Global Fiancial Meltdown of 2007
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Transcript of Global Fiancial Meltdown of 2007
Financial Meltdownand its impact onFinancial Markets
Created by:
Ajay Kr Dhamija (N-1) Hanish Rajpal (N-67) Himanshu Goenka (N-22) Adil Zaidi (S-8) Snehal Soni (N-47) Geetanjali Aggarwal (S-20) Tripat Preet Singh (N-53) Radhika Gulati (S-40)
Terminology 2
Agenda
Terminology
Historical Linkage & Timeline of Current Crisis
Model of Mortgage Loan
Complexity of Financial Products & Model
Tea Break
Faults in the Model & Aftermath
Crisis Toll
How does it affect India
Learning and change of the model
Conclusion
Terminology 3
Terminology
Interest Rate Swap
Credit Default Swap
Securitization
Asset-backed security
Mortgage Backed Security
Collatarized Debt Obligation
Subprime Lending
Foreclosure
Credit rating agency (CRA)
Terminology 4
Interest Rate Swap
Swap
Bank
LIBOR + ½%
10 3/8 %
LIBOR – 1/8%LIBOR – ¼%
10 ½%
B saves ½ %
Bank
A
Company
BA saves ½ %
The swap bank makes ¼ %
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + .5% LIBOR .5%
QSD = 1.25%
10% Note that the total savings ½ + ½ + ¼ = 1.25 % = QSD
Terminology 5
Credit default Swap
Company A - BB
Insurance A - AA
Pension Fund 1
CRA (Moody’s)
$2B10%
Pension Fund 2
Hedge Fund 1
Insurance B - AA ->
B+
Company B – B+
100 BPInsurance on B for $10B
$1B
12%
200 BP200 BP = $200M
Insurance on B for $2B
Insurance on B for $1B
Terminology 6
Securitization
Securitization
-Structured Process
-The assets are combined into a pool, and then that pool is split into
shares.
-The shares are sold to investors who share the risk and reward of
the performance of those assets collectively
- Present Value of Future Cash Flows
- Categorization
Terminology 7
Motives for securitization
Advantages to issuer•Reduces funding costs
•Reduces asset-liability mismatch
•Lower capital requirements
•Locking in profits
•Enables Transfer of risks by one who does not want to take it
•Earnings
•Admissibility
•Liquidity
Terminology 8
Asset-backed security
An asset-backed security is a type of debt security that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets.
Backing assets-loans, lease, credit card debt, company receivables, royalty
Non Mortgage Assets
Prepayment Risk High
Terminology 9
Mortgage Backed Security
A Mortgage-Backed Security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loansPrepayment Risk LowGovernment Guarantees
Terminology 10
Collateralized Debt Obligation
Securitized Interest in a pool of assets- ABS
Constructed from Portfolio of fixed income assets.Types
• CLO• CBO
Non Mortgage loans or Bonds
Multiple Tranches of SecuritiesSenior (AAA)Mezzanine(AA to BB)Equity(Unrated)
Losses in reverse order of seniority of tranchesServicing Agent
Terminology 11
Collateralized Debt Obligation
Bank Investment Bank
SPV
Investors
Equity
Mezzanine
SeniorCDO
300 M (300K shares @ 16.5% = $55M)
Mortgagors
$1B
1000 * $100K = $100M
And $1B
MBS
$1000 K * 1M shares
$1B
300 M (300K shares @ 7% = $21M)
400 M (400K shares @ 6% = $24M)
$1B
$1B * 10% = $100M
Terminology 12
What is Subprime Lending?Near-prime, non-prime, or second chance lending
Providing credit to borrowers who do not meet prime underwriting
guidelines.
A sub-prime lender is one who lends to borrowers who do not
qualify for loans from mainstream lenders or prime financing terms-
Low Credit Scores
Subprime loans are not predatory loans
Terminology 13
Why Subprime Lending ?
