we were in free fall and the entire banking system was on the verge of collapse in the United States. Global shocks had not ended either, as UK institutions were increasingly under attack as well, having been damaged by their own property bubble. At the urging of the British Prime Minister and the UK regulatory authorities, Lloyds TSB bought Britain's largest mortgage lender HBOS, which was in jeopardy of failing.

20. By this time, the Feds had had enough. The time for ad hoc crisis management was at an end. Hank Paulson moved decisively and put forward his $700 billion bailout plan. Which was later approved….

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Impact of the squeeze??? Here are some startling statistics that make our financial crisis all too real: 2/3 of Americans believe their children will be economically worse off then they are. Profits are at a 40 year high for Fortune 500 companies ($705 billion) nearly 2X previous high. But average wages only up 1% (inflation adjusted) (Bureau of Labor Statistics (BLS)). Median personal income is actually down, below 2000 levels (BLS), and also below 1977 levels in real

dollars! The real median income in 1977 was $51,223 (inflation adjusted). In 2006 it was $50,700. (National Center for Education Statistics (NCES)).

Virtually all income gains have gone to the richest Americans, the owners of capital and senior management compensation, which is now an incredible 400 times the average employee wage.

In USA , out of 300 million people in which the richest 3 million own more than the bottom 256 million. 1% owns more than 90% of us put together!

Prices in real terms of housing, education, and health care have risen nearly 300% more in the past 30 years, while individual incomes are stagnant.

The amount of monthly income it takes to buy a house today is nearly 23% vs. 17% in 1970. People who pay 50% of their income for rent or mortgage payments are at an all time high.

Private college tuition and public tuition is up nearly 300% (College Board). The average debt of a college graduate is nearly $20,000+ (College Board). A majority of Baby Boomers expect to work beyond age 65 because they can’t afford not to. 47 million are medically uninsured. Most are in families with at least one full time worker. Medical Insurance Premiums of an average American family exceed $1000 per month. Loan defaults and foreclosures are doubling monthly in many parts of the country. In Cleveland, Ohio nearly 10% of the homes are vacant and abandoned due to foreclosure caused by

job loss. Retail sales are declining due to increase costs of gasoline, insurance, and housing. The savings rate for the average American 30 years ago was 9%. Today it is at zero. America has fewer manufacturing jobs (14.3 million) than it did in 1950 with 2 times the population.

(In 1950 there were approximately 150 million Americans; today there are approximately 300 million. ) Since 1977, inflation-adjusted medium income for U.S. males has declined 7.5%. U.S. productivity in terms of output ranks 8th behind Norway, Belgium, France, Ireland, Italy, Austria,

and Germany (OCED). U.S household debt exceeds $12 trillion. U.S. Federal Deficit is $8.8 trillion! And climbing every second.

“the elephant in the room”

Origin point of the crisisOrigin point of the crisis United States, 2007: a price bubble in the housing market United States, 2007: a price bubble in the housing market

bursts…bursts…

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Nominalne cene nepremičnin Cene nepremičnin, prilagojene za inflacijo


Origin point of the crisisOrigin point of the crisis … … marking the end of the largest speculative surge of real marking the end of the largest speculative surge of real

housing prices in the U.S. in the last 50 years …housing prices in the U.S. in the last 50 years …

Notice the Notice the prolonged prolonged

exponential exponential growth!growth!


Origin point of the crisisOrigin point of the crisis … … and resulting in a surge of loan delinquencies in the residential and resulting in a surge of loan delinquencies in the residential

mortgage loan market …mortgage loan market …


Origin point of the crisisOrigin point of the crisis … … especially among the recent especially among the recent

loan vintages on the loan vintages on the “subprime” market segment. “subprime” market segment. Vintage 2007 is the worst Vintage 2007 is the worst performing yet…performing yet…

% of % of delinquent delinquent loans (60+ loans (60+

days)days)

Months from originationMonths from origination


Several questions pop up…Several questions pop up… What has fueled the observed house price bubble?What has fueled the observed house price bubble?

U.S. monetary policy?U.S. monetary policy? Global saving glut?Global saving glut? Lack of (other) investment opportunities?Lack of (other) investment opportunities?

How can lower house prices increase mortgage loan defaults?How can lower house prices increase mortgage loan defaults? Does the ability to repay mortgage loans depend on the value of Does the ability to repay mortgage loans depend on the value of

the underlying real estate?the underlying real estate?

Why was the crisis not contained at the point of origin?Why was the crisis not contained at the point of origin? Shouldn’t risks be borne by those who originate them (=mortgage Shouldn’t risks be borne by those who originate them (=mortgage

banks) ?banks) ?

Can the crisis affect the real economy and the world?Can the crisis affect the real economy and the world? How can problems in a relatively small segment of the U.S. How can problems in a relatively small segment of the U.S.

economy affect growth inside and outside of the U.S.?economy affect growth inside and outside of the U.S.?


Mortgage loan market in the U.S. – segmentation Mortgage loan market in the U.S. – segmentation of the marketof the market

U.S. mortgage U.S. mortgage loan marketloan market

““Prime”Prime”LTV<80%LTV<80%FICO>660FICO>660

““Non-prime”Non-prime”

““Conforming”Conforming”Principal <Principal <

““conforming” limitconforming” limit

““Jumbo”Jumbo”Principal >Principal >

““conforming” limitconforming” limit

““Near-prime” Near-prime” (Alt-A)(Alt-A)

LTV~80-90%LTV~80-90%FICO~581-659FICO~581-659

““Subprime”Subprime”LTV>90%LTV>90%FICO<580FICO<580

Government guarantee Government guarantee and securitization and securitization

GSEs- Fannie Mae, GSEs- Fannie Mae, Freddie Mac…Freddie Mac…

Private securitization marketPrivate securitization marketCountrywide financial, Bear Stearns, Countrywide financial, Bear Stearns, Lehman Brothers, Bank of America, Lehman Brothers, Bank of America, Wells Fargo, Washington Mutual…Wells Fargo, Washington Mutual…


Mortgage loan market in the U.S. – relative size of Mortgage loan market in the U.S. – relative size of the “subprime” segmentthe “subprime” segment The share of subprime increased by 130% from 2003 to 2005!The share of subprime increased by 130% from 2003 to 2005! The percent of loans securitized increased by 60% from 2001 to The percent of loans securitized increased by 60% from 2001 to

2005!2005!