Realization of a demand for loans to high-risk
borrowers with imperfect credit.
Fall in prime interest rates with real interest becoming
negative- allowing modest subprime rates to flourish.
Relaxation of usury laws - Confidence to foreclose
assets in case of default.
Credit Repair Option.
Terminology 14
How do we know a Sub-prime Borrower
Payment delinquencies
Reduced Repayment capacity as measured by credit scores
Poor debt-to-income ratios
Limited income or having poor credit scores
Relatively high heightened perceived risk of default
History of loan delinquency,
Recorded bankruptcy,
Limited debt experience.
Charge-offs, Set offs, judgments.
Terminology 15
Credit profile keeping a borrower out of a prime loan may include the following
Two or more loan payments paid past 30 days due in the last
12 months, or
one or more loan payments paid past 90 days due the last 36
months;
Judgments, foreclosure, repossession, or non-payment of a
loan in the past;
Bankruptcy in the last 5 years;
Hi default probability as evidenced by the credit score.
Accuracy of the credit line data obtained by the underwriter.
Terminology 16
Foreclosure
Foreclosure is the legal and professional proceeding in which a mortgagee, or other lienholder, usually a lender, obtains a court ordered termination of a mortgagor's equitable right of redemption.
Types of foreclosure
1. Judicial Foreclosure – Court Proceedings
2. Power of Sale- Where Sale Clause provided or a trust deed
used
Terminology 17
Credit Rating Agency (CRA)
Is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments
The Basel II guidelinesObjectivityIndependenceTransparency
Terminology 18
Agencies that assign credit ratings for corporations include:
A. M. Best (U.S.)
Baycorp Advantage (Australia)
Dominion Bond Rating Service (Canada)
Fitch Ratings (U.S.)
Japan Credit Rating Agency (Japan)
Malaysian Rating Corporation (Malaysia)
Moody's (U.S.)
Standard & Poor's (U.S.)
Pacific Credit Rating (Peru)
Rating Agency Malaysia (Malaysia)
Egan-Jones Ratings Company (U.S.)
Capital Intelligence Ltd (Cyprus)
CRISIL (India)
Terminology 19
Historical Linkages --Manias, Panics and Crashes
Terminology 20
Rise of Securitized Mortgage Lending
Period Home Loan Securitized
Before 1970’s <1%
1980’s ~10%
Late 2000’s – Sub Prime Crisis 56%+
Mortgage Lending 1930s-80s: Funds derived primarily from deposits of the lending institution
1980-2007: Funds derived increasingly from credit markets through securitization process
Terminology 21
Mechanism of A Meltdown
There is a change in legislation/policy/practice - a loophole is discovered
“Financial Asset” is innovated/ created around the loophole
Mass “staged dealing” takes place, valuations are artificially blown up
Sudden fall in fundamental asset
Bull run turning into sudden “Meltdown” and panic impacting economy for
long period
Lets take last 20 years and see if there is a trend:
Financial Meltdown Financial Assets which were overvalued
Late 1980’s – Saving & Loan Crisis Junk Bond
Later 1990’s – Tech Bubble Internet Stock
Late 2000’s – Sub Prime Crisis Sub-Prime Mortgages
Terminology 22
Late 80’s – Saving and Loan Crisis
In 1980 – US Congress allowed Thrift – (Saving and Loan) Associations to lend consumer loans/commercial loans, issue credit cards, - These were high risk and below investment grade loan
Further in 1981 –S&L Associations were allowed to sell their risky loans and use cash generated to seek better returns – to invest in even riskier loans .
Major Wall Street Firms started buying and these bonds at 60-90%, bundling and trading in them as Government Backed Bonds
“Staged dealing” – back and forth trading amongst close group to establish “value” and sell it to outsiders (banks)
As the initial assets (loans) started defaulting – bonds became worthless
Eventually Bond failed and created a trillion $ crisis for US taxpayers
Terminology 23
Late 90’s – Tech Bubble
Internet Stocks (A stock gets its value from underlying sales, growth and
overall prospects of future)
Company needs to prove themselves by being in existence for several
years before they could be traded on stock exchanges – this standard was
thrown away - That was the Loophole
To pump up the value – companies engaged in “ staged dealings” – (back
and forth sales/billing of ads on mutual sites to create false Revenues)
These sales numbers were used to fraudulently value the companies and a
lot of money was raised on totally worthless companies.
Eventually these companies failed and created another trillion $ crisis
Terminology 24
Late 2000’s – Sub-Prime Crisis
In current case – instrument - Sub Prime Mortgages.
Previously Sub-Prime Mortgages had very little trading value. Only specialist use to deal in them.
Mortgage Industry changed Lending standards and Wall Street innovated -“If we take LOTS of these mortgages and assemble them into large pools and then slice and dice the pools in various ways, we can sell the slices to banks and other investors as AAA paper”
To pump up the value – Banks sold them (at a fee) to each other and due to “ staged dealings” – declared them valuable.
Eventually Housing Industry came under pressure and everyone on the top starting falling
Terminology 25
Historical Linkages
Financial Meltdown
Terminology 26
Crisis and Financial Meltdown
Crisis is a result of change in legislative, its fraudulent use to
create false value, a bull run and then…
A Sudden Market Crash
Full scale financial system break down – bankruptcies
Economic Meltdown - fall in Industrial output, rise in unemployment,,
household net-worth drops,
Terminology 27
Time Line - Past Few Years
Low interest rate regime and availability credit/ securitization
resulting into increased liquidity since 2003
Lending to Sub Prime customers on increased
Home Prices rise till 2005 and busting of housing bubble in 2005
Rise in Interest rate in 2006 – refinancing became difficult
Defaults and foreclosure on rise through 2007-08
Average debt of American
American way of Debt
Terminology 28
Time Line . . . . .
Initial Impact: Mortgage LendersCountry wide
Bears Stears
Indy Mac
Fannie Mac & Mae
Secondary Impact : Investment Banks followed by Commercial BanksLehman Brothers
Merrill Lynch
and it spreads to rest of world
Terminology 29
Timeline of current crisis
January 11,2008 : Bank of America buys mortgage lender Countrywide Financial for $4 billion in an all-stock deal.
March 16,2008 : JP Morgan Chase buys brokerage firm Bear Stearns for $2/share in a deal backed by the Fed and Treasury Department. The price islater revised to $10/share.
July 11,2008 : IndyMac is seized by the FDIC after depositors withdraw $1.3 billion over an 11-day period. This brought to 12 the number of banks seized by FDIC in 2008.
Source: www.investmentbankeronlife.com
Terminology 30
Timeline of current crisis
July 13,2008 : Government-sponsored mortgage finance companies Fannie Mae and Freddie Mac are nationalized by the federal government in an effort to support the U.S. housing market.
Sep 7,2008 : The federal government takes control of financial giants Fannie Mae and Freddie Mac, which were nationalized in July. The two hold or guarantee about half the nation's $10 billion in mortgage loans.
Sep 15,2008 : Investment bank Lehman Brothers files for Chapter 11 bankruptcy protection.
Rival Merrill Lynch agrees to be takenover by Bank of America.
The Dow Jones fell 504 points, the index’s worst since the 2001 terrorist attacks. Top 10 Bankruptcies
Source: www.investmentbankeronlife.com
Terminology 31
Timeline of current crisis
Sep 16,2008 : Insurer American International Group (AIG) is rescued by the federal government through an $85 billion loan package in return for an 80% stake in the company. The move comes amid a cash crunch, triggered by $18 billion of losses over three quarters, a sinking stock price and debt downgrades.