Share of subprimeShare of subprimeIn total U.S. economy In total U.S. economy

(measured by GDP): 1% (measured by GDP): 1% (2001), increasing to 5% (2001), increasing to 5%

(2005)(2005)


Mortgage loan market in the U.S. –Mortgage loan market in the U.S. –types of productstypes of products

Mortgage loansMortgage loans

Fixed rate Fixed rate mortgage mortgage

(FRM)(FRM)

Adjustable rate Adjustable rate mortgage mortgage

(ARM)(ARM)

Common ARMCommon ARM ARM ARM payment optionpayment option

Interest only Interest only (I-O) ARM (I-O) ARM Hybrid ARMHybrid ARM


Functioning of the mortgage loan market in Functioning of the mortgage loan market in favorable market conditionsfavorable market conditionsAssumptionsAssumptions Rising real estate pricesRising real estate prices Rising income levelsRising income levels Low or falling interest ratesLow or falling interest rates

ResultResult Additional real estate equity Additional real estate equity

due to price appreciationdue to price appreciation Borrowers are able to repay Borrowers are able to repay

their loans with refinancing.their loans with refinancing.

Example of refinancing: Example of refinancing:

Real estate Real estate value: value:

$200.000$200.000

Mortgage Mortgage loan: loan:

$200.000$200.000

Real estateReal estatevalue: value:

$300.000$300.000

After 1 yearAfter 1 year

MortgageMortgageloan: loan:

$300.000$300.000

Repayment Repayment of initial of initial

loan: loan: $200.000$200.000

Cash remainingCash remaining$100.000$100.000


Functioning of the mortgage loan market in strained Functioning of the mortgage loan market in strained market conditionsmarket conditionsAssumptionsAssumptions Stagnating or falling real Stagnating or falling real

estate prices.estate prices. Stagnating or falling income Stagnating or falling income

levels.levels. High or rising interest rates.High or rising interest rates.

ResultResult No new real estate equity.No new real estate equity. Repyment of loans by Repyment of loans by

refinancing not possible.refinancing not possible. Borrowers faced with Borrowers faced with

increasing difficulties in increasing difficulties in servicing real estate debt.servicing real estate debt.

Figure: Figure: Interest rate movements on U.S. Interest rate movements on U.S.

mortgage market (hybrid ARM mortgage market (hybrid ARM rates).rates).


Risk factors contributing to the escalation of the Risk factors contributing to the escalation of the crisis in the U.S.crisis in the U.S. Global capital imbalancesGlobal capital imbalances: Asia & Middle East – surpluss savings; United : Asia & Middle East – surpluss savings; United

States – deficit savings; Europe – mostly balanced.States – deficit savings; Europe – mostly balanced.

Global demand for higher yieldsGlobal demand for higher yields – low rates of return on classical high risk – low rates of return on classical high risk instruments (i.e. shares), in the post dot com era (after 2000).instruments (i.e. shares), in the post dot com era (after 2000).

Predatory lending practices among U.S. mortgage banksPredatory lending practices among U.S. mortgage banks – Combination of – Combination of capital abundance in the U.S. due to international inflows and demand for capital abundance in the U.S. due to international inflows and demand for higher yields provides incentives to U.S. banks for aggressive lending. higher yields provides incentives to U.S. banks for aggressive lending. Failure of prudent lending practices – loans made to individuals with poor Failure of prudent lending practices – loans made to individuals with poor or no credit histories, no documentation, no regular income!or no credit histories, no documentation, no regular income!

Widespread use of decieving credit products (hybrid ARMs)Widespread use of decieving credit products (hybrid ARMs) – Low initial – Low initial fixed rates marketed to lure high credit risk individuals into borrowing fixed rates marketed to lure high credit risk individuals into borrowing without giving enough consideration to possible subsequent default; upon without giving enough consideration to possible subsequent default; upon resetting of interest rates (fixed to floating) debt servicing requirements resetting of interest rates (fixed to floating) debt servicing requirements alone could increase 15-30%!alone could increase 15-30%!


Global financial imbalancesGlobal financial imbalances U.S. current account deficit recently as high as 6% of U.S. U.S. current account deficit recently as high as 6% of U.S.

GDP! Financing provided mostly by capital inflows from GDP! Financing provided mostly by capital inflows from Asian countires and oil exporters.Asian countires and oil exporters.


Equity marketsEquity markets Equity markets were not Equity markets were not

an attractive investment an attractive investment opportunity in the opportunity in the aftermath of the collapse of aftermath of the collapse of the dot com bubble.the dot com bubble.


Interest ratesInterest rates Interest rates in 2002-2003 were historically low as a result Interest rates in 2002-2003 were historically low as a result

of expansionary monetary policies by major world central of expansionary monetary policies by major world central banks.banks.


Risk factors revisited:Risk factors revisited:The final touch that puts it all together…The final touch that puts it all together…1.1. Global financial imbalances Global financial imbalances infusion of liquidity into infusion of liquidity into

international financial system, searching for yieldinternational financial system, searching for yield

2.2. Low yields on equities Low yields on equities incentives to invest into new high risk incentives to invest into new high risk instruments with adequate risk profileinstruments with adequate risk profile

3.3. Low interest rates Low interest rates incentives to borrow for those who would incentives to borrow for those who would normally never be able to afford it. normally never be able to afford it.

Are the owners of global capital really willing to invest into high Are the owners of global capital really willing to invest into high credit risk U.S. individuals? Probably only in small amounts…credit risk U.S. individuals? Probably only in small amounts…

……unless the risks can be dispersed! unless the risks can be dispersed!

STRUCTURED FINANCE & SECURITIZATIONSTRUCTURED FINANCE & SECURITIZATION


Structured finance: the first round of securitization Structured finance: the first round of securitization (schematic presentation)(schematic presentation)

Mortgage Mortgage loansloans

Total value:Total value:$900.000$900.000

Mortgage loan portfolio Mortgage loan portfolio can be divided into 9.000 can be divided into 9.000

bonds with $100 face falue. bonds with $100 face falue. Different tranches of bonds Different tranches of bonds

carry different levels of carry different levels of risk depending on their risk depending on their

seniority/subordination in seniority/subordination in debt repayment.debt repayment.

1. tranche 1. tranche (low risk)(low risk)

3.000 bonds at $1003.000 bonds at $100Coupon rate: 10 % Coupon rate: 10 %

2. tranche2. tranche(medium risk)(medium risk)

3.000 bonds at $1003.000 bonds at $100Coupon rate: 15 %Coupon rate: 15 %

3. tranche3. tranche(high risk)(high risk)

3.000 bonds at $1003.000 bonds at $100Coupon rate: 20 %Coupon rate: 20 %

SecuritizationSecuritization

Mortgage backed securities (MBS) Mortgage backed securities (MBS)

Demand:Demand:financial financial investorsinvestors

Supply:Supply:originatorsoriginatorsof mortgageof mortgage

loans loans


Structured finance: Structured finance: The key to high (AAA) ratingsThe key to high (AAA) ratingsCredit enhancement facilitiesCredit enhancement facilities

External:External: Bond insurance – monoline insurers;Bond insurance – monoline insurers; Letter of credit – banks.Letter of credit – banks.

Internal:Internal: Overcollateralization;Overcollateralization; Excess spread;Excess spread; Reserve account;Reserve account; Senior/subordinated debt structure.Senior/subordinated debt structure.