Sep 19,2008 : U.S. Treasury Secretary Henry Paulson calls for the government to spend hundreds of billions of dollars to take toxic mortgage assets off the books of financial companies to restore financial stability . News of the bailout plan helps world stock markets soar.
Sep 20,2008 : Treasury Secretary Henry Paulson outlines details of a $700 billion bailout plan for firms troubled by bad mortgage debt.
A U.S. bankruptcy judge approves a revised version of Barclays purchase of the core U.S. business of Lehman.
Source: www.investmentbankeronlife.com
Terminology 32
Timeline of current crisis
Sep 21,2008 : Goldman Sachs Group Inc. and Morgan Stanley become bank holding companies regulated by the Fed, essentially ending Wall Street's investment banking model.
Sep 23,2008 : Warren Buffett’s Berkshire Hathaway invests $5 billion in Goldman Sachs, citing the rescue plan as a contributing factor.
Sep 25,2008 : Washington Mutual is seized by the FDIC, making it the largest U.S. bank failure, with $307 billion in assets.
JPMorgan Chase buys WaMu’s banking assets for $1.9 billion.
Source: www.investmentbankeronlife.com
Terminology 33
Timeline of current crisis
Sep 29,2008 : U.S. House of Representatives rejects the $700 billion rescue plan in a stunning 228-205 vote. The Dow Jones falls by a record 777 points.
Wachovia agrees to sell most of its assets to Citigroup in a
deal brokered by regulators.
Oct 1,2008 : U.S. Senate passes a modified U.S. financial rescue plan aimed at restoring global financial stability, sending the measure to the U.S. House of Representatives for a vote on Friday.
Oct 3,2008 : President Bush signs the historic $700 billion rescue bill approved just hours earlier by the U.S. House of Representatives in a 263-171 vote.
Wells Fargo agrees to buy Wachovia for $15.4 billion or $7 a share, better than Citigroup’s earlier offer of about $1 a share.
Source: www.investmentbankeronlife.com
Terminology 34
Model of Mortgage Loan
Mortgage Broker
Sub-prime Mortgage
Secondary Mortgage Market
CRA Certification
Investors – OTC Market
Home Mortgage Evolution
Repackaging into MBS, CDO
Private Sub-prime Mortgage Process
Source: The Economist: Making Sense of Modern Economy
Terminology 35
Mortgage Broker
Mainly found in developed economies like US, Western Europe
Professionals who are paid a fee to bring together lenders and borrowers
Sells mortgage loans on behalf of businesses (ex. Banks)
Source: Wikipedia
Terminology 36
Sub-prime mortgage – What’s that?
Home loans made to borrowers with poor credit ratings — a group
generally defined by FICO scores below 620 on a scale that ranges
from 300 to 850
FICO - a number that is based on a statistical analysis of a person's
credit report, and is used to represent the creditworthiness of that
person. (FICO is the acronym for Fair Isaac Corporation, a publicly-traded corporation (under the symbol
"FIC") that created the best-known and most widely used credit score model in the US.)
Creditworthiness—the likelihood that the person will pay his or her
debts. Calculated by credit reporting agencies.
Ex. Equifax, Experian, and TransUnion in US
Source: Wikipedia
Terminology 37
Secondary Mortgage markets
The secondary mortgage market allows banks to sell mortgages,
giving them new funds to offer more mortgages to new borrowers.
If banks had to keep these mortgages the full 15 or 30 years, they
would soon use up all their funds, and potential homebuyers would
have a more difficult time to find mortgage lenders.
Many of the mortgages on the secondary market are bought by
Fannie Mae.
Other are packaged into mortgage-backed securities, and sold to
investors.
Source:http://www.urbandigs.com/2007/08/how_mortgage_backed_securities.html
Terminology 38
Credit Rating Agency (CRA)
Company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves
A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued
Ex: Moody's (U.S.), Standard & Poor's (U.S.)
Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments.
For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk.