Liquidity facilities – sponsor banksLiquidity facilities – sponsor banks


Structured finance: Structured finance: The players in securitizationThe players in securitization

OriginatorOriginator

End borrowersEnd borrowers

Conduit/trust/ Conduit/trust/ SPV/SPE/SIVSPV/SPE/SIV

Investment bank Investment bank (underwriter)(underwriter)

Rating agencyRating agency Institutional Institutional investorinvestor

End lendersEnd lenders

Insurance Insurance companycompany

BrokerBroker

ServicerServicer$$

$$

$$

$$

$$

MortgagesMortgages

MortgagesMortgages

MBSMBS

I&P ($)I&P ($)

I&P ($)I&P ($)

MBS, I&P ($)MBS, I&P ($)

Financial Financial returns ($)returns ($)

LEGEND KEYLEGEND KEYO&G – interest and principalO&G – interest and principal

SPV – special purpose vehicleSPV – special purpose vehicleSPE – special purpose enterpriseSPE – special purpose enterpriseSIV – special investment vehicleSIV – special investment vehicle

MBS – mortgage backed securitiesMBS – mortgage backed securities

Founder: loan originator or Founder: loan originator or investment bankinvestment bank

Purpose: transfering Purpose: transfering ownerhship of claims (loans) ownerhship of claims (loans) and collateral (mortgages) in and collateral (mortgages) in

order to issue mortgage backed order to issue mortgage backed securities (bonds).securities (bonds).

Exposure of founder: implicit Exposure of founder: implicit guarantee in case of large guarantee in case of large

losses.losses.

Assigns credit Assigns credit rating to issued rating to issued

MBSs.MBSs.

Organizes issuing of Organizes issuing of MBSs and places MBSs and places

MBSs to investors in MBSs to investors in financial markets.financial markets.

Broker places mortgage Broker places mortgage loans to borrowers for feeloans to borrowers for fee

Manages the flow of Manages the flow of interests and principal interests and principal (I&P); usually, but not (I&P); usually, but not

necessarilly the Originator necessarilly the Originator

Typically a specialized Typically a specialized mortgage bankmortgage bank

Mutual funds, Mutual funds, pension funds, pension funds, hedge funds…hedge funds…

Can assume part of Can assume part of risks (insurance of risks (insurance of

mortgage loans, mortgage loans, insurance of MBS insurance of MBS

returns).returns).


Structured finance:Structured finance:The second round of securitizationThe second round of securitization

Mortgage bondsMortgage bondsRating: AAA/AaaRating: AAA/Aaa

Mortgage bondsMortgage bondsRating: AA/Aa2Rating: AA/Aa2

Mortgage bondsMortgage bondsRating: A/A2Rating: A/A2

Mortgage bondsMortgage bondsRating: BBB/Baa2Rating: BBB/Baa2Mortgage bondsMortgage bondsRating: BB/Ba2Rating: BB/Ba2Mortgage bondsMortgage bonds

Rating: B/B2Rating: B/B2

““Equity” trancheEquity” tranche

Mortgage backed securities (MBS) Mortgage backed securities (MBS)

InvestmentInvestmentgradegrade

Speculative Speculative gradegrade

CDOCDORatings: AAA/Aaa – BBB/Baa2Ratings: AAA/Aaa – BBB/Baa2

CDOCDORatings: less than BBB/Baa2Ratings: less than BBB/Baa2

Collateralized debt obligations (CDO)Collateralized debt obligations (CDO)

InvestmentInvestmentgrade grade MBSMBS

Other Other claimsclaims


Structured finance:Structured finance:The third round of securitization…The third round of securitization…

A mil. $ question: A mil. $ question: if I am a sponsor bank if I am a sponsor bank of the SIV that issued of the SIV that issued

CDO2, what is my CDO2, what is my risk exposure?risk exposure?


Structured finance:Structured finance:Instruments and volumesInstruments and volumes

RMBS – residential mortgage backed RMBS – residential mortgage backed securitiessecurities

CMBS – commercial mortgage backed CMBS – commercial mortgage backed securitiessecurities

MBS – mortgage backed securitiesMBS – mortgage backed securities ABS – asset backed securitiesABS – asset backed securities CDO – collateralized debt obligationsCDO – collateralized debt obligations CDS – credit default swapsCDS – credit default swaps


Structured finance: ratings of issued securities and types Structured finance: ratings of issued securities and types of claims for SIVsof claims for SIVs


Structured finance: funding profile of SIVs and claims of Structured finance: funding profile of SIVs and claims of ABCP conduitsABCP conduits

International transmission of the crisis – International transmission of the crisis – institutional investors (1)institutional investors (1)Key question Key question

Why has a crisis in a relatively narrow segment of the U.S. Why has a crisis in a relatively narrow segment of the U.S. financial system send such strong shockwaves through the U.S. financial system send such strong shockwaves through the U.S. and international financial environment?and international financial environment?

ExplanationsExplanations

Investor miopiaInvestor miopia – excessive focus on yield and insufficient focus on – excessive focus on yield and insufficient focus on risk due to benign international financial environment.risk due to benign international financial environment.

Difficulties in estimating risks Difficulties in estimating risks – failure of risk assessment models – failure of risk assessment models for structured finance instruments, which are not actively traded for structured finance instruments, which are not actively traded in the secondary markets (such as CDO and CDO2).in the secondary markets (such as CDO and CDO2).

International transmission of the crisis – International transmission of the crisis – institutional investors (2)institutional investors (2) Over reliance on credit rating agencies Over reliance on credit rating agencies – systematic large – systematic large

downgrades of MBS credit ratings since July 2007 cause panic downgrades of MBS credit ratings since July 2007 cause panic among investors and subsequent “flight to quality” among investors and subsequent “flight to quality” repricing of repricing of risk!risk!

Contagion effectContagion effect – a lack of confidence spread from the narrow – a lack of confidence spread from the narrow MBS segment to the wider ABS segment, which is based on a MBS segment to the wider ABS segment, which is based on a much broader pool of claims, including corporate bonds, student much broader pool of claims, including corporate bonds, student loans, car leases, credit card payments etc.loans, car leases, credit card payments etc.

Self-fulfilling negative spiralsSelf-fulfilling negative spirals – investors’ lack of condifence – investors’ lack of condifence fire fire sales of structured finance instruments sales of structured finance instruments stressed liquidation of stressed liquidation of SIV/SPV/SPE assets SIV/SPV/SPE assets falling prices of illiquid structured finance falling prices of illiquid structured finance instruments instruments further lack of confidence further lack of confidence accelerated fire sales accelerated fire sales of structured finance instruments… of structured finance instruments…

Unreliable ratings of rating agencies in the MBS Unreliable ratings of rating agencies in the MBS marketmarket

Transmission of risk aversion (1): Transmission of risk aversion (1): From the RMBS to the CMBS segment…From the RMBS to the CMBS segment…

Record drops Record drops in pricesin prices

Record increases Record increases in risk premiumsin risk premiums


Transmission of risk aversion (2): Transmission of risk aversion (2): …from MBS to the entire ABS market……from MBS to the entire ABS market…


Transmission of risk aversion (3): Transmission of risk aversion (3): …and even to corporate debt markets…and even to corporate debt markets


International transmission of the crisis –the International transmission of the crisis –the interbank money market (1)interbank money market (1)Key questionKey question How has the crisis jumped from institutional investors to the How has the crisis jumped from institutional investors to the

interbank market?interbank market?