Source: Wikipedia
Terminology 39
OTC market
A decentralized market of securities not listed on an exchange where
market participants trade over the telephone, facsimile or electronic
network instead of a physical trading floor. There is no central exchange
or meeting place for this market.
In the OTC market, trading occurs via a network of middlemen, called
dealers, who carry inventories of securities to facilitate the buy and sell
orders of investors
Trading is private and prices and
volumes are not disclosed
Price discovery non transparent
Source : http://www.investopedia.com/terms/o/over-the-countermarket.asp
Terminology 40
Evolution of home mortgage Home loan funding
1930sPrincipal + interest payable over long term
Borrower-IndividualsLender-Banks• Owning a house was not affordable to many
• Great Depression brought industry to a halt. Large scale defaulters and lenders could not recover by reselling
• To simulate the industry again Government as part of New Deal policy created the Federal National Mortgage Association (Fannie Mae) in 1938. This created a secondary market for mortgages
Lender-Banks Borrower-Individuals
Home loan funding
Principal + interest payable over long term
Bought loan
Cash
Transfer of credit risk, market risk
Had Access to long term borrowing
Bought only those which conformed to certain underwriting standard ( called Prime
Mortgages)
Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,Subprime Mortgage Market Turmoil, Christopher L. Peterson, Asst Prof of Law, Univ of Florida
Terminology 41
Evolution continued…
Fannie Mae proved very successful . But by 1960s , borrowing done by it constituted a significant share of the debt owed by US government.
1968- Government National Mortgage Association (Ginnie Mae) was created to handle government guaranteed mortgages.
Fannie Mae became federally chartered, privately held
1970- Ginnie Mae developed MBS -- shifted the market risk to investors --eliminated debt incurred to fund government housing program
1970-Federal National Mortgage Corporation (Freddie Mac) created To securitize conventional mortgages
Provide competition to Fannie Mae
Over time Fannie Mae and Freddie Mac together provided enormous amount of funding for US mortgage
Since Fannie Mae and Freddie Mac guaranteed loans, much of credit risk stayed with them. Size and diversification allowed them to handle it.
Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,
Terminology 42
New Model of mortgage lending
Lender-Banks
Home loan fundingBought loan
Cash
Transfer of credit & market risk
MBS
Ca
Principal + interest payable over long term
Advantages
• More liquidity in market
• Risk spread out
• Long term funding for mortgage lending
• MBS- allows originators to earn fee income from underwriting activities without exposure to credit, market or liquidity risks as they see the loans they make
SPV
Secu
ritiz
atio
n fe
es
sh
Transfer of market risk
Terminology 43
Private Players joined
1977- Private label securitization started first done by BOA and Salomon Brothers
1980s- pricing, liquidity and tax hurdles were resolved in same
Unlike 2-3 party , private label securitization has 10 or more different parties playing independent role
Big private players in this field wereWells Frago
Lehman Brothers
Bear Stearns
JP Morgan
Goldman Sachs
Bank Of America
• Indymac
• Washington Mutual
• Countrywide
Terminology 44
Repackaging into MBS / CDOMBS
MBS CDO
• Created in 1987 by now defunct investment firm Drexel Burnham Lambert
• Not traded on exchange but OTC market
Terminology 45
Details : Private Sub-prime mortgage process
1. Brokers identify borrowers
2. Originator and broker identify a loan for borrower after looking at his credit rating
3. Formal application for loan by borrower
4. Originator transfers the loan to the subsidiary of an investment banking firm ( Seller)5. Seller(Investment bank) collects a pool of loans and call it as SPE/SIV/SPV. Off balance sheet instrument6. SPV can be a corporation, partnership or limited liability company. Most often a Trust. It has nothing else except mortgage loans7. Underwriter purchases all the securities (derivative income streams) 8. In designing SPV and its tranches underwriter works with credit rating agencies
9. Underwriter then sells the securities to the investors10. High rated tranches might be guaranteedby a 3rd party insurance company11. Seller also arranges to sell the rights to service the loan pool to a company or sometimes Originator takes these rights
12. MERS – document custodian. Company to keep track of mountains of paper work on loans in the pool. At National level. Source : Subprime Mortgage Market Turmoil , testimony by Christopher L. Peterson
Terminology 46
Complexity of Financial Products & Models
Mark to Market / Model
Blame the models
The fragility of models
Four Major Implications
VaR
Market risk model
CRA’s: SIV & Sub-prime
Unrealistic demands
Use models but…
Terminology 47
Mark to Market / Model
Last year, Banta bought an apartment in Gurgaon. He spent Rs 1 Cr. His Real Estate agent says it’s worth Rs 60 Lac today.