ExplanationsExplanations

Realization of contingent liabilitiesRealization of contingent liabilities of banks to various investment of banks to various investment vehiclesvehicles

Important role of ABCP (asset backed commercial papers) with partial Important role of ABCP (asset backed commercial papers) with partial exposure to U.S. subprime market in transmission of the crisis! exposure to U.S. subprime market in transmission of the crisis!

Conduits issuing ABCPs were established & sponsored by several european Conduits issuing ABCPs were established & sponsored by several european banks. Problems at German banks IKB and Sachsen LB and french BNP banks. Problems at German banks IKB and Sachsen LB and french BNP Paribas.Paribas.


International transmission of the crisis –the International transmission of the crisis –the interbank money market (2)interbank money market (2) Non-functioning of the securitization market Non-functioning of the securitization market – banks can no – banks can no

longer transfer risks off their balance sheets (problems with longer transfer risks off their balance sheets (problems with pending LBOs). Unwanted claims put pressure on banks’ capital pending LBOs). Unwanted claims put pressure on banks’ capital adequacy.adequacy.

Larger liquidity requirements at banksLarger liquidity requirements at banks – due to increased risks of – due to increased risks of realization of additional contingent liabilities.realization of additional contingent liabilities.

Crisis of confidence between banksCrisis of confidence between banks – problem of adverse selection – problem of adverse selection creates a dangerous liquidity squeeze in the interbank money creates a dangerous liquidity squeeze in the interbank money market. Banks respond by toughening lending standards.market. Banks respond by toughening lending standards.

Increased liquidity requirements of nonfinancial companiesIncreased liquidity requirements of nonfinancial companies – Due – Due to stressed liquidity conditions, companies try to secure cash, to stressed liquidity conditions, companies try to secure cash, creating further liquidity pressures for banks.creating further liquidity pressures for banks.


Transmission of the crisis to the interbank market – increase Transmission of the crisis to the interbank market – increase in credit and liquidity risksin credit and liquidity risks


Countermeasures (1)Countermeasures (1) Infusion of liquidity to the interbank marketInfusion of liquidity to the interbank market (Fed, ECB and other (Fed, ECB and other

central banks) – liquidity provided in exchange for securities that central banks) – liquidity provided in exchange for securities that “nobody else wants”. “nobody else wants”.

Lowering interest ratesLowering interest rates (Fed) – with the objective to prevent a (Fed) – with the objective to prevent a sharp recession in the U.S. and to ease conditions in the mortgage sharp recession in the U.S. and to ease conditions in the mortgage marketsmarkets

Balance sheet clean-up and recapitalizationBalance sheet clean-up and recapitalization of large, systemically of large, systemically important banks – substantial role of the so called sovereign important banks – substantial role of the so called sovereign wealth funds.wealth funds.


Countermeasures (2)Countermeasures (2) Bailouts of failed banksBailouts of failed banks – nationalization in case of Northern Rock, – nationalization in case of Northern Rock,

takeover (by JP Morgan Chase) in case of Bear Stearns, with the takeover (by JP Morgan Chase) in case of Bear Stearns, with the objective to contain systemic risks – problem of moral hazard! objective to contain systemic risks – problem of moral hazard!

Measures to improve the conditions in the mortgage marketMeasures to improve the conditions in the mortgage market (U.S.) (U.S.) – moratorium on loan repayments, increased authority for – moratorium on loan repayments, increased authority for intervention by government sponsored enterprises (GSEs) both in intervention by government sponsored enterprises (GSEs) both in granting guarantees and securitization, fiscal stimulation. granting guarantees and securitization, fiscal stimulation.

Reconsidering the role of regulation and supervisionReconsidering the role of regulation and supervision of nonbank of nonbank financial institutions and off balance sheet conduits and financial institutions and off balance sheet conduits and investment vehicles. investment vehicles.


Bank capital write-downs and recapitalizationsBank capital write-downs and recapitalizations


What are the costs of the crisis?What are the costs of the crisis? Current estimates of potential Current estimates of potential

losses from the crisis are $945 bil. losses from the crisis are $945 bil. (IMF).(IMF).

Of this, $ 225 bil. is due to Of this, $ 225 bil. is due to estimated losses on outstanding estimated losses on outstanding loans, $ 720 bil. due to estimated loans, $ 720 bil. due to estimated losses on securities.losses on securities.

About $440-510 bil. losses About $440-510 bil. losses expected in banks, $105-130 bil. expected in banks, $105-130 bil. losses in insurance, $90-160 bil. in losses in insurance, $90-160 bil. in pensions/savings, $70-140 bil. in pensions/savings, $70-140 bil. in GSEs and government and $110-GSEs and government and $110-200 bil. in other institutions 200 bil. in other institutions (including hedge funds).(including hedge funds).


How will the crisis evolve in the future?How will the crisis evolve in the future? Problems in the U.S. mortgage market are far from over which Problems in the U.S. mortgage market are far from over which

implies more potential for realization of contingent liabilities in implies more potential for realization of contingent liabilities in financial institutionsfinancial institutions

Delinquencies and defaults expected to continue;Delinquencies and defaults expected to continue;

Write-downs in financial institutions expected to continue.Write-downs in financial institutions expected to continue.

Signs of cooling housing markets accross EuropeSigns of cooling housing markets accross Europe

United Kingdom, Ireland, Spain…United Kingdom, Ireland, Spain…

Could there be a mini subprime case in Europe?Could there be a mini subprime case in Europe?


How will the crisis evolve in the future?How will the crisis evolve in the future? Impact of the crisis on credit risk premiumsImpact of the crisis on credit risk premiums

Implications of the “flight to quality”: repricing of risk – significantlly Implications of the “flight to quality”: repricing of risk – significantlly higher required yields for riskier investments than until recently.higher required yields for riskier investments than until recently.

Danger of global growth slow down, if the crisis turns into a credit Danger of global growth slow down, if the crisis turns into a credit crunch and threatens smooth borrowing of nonfinancial enterprises.crunch and threatens smooth borrowing of nonfinancial enterprises.


Conclusion: systemic risks in international financial system Conclusion: systemic risks in international financial system have increasedhave increased


Sub-prime lendingSub-prime lending had spread from

inner-city areas right across the US by 2005. By then, one in five mortgages were sub-prime, and they were particularly popular among recent immigrants trying to buy a home for the first time, and the poor.