Banks are not lending, so no one is offering to buy Banta’s apartment. A drunk guy , Santa, met at the bar said he would pay Banta Rs. 5 Lac
Rs 60 Lac is the Mark to Model.
Rs 5 Lac is the Mark to Market.
How much is Banta’s apartment worth?
If he used it as collateral for a loan, how much would you lend him?
A mark to model is less reliable
Assumptions
May assign a liquidity which is not present.
complex financial instruments
no ready market => mark to model
Source :http://innovationcreators.com/wp/?p=464
Terminology 48
Blame the models
Quality of Statistical Risk Models was much lower
Ignored Black Swans ( the highly improbable and unpredictable events that
have massive impact. ) - Fractals Theory & Chaos Theoryno one managed to prove that the use of a model that does not work is neutral,
volatility as an indicator of stability has fooled the banking system.
Identification of fourth quadrant (danger zone) is important
Ignored liquidity
Ignored increase in correlation during downturn
Ignored leverage ratios
Ignored the fact that events are correlated and risks are auto correlated.
Trading in OTCEI further made value & risk assessment difficult
No standard contracts
No information on holdings and pairings
Sources: Blame the Models by Jon Daniielson , London School of Economics
Ian Stewart, Does God Play Dice? The Mathematics of Chaos
Terminology 49
The fragility of Models
Finance is not physics; it is more complex. Endogenous risk:
Statistical properties change under observation since market participants react to
information
We can only model aggregate behavior.
Financial modeling changes the statistical laws in real-time,
we can ignore endogenous risk in calm. In a crisis, we cannot. And that is when
the models fail.
Quality of assumptions
Modelers tend to ignore what is difficult, not what is important.
liquidity had generally been ignored in model design
Data quality
Financial data have the annoying habit of being of short duration.
The statistical properties of financial data change over time
Source: Blame the Models by Jon Daniielson , London School of Economics
Terminology 50
Four Main Implications
1. SF Pool Losses Don’t Recover2. SF Pool Losses are Skewed3. SF Pool Losses are Moving Target4. SF Pool Loss Distribution Narrows Over Time
Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.
Terminology 51
VaR (Value at Risk)
What is my worst case scenario (compare volatility)
Three components: a time period, a confidence level (relatively high) and a loss amount (or loss percentage).
What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month?
3 MethodsHistorical Method – actual historical distribution
Variance-covariance Method – assumes normal distribution
VaR = Value * Z * σdaily * (horizon Period)1/2
1% VaR of $400m with σdaily = .75% for 10 day period
= $400m * .0075 * 2.326 * 10 = $22.07m
Basel (rule based) : 8% of $400m = $32m
Monte Carlo Simulation – any method of randomly generated trials
Source :http://www.investopedia.com/articles/04/092904.asp
Terminology 52
Market Risk Model
Daily 99% VaR estimates for a $1000 portfolio of IBM for May 1, 2008Sample size 1 year 4 years 10 years
Estimation method
Historical simulation $22.8 $17.7 $29.9
Moving window $24.7 $18.8 $32.6
Exponentially moving average $21.3 $21.3 $21.3
Normal GARCH $25.5 $23.4 $24.0
Fat tail GARCH $27.6 $20.6 $22.9
Source: Blame the Models by Jon Daniielson , London School of Economics
No easy way to pick the best method.