House prices were high, and it was difficult to become an owner-occupier. But these mortgages had a much higher rate of repossession than conventional mortgages (and thus much riskier) because they were adjustable rate mortgages (ARMs). Payments were fixed for two years, and then became higher and linked to Fed interest rates, which also rose substantially.


Subprime 2A wave of repossessions is sweeping

America as many of these mortgages reset to higher rates. By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust, acting for of bondholders, was the largest property owner in the city.

As many as two million families will be evicted from their homes as their cases make their way through the courts. The Bush administration is pushing the industry to renegotiate, but mortgage companies are being overwhelmed by a tidal wave of cases.


Scale and SpreadCollapse of the government backed mortgage

system in the USA (Fannie and Freddie) followed by meltdown of major investment banks (Lehman, Bear, Merrill) exposed to mortgage market

Mark-to-market asset pricing effects on balance sheets and cumulative liquidity retraction due to rising risk aversion;

Now affecting Insurance (AIG) ; and pensions funds next?


Financial Times, 20 Sept 2008 “…bank boards and bank executives have failed

to understand complex mortgage-backed banking products, as have central bankers, regulators and credit rating agencies.”

“…a reward system that has granted huge bonuses to those who peddled toxic mortgage-related products….”

“Almost as absurd has been the degree of leverage racked up by investment banks.”


Policy reactions“There are no atheists in foxholes and no

ideologues in financial crises,” Mr. Bernanke told colleagues…(NYT 21.09.08)

Freddie Mae and Freddie Mac (re)nationalised; Merrill sold to BankAmerica; Lehman to Barclays; Goldman and Morgan become banks again; US govt $700bn purchase of bad debt; G3 central banks support world banking.

Expansionary monetary policy (to avoid recession like 1930s) and scale of US Govt (and G3) bailouts will have large repercussions, yet to be evaluated [lessons of Mexico etc?]


Growth and tradeWorld GDP growth already projected by IMF

to slow down by 2 % points (from 5 to 3 for 2008 and 09); probably more. So with 2% world growth; global GDP per capita falls

Asia probably most resilient (though exports to US will fall); LA will slow down, Africa recession?

Commodity prices declining already; volumes too. Natural resource exporters will be hit; food and oil importers to benefit.


Investment and aidInternational investment (bonds, FDI) will

slow down; as will emerging market stocks; as global confidence declines

Sovereign spreads will rise due to rising risk premium (default probability x risk aversion): already up to 4%.

Aid flows already under pressure; will be hurt by fiscal overload in G3.


Recent ODA rise will be difficult to sustain


Poverty and human developmentMDG goals even less likely to be met (growth

and aid are main drivers)Limitations of family support (Asia), few

universal benefits (LA) and narrow safety nets (Africa): effect on poor

Previous crises increased inequality, which remains even when growth recovers

Commodity price reverse will change lottery of winners and losers


Proactive macroeconomic policyCountercyclical monetary policy and real

exchange rate management (inc. capital controls) necessary: MICs with forex reserves already do this;but LICs constrained by IMF.

Support domestic banks (esp for agriculture and SMEs), underwrite longterm investment lending; keep real interest rates low.

Raise tax pressure (not rates) to maintain fiscal balance and reduce public borrowing.


HD strategy for difficult timesEvidence (UNICEF) that for children

employment stability more important than wages; implications for e.g. inflation policy

Essential to ringfence budgets (in real terms) for education and health; extend schemes for (simple) universal benefits.

Focus on inequality (especially horizontal) rather than just poverty; to reduce conflict and increase social cohesion.


International action and the “duty to protect”

Essential to moderate G8 policy shifts (e.g. bank regulation, interest rates, exchange rates) from viewpoint of impact on world poor.

Need for UN to speak in a clear, timely and credible fashion on these issues (TDR08 good, UN/DESA etc silent)

Regional arrangements for mutual currency support etc are vital (Asia progressing; LA talking; Africa nothing). Role for sovereign wealth funds?


Main pointsThe US real estate market downturn, the associated

global financial crisis, and the surge in commodity prices has pushed the probability of a world economic recession to its highest level since 2001.

Neither Europe nor Japan is in a position to fill the gap left by weaker US demand. Moreover, commodity exporting and emerging market countries are likely to offset only part of the effects of the US slowdown. Hence, global growth is likely to fall to its lowest level since 2003.

Euroland is unlikely to de-couple from the US, as the ECB expects. Hence, the ECB in our view is “falling behind the curve”.


Housing prices adjusted for inflation(GDP weighted averages for Euroland)

Source: OECD, DB Global Markets Research74

-20-15-10-505

1015202530

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07

EurolandUS

% deviation from trend

Price-to-rent ratio Price-to-income ratio

75

Source: OECD, DB Global Markets Research

0.8

0.9

1

1.1

1.2

1.3

1.4

1996:1 1997:4 1999:3 2001:2 2003:1 2004:4 2006:3

USAeuro area

2000=1.0

0.8

0.9

1

1.1

1.2

1.3

1.4

1970:1 1975:1 1980:1 1985:1 1990:1 1995:1 2000:1 2005:1

USAeuro area

2000=1.0

Housing prices adjusted for inflation


-60

-40

-20

0

20

40

60

80

71 74 77 80 83 86 89 92 95 98 01 04 07

FranceItalySpainGermany

% deviation from trend



-10

-5

0

5

10

15

71 74 77 80 83 86 89 92 95 98 01 04 07

UShpEURhp

% yoy


R2 = 0.6523

0

10

20

30

40

50

60

-50 0 50 100 150

house prices (%)

consumption (% 98-06)

ES

IRE

F

I

FIN

NLD

Source: ECB, Haver, DB Global Markets Research

The cooling real estate market is likely to exert a drag on construction investment and consumption

60708090

100110120130140

1995 1997 1999 2001 2003 2005 2007

EurolandResidential housing permits, sa, 2000=100


…and credit…

Source: Bloomberg, DB Global Markets Research

Credit spreads relative to US Treasuries

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08

%

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5%

Agency AAAMuniHigh gradeAgency MBS

1535557595

115135155175

20/03/2007 20/07/2007 20/11/2007 20/03/2008150

200

250

300

350

400

450

500

550

600

650

investment gradehigh yield (rhs)

bpbp Credit default sw ap spreads in Europe


…leading to a tightening of lending standards…

Sources: Fed, ECB, GM Research

-40

-20

0

20

40

60

80

100

90 92 94 96 98 00 02 04 06

AllPrimeSub-prime

% FRB senior off icers survey: tightening of mortgage lending standards

-30-20-10

010203040506070

2003 2004 2005 2006 2007 2008

housing loansconsumer loansenterprises

%

tighter


…and in Euroland to an increase in bank lending rates

Consumer credit

Mortgages Small corporations

Large corporations

Feb 07 – Feb 08

+0.38bp +0.25bp +0.41 +0.77

Lending rates on new loans with 1-5 year fixed rates

Sources: ECB, GM Research


Hunt for collateral widens Euroland sovereign spreads…

010203040506070

J un-07

J ul-07

Aug-07

Sep-07

Oct-07

Nov-07

Dec-07

J an-08

Feb-08

Mar-08

Austria FranceGreece Spain Italy


bp



94

96

98

100

102

104

106

108

110

Jan-2007 Apr-2007 Jul-2007 Oct-2007 Jan-2008

Index

122

126

130

134

138

142

IndexBroad TWI: US (ls)

DB's Broad TWI: Euro area (rs)

…while policy divergence is creating exchange rate tensions


Table 1. A scorecard for countries' vulnerability to the financial crises Stocks* Score Housing* Score

Current account** Score

Household debt***

Score

Equity capital** Score

Total Score

Spain 146.7 7 76.3 8 -9.8 8 **** 8 96.9 4 35 UK 67.7 1 46.4 6 -2.9 6 30.6 7 151.4 8 28 France 97.6 4 67.4 7 -1.3 4 14.0 5 104.0 5 25 US 68.4 2 45.6 4 -5.6 7 25.9 6 115.2 6 25 Canada 110.2 5 46.1 5 1.9 3 5.4 3 128.6 7 23 Italy 84.0 3 37.1 3 -2.0 5 10.5 4 52.6 1 16 J apan 111.4 6 -17.2 1 4.7 2 -2.1 2 95.4 3 14 Germany 176.8 8 9.3 2 6.0 1 -7.2 1 65.4 2 14 India 293.3 2 -2.1 4 147.2 4 10 Brazil 394.7 4 0.8 3 120.5 2 9 Russia 340.9 3 5.9 2 88.6 1 6 China 187.4 1 11.7 1 127.9 3 5

* % change end 2002 to mid-2007 ** 2007 ***Change between 2002 and 2006 ****We did not find comparable household debt ratios for Spain, but available indicators pointed to an increase even greater than in the UK. Source: OECD, Haver, DB Global Markets Research


0

1

2

3

4

5

6

7

2000 2001 2002 2003 2004 2005 2006 2007-4.5-4.0-3.5-3.0-2.5-2.0-1.5-1.0-0.50.0

Profits (gross operating surplus) (lhs)

Non-financial corprate sector financialbalance (- means net borrower) (rhs)

% yoy % of GDP

Despite rising profits, firms need credit to fund their growth

Source: Haver, Bloomberg, DB Global Markets Research


Source: Eurostat, Haver, DB Global Markets Research

Investment has benefited from buoyant export growth

-4

-2

0

2

4

6

8

10

12

14

16

1999 2000 2001 2002 2003 2004 2005 2006 2007

Real exportsReal investmentReal op.surplus

% yoy


Source: Eurostat, Haver, DB Global Markets Research

-4-202468

10121416

96 97 98 99 00 01 02 03 04 05 06 07

-15

-10

-5

0

5

10

15

20

exportsreer (rhs)

% yoy % yoy

Export elasticities*Activity Exchange rate

US 1.9 -0.4Euroland 1.1 -0.5* Long-term values (mean lag US=1.9qu., Euroland=1.4qu.Source: DB Global Markets Research

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

98 99 00 01 02 03 04 05 06 07

s.t.coeff.+2 s.e.-2 s.e.

Recursive eur regressions suggest no major changes in coefficient


-1.5-1.0-0.50.00.51.01.52.02.53.0

2006 2007 2008 2009

ConstructionEquipmentTotal investment

Real, % qoq

Forecasts

Source: ECB, Haver, DB Global Markets Research


Great losers (trade balance worsening greater than by 1% of GDP)

Small losers (trade balance worsening less than by 1% of GDP) Small gainers (trade balance improving by less than by 1% of GDP) Big gainers (trade balance improving by greater than by 1% of GDP) No data

First-round impact on trade balance of the oil price surge since September 2007

Sources: IMF, DB Global Markets Research


Falling terms of trade hurting consumer

60

70

80

90

100

110

120

130

98 99 00 01 02 03 04 05 06 07 08

USEurolandJ apan

2000=100

Source: Haver, DB Global Markets Research


Retail sales plunge as surging food and energy prices tax consumers

Source: Haver, DB Global Markets Research

-0.50

0.51

1.52

2.53

3.5

98 99 00 01 02 03 04 05 06 07 08

-1

0

1

2

3

4

5

6

7

8

Retail salesFood & energy prices (rhs)

% yoy

smoothed

% yoy

00.5

11.5

22.5

33.5

44.5

98 99 00 01 02 03 04 05 06 07 08-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0Retail sales (smoothed)PCEconsumer confidence (rhs)

% yoy % yoy


Source: ECB, OECD, Haver, DB Global Markets Research

Headline inflation boosted by food and energy

Wage inflation remaining contained

92

1.8

2.0

2.2

2.4

2.6

2.8

3.0

1999 2001 2003 2005 2007 2009-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

contract wagesoutput gap (-1y) (rhs)

% yoy %

0.00.51.01.52.02.53.03.54.0

1998 2000 2002 2004 2006 2008

HICPcore

% yoyforecast

Source: DB Global Markets Research

93

2007 2008F 2009F 2007 2008F 2009FUS 2.2 1.2 1.3 2.9 3.7 2.5J apan 2.0 1.1 1.8 0.0 0.6 0.3Euroland 2.6 1.7 1.1 2.1 3.3 2.1

G7 2.2 1.3 1.5 2.2 2.9 2.0Asia(ex J apan) 9.4 7.5 7.5 4.3 6.3 4.1EMEA 6.7 6.0 6.2 10.5 9.7 7.4Latam 5.4 4.8 4.2 6.8 7.0 7.3

Global 4.7 3.6 3.7 3.6 4.5 3.4

GDP growth, % CPI inflation, %

Source: DB Global Markets Research

94

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

1980 1984 1988 1992 1996 2000 2004 2008

Global GDPIC ontr.(pp)EM contr. (pp)

% yoy f'cast

Hypotheses about the Origin of the Current Financial Turmoil

Highly expansive monetary policy in industrial countries.

The persistence of global macroeconomic imbalances.

Technological developments in financial markets, which led to the creation of complex instruments.

Insufficient transparency of non-bank entities’ operations and off-balance sheet bank operations.

Inadequate regulation for the current sophisticated financial and equity markets.


Hypotheses about the Origin of the Current Financial Turmoil

ALL the advanced hypotheses are part of the problem.

But there is one more:A not-yet learned lesson: capital markets

complement, not substitute the banking system.

All financial crisis are characterized by the presence of incentives for excessive risk taking.

The Crisis: Policies and Incentives

Excepting the period 2005-2006, monetary policy has remained expansive in industrial countries (with periods of negative real interest rates).

US Fed Funds Rate (%)

-4

-2

0

2

4

6

8

2000

2001

2002

2003

2004

2005

2006

2007

Q1

2007

Q2

2007

Q3

2007

Q4

May

-08

Nominal RealSource: IFS-IMF and FED.

Japan Overnight Call Rate (%)

-0.2

0

0.2

0.4

0.6

0.8

1

2000

2001

2002

2003

2004

2005

2006

2007

Q1

2007

Q2

2007

Q3

2007

Q4

May

-08

Nominal RealSource: IFS-IMF and Central Bank of Japan.

c

Euro Area Main Refinancing Rate (%)

-1

0

1

2

3

4

5

2001

2002

2003

2004

2005

2006

2007

Q1

2007

Q2

2007

Q3

2007

Q4

May

-08

Nominal RealSource: IFS-FMI andEuropean Central Bank.


The Crisis: Policies and Incentives

The main reasons that prevented a restrictive monetary policy in the US:

The vulnerability of the economic recovery after the 2001 recession, especially in the context of geopolitical risks.

Low inflation expectations.


The Crisis: Policies and IncentivesDespite the stock markets crash in 2001, monetary policy

stabilized real consumption growth in the period 2000-2006, through its effects on the consumers’ wealth. This was possible because of the large increase in housing prices associated with low interest rates.

Over the last decade, consumption has offset declines in investments. This responds to the consumers’ perception of greater wealth, through the value of stocks at first and then through the value of real state.

GDP, Consumption and Investment Growth (%)

-4

-2

0

2

4

6

8

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Consumption Investment GDPSource: Bureau of Economic Analysis


The Crisis: Policies and IncentivesThe large global liquidity (low interest rates) created

incentives for:The aggressive expansion of financial non-bank

intermediaries (mortgage lenders, hedge funds) with increasing demand for high-yield assets.

The use of financial products that “saved” capital for banks through “securitization”. (Under Basel I, mortgages held on banks’ balance sheets are subject to a 50% capital charge. There is no capital charge when mortgages are sold to a SIV.)

The use of housing equity to get individual funding (home equity loans). In contrast to the 2001 crisis, in 2008 the American consumer is highly indebted.


The Crisis: Policies and IncentivesThe Mortgage Loans Expansion in the Industrial

WorldBefore:

Traditional Relationship between Borrower and Creditor

Bank

Borrower

- Pays interest andprincipal

- Lends money- Manages delinquencies


The Crisis: Policies and IncentivesThe system, though complex, can work if risks are correctly assessed.

The problem is that under conditions of large liquidity, the quest for “returns” encourages excessive risk taking and exposes the system’s vulnerabilities:Market participants that work for fees (mortgage brokers,

payments receivers) don’t have incentives to monitor the quality of loans, only to increase the quantity of loans.

The same thing happens with the credit rating agencies which supply “ratings” for the structured products and do not face any financial responsibility to cover losses from their mistakes.

Regulatory Arbitrage: different financial institutions undertaking similar activities face different regulations (especially capital requirements).

Principal-Agent Problem: huge disparity in traders’ maximum loss (zero bonus) vs. investors’ losses (the full capital invested).


The Crisis: Policies and IncentivesBut the largest problem is that, if an adverse

shock to the system occurs (in this case, the generalized fall of housing prices), all the involved financial institutions lose capital.

Because banks provide liquidity to capital markets and hold structured products as assets, a complex system in crisis might collapse to the simple system: bank-borrower.

This trend is already happening:Banks have absorbed many SIVs into their books.Banks faced pressures from authorities to finance

insurers (monolines).Many mortgage brokers have declared bankruptcy.


Would Basel II Helped Prevent the Crisis?Most likely not!Under the “Standardized Approach” Basel II

emphasizes the reliance on external credit ratings. The current crisis has seriously questioned the credibility of these agencies for the adequate assessment of risks.

For large and sophisticated banks, Basel II relies on the banks’ internal risk models for assessing credit risk. During the current crisis, large banks were heavily affected using their own internal models!

Because of the large demand from investors for mortgage-backed structured products, a reduction in capital charges (from 50 to 35 percent in Basel II for mortgage held on banks’ balance sheets) would not have prevented excessive securitization.

Basel II does not properly take into account liquidity risk. Funding for SIVs collapsed when doubts about the quality of their assets emerged. Under huge liquidity constraints, many SIVs were forced to sell their assets at very low prices.


And Moving Forward?Under current circumstances, when the value of

the fundamentals is adjusting (the decrease in housing prices)…

Housing Prices (% annual change in S&P - Case Shiller Index)

-10

-5

0

5

10

15

20

2003 2004 2005 2006 2007Source: Thomson Datastream

CME Housing Prices Futures (contract mid price)

140

150

160

170

180

190

2008 2009 2010 2011 2012Source: Chicago Merchantile Exchange; Bloomberg


And Moving Forward?… The system’s equilibrium involves a lower

size of the banking system (according to the available capital)…

… And that’s already happening.

Market Capitalization ($bn)

0 50 100 150 200

HSBCSantander

UniCreditIntesa Sanpaolo

BNP ParibasBBVA

SberbankRBSUBS

Société GénéraleDeutsche Bank

Barclays

Mar 5 2008 Jan 1 2007Source: Thomson Datastream


And Moving Forward?With a lower lending capacity to corporations

(affecting investment) and with a poorer consumer (decrease in wealth), the chances of a prolonged US slowdown or recession are very high.University of Michigan Consumer Confidence Index

40

50

60

70

80

90

100

110

120

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Source: University of Michigan


Effects of the Current Financial Turmoil on Emerging Markets

Up to now, the effects of the financial turmoil in industrial countries on emerging markets have been:

Mild and mostly limited to financial variables

Different between regions and between countries

HAVE NOT BEEN AN OBSTACLE TO THE CONDUCT OF FISCAL AND MONETARY POLICY


Effects of the Current Financial Turmoil on Emerging MarketsA most important current feature of many emerging

markets is their ability to tighten monetary policy -increase interest rates- in the presence of inflationary pressures.

Source: Central Banks and IFS-IMF

Czech Republic

1%

2%

3%

4%5%

6%

7%

8%

J an-06 May-06 Oct-06 Mar-07 Aug-07 J an-08Inflation P olicy rate

Chile

1%2%3%4%5%6%7%8%9%


China

%1%2%3%4%5%6%7%8%9%


Colombia

3%

4%

5%

6%

7%

8%

9%

10%


South Africa

3%4%5%6%7%8%9%

10%11%12%


South Korea

1%

2%

3%

4%

5%

6%


Effects of the Current Financial Turmoil on Emerging Markets

This contrasts with monetary policy in industrialized countries where fears of a significant slowdown in economic growth are keeping interest rates low and decreasing…

… in spite of expectations of higher inflation.

Inflation

%

1%

2%

3%

4%

US Euro Area Japan

2007 2008FSource: Market Forecasts

Interest Rates Forecasts

%

1%

2%

3%

4%

5%

6%

2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4

US Fed Funds Rate ECB Refinance Rate Bank of Japan Call Rate

Source: Market Forecasts


What Factors might weaken the Performance of Emerging Markets?

Severe and protracted recession in the US / Banking crisis (a mild recession is already priced in).

High inflation leading to increases in industrial countries interest rates (more relevant in 2009).

The China factor and the sustainability of high commodity prices.


The External Risks affecting Emerging Markets1. US Recession / Banking Crisis

Without doubt the worst case scenario for global growth and emerging markets performance is a systemic banking crisis in the US.

This worst case scenario can only materialize if the US enters in a vicious circle where:severe decline in the value of banks’ assets loss of bank

capital credit crunch financing problems in corporations and

non-bank financial institutions recession increase in severity of

bad banks’ assets banking crisis prolonged recession

This is still a relatively low probability scenario, however, because the Fed and the Treasury are currently aligned to prevent its occurrence.



While a mild US recession would find emerging markets in good standing, a severe and prolonged recession would increase risk aversion, hurting investment inflows to emerging markets.

Foreign direct investment tend to decline sharply in the face of global slowdowns.

Global Foreign Direct Investment (as % of GDP)

-2%

0%

2%

4%

6%

8%

10%

12%

1990 1992 1994 1996 1998 2000 2002 2004 2006

Source: IFS - IMF.



Trade flows would also be affected, especially if the US financial troubles expand to other industrial countries, particularly Europe (some markets estimations calculate that UK residential properties are 30% overvalued).

Export growth has suffered the most in periods of global

slowdowns. Re-emerging calls for trade protectionism in the US exports

are also a potential threat for emerging markets exports.

Global Real GDP and Merchandise Export Volume (Annual % change)

-5

0

5

10

15

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Real GDP Merchandise Export VolumeSource: WEO - IMF.


The External Risks affecting Emerging Markets2. The Costs of Preventing a US Financial Meltdown:

Inflation Concerns about inflation are keeping long-term interest rates

high.

A medium-term risk (2009 onwards) is a sudden increase in interest rates in industrial countries to contain inflation.

This risk, which will affect emerging markets financing costs, has a low probability under current circumstances, when fears of a prolonged recession in the US is the main driver of monetary policy.

Fed Funds Target Rate and Corporate BAA Rated

1%

2%

3%

4%

5%

6%

7%

8%

Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08

Federal Funds Target Rate Corporate BAA RatedSource: FED


The External Risks affecting Emerging Markets3. A Decline in Commodity Prices? Although, as stated before, global exports are at risk in the

face of a US-led global slowdown, the sustainability of high commodity prices is less risky in the short and medium-term due to two factors:

A. Cyclical

There is an inverse correlation between the value of the dollar and the price of commodities.

This is because commodities (especially oil and gold and food, more recently) are perceived as a hedge against dollar weakness and the risk of inflation.

Nominal Dollar Broad Index (traded weighted) and CRB Commodities Index

80

90

100

110

120

130

140

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08150

200250

300

350

400450

500

550

Dollar Index CRB CommoditiesSource: FED and CRB.

The External Risks affecting Emerging Markets3. A Decline in Commodity Prices?

A. Cyclical

… and the dollar is expected to depreciate further, especially with respect to Asian currencies. Recent policy signals by the Chinese authorities to control inflation point towards further increases in interest rates in China and further appreciation of the RMB against the US dollar.

JPY per USD: Spots and Forwards

80

90

100

110

120

130

140

2002 2003 2004 2005 2006 2007 2008 2009 2010Source: JP Morgan

Forw ards

The External Risks affecting Emerging Markets

3. A Decline in Commodity Prices?B. Structural Factors China, a major importer of many commodities -

second importer of oil-, will continue a strong path of growth in the coming years.

Supply problems in the precious and industrial metals are a long-term issue, especially given South Africa’s power crisis (SA produces 69% of platinum, 30% of palladium and 18% of world’s supply of gold). Supply problems of aluminum are also large.

Land and water constraints supporting high prices for agricultural commodities.

The External Risks affecting Emerging Markets3. A Decline in Commodity Prices?

B. Structural Factors

And the markets are forecasting a continuation in the upward trend of major commodities prices.

Aluminum prices: Spots and Futures

1200

1400

1600

1800

2000

2200

2400

2600

2800

3000

2002 2003 2004 2005 2006 2007 2008 2009 2010U

SD p

er m

etric

ton

Source: IFS-IMF and LME

Futures

Gold prices: Spots and Futures

200

400

600

800

1000

1200

2002 2003 2004 2005 2006 2007 2008 2009 2010

USD

per

troy

oun

ce

Source: IFS-IMF and NYMEX

Futures


The External Risks affecting Emerging Markets

3. A Decline in Commodity Prices?Also oil prices will remain high, supported by: (a) China’s strong demand, (b) ageing infrastructure leading to unplanned outages and (c) climate change leading to extreme weather conditions.

Future prices anticipate a modest decline, but these prices have not been effective predictors of oil returns in the past.

Oil Prices: Spots and Futures

0

20

40

60

80

100

120

140

2002 2003 2004 2005 2006 2007 2008 2009 2010

USD

per

bar

rel

Spot Future Sep-04 Future Apr-05 Future Oct-07 Future May-08

Source: IFS-IMF and NYMEX

Sign of Economic Recovery

-4

-2

0

2

4

6

8

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04CY

(year on year, %)

121

Real GDP growth


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What not to doFed has effectively underwritten balance

sheet (not equity) of entire US banking system (large banks) without any material conditionality or pain for the banksMassive moral hazard (future reckless lending)Massive adverse selection (pricing of collateral

at range of new facilities for Primary Dealers).Fed uses risk-free rate cuts to target

illiquidity and help banks to recapitalise themselves


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What more is there to come?Further shake-out globally in banking system from subprime

& alt-A exposuresOther eruptions of previously underpriced default risk &

other riskOther secured credit to households (car loans and ABS

backed by pools of car loans)Unsecured credit to households (e.g. ABS secured by credit

card receivablesNon-sovereign risk in emerging markets, especially exposure

to EM private sector & SOEs where rule of law is weak (China, Russia, Kazakhstan)

Sovereign risk with the usual suspects Argentina Turkey Philippines Ecuador Venezuela South Africa


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What more is there to come?Non-sovereign default risk & market risk in

overheating EMs: Baltics, Bulgaria, Romania.Sectoral risks in advanced industrial

countries. Housing & commercial property: US, UK, Spain,

IrelandLiquidity risks for any complex structuresLongevity risks for pension funds

Interesting times indeed!Making difference & creating inspiration through life changing presentations @ [email protected]

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Abc Of Global Financial Crisis 2008

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