The model risk increases as we increase the number of assets.
Aggregation Method & its associated assumptions ?
Assets traded on different exchanges, time zones and opening hours,dates of holidays
, asset categories
Terminology 53
CRA’s : SIV & Sub-prime
Modeling process is much more complicated and harder to verify,which increases the risk of mistakes.
Aggregation problem
the short data sets mean that we can not obtain the default probabilities => need to model default probabilities.
The rating agencies like Moody’suse historical credit data and ignore the actual loan applications
Underestimated the importance of the business cycle and the presence of a speculative bubble in housing markets.
default correlations and low rates of defaults of mortgages initially
mortgage defaults become highly correlated in downturns
Data samples used to rate SIV’s often were not long enough to include a recession
Didn’t include key data fields like debt-to-income,appraisal type,originating lender & rate,resets
Source: Blame the Models by Jon Daniielson , London School of Economics
Moody’s Fiasco
Terminology 54
Unrealistic demands
A high quality modeling process is harmonization between probability levels, sample sizes, and testing.
Can’t use same models in all situations (95%,99%)
Models which can’t be backtested , 99.9% model (risk of loss in every 1000 years), fat tail VaR model
Exceptions are copulas etc. which are still at experimental level
Dependence on Basel II Accord (based on regulation by models) could be problematic since model risk could go out of sync
Source: Blame the Models by Jon Daniielson , London School of Economics
Terminology 55
Use models but …
The financial institutions that are surviving this crisis best are those with
the best management, not those who relied on models to do the
management’s job.
The solution to a problem like the sub-prime crisis is not Basel II but to
understand the products ,interaction with institutions and risks involved
Taleb’s Thumb rulesLearn to love redundancy
Beware presentations of risk numbers
Absence of Volatility is not absence of risk ……
Source: Blame the Models by Jon Daniielson , London School of Economics
Terminology 56
Faults in the model and aftermath…
Financial Turbulence
Sources of Market Failure
Regulatory Shortcomings
Reasons for forming of sub-
prime mess
Big Assumptions and
misaligned incentives
Terminology 57
Financial Turbulence
Crisis precipitated by failure of America’s financial
sector toManage Risk
Allocate Capital
Financial sector made Bad Loans & engaged in multi
billion dollar gamble through derivatives & Credit
default Swaps.
Source: The Economist: Making Sense of Modern Economy
Terminology 58
Sources of Market Failure
Poor Credit appraisal standards – Loans for NINJAS
New dimension to bank liquidity
Faulty Risk Management Tools & Models
Role of Credit Rating Agencies – Understatement of Risk
Weak Public disclosures of Risk & Exposures
Source: The Economist: Making Sense of Modern Economy
Terminology 59
Regulatory Shortcomings
Lax regulations which did not keep pace with the
innovations happening in financial engineering
Limited regulation on investment Banking
Failure of regulators – overestimation of strength &
resilience of financial system
Source: The Economist: Making Sense of Modern Economy
Terminology 60
Leading to . . .
Inadequate capital
growth of unregulated exposures
excessive risk-taking
weak liquidity risk management.
For eg : Hedge funds leverage ratio of the order of 500%
Shortcomings associated with the valuation and financial
reporting of structured products
CDOs and credit derivatives trade on OTCEI
Source: The Economist: Making Sense of Modern Economy
Terminology 61
Reasons for forming of Sub-prime mess
Giant pool of money available for investment through
savings of Oil exporters , economic development in BRIC
countries.
US kept interest rates too low for too long in post dotcom
bust period
Building up of the housing bubble
Terminology 62
Reasons for forming of Sub-prime mess
Private share in mortgage market growth in large part
through origination and securitization of high risk sub-prime
and Alt-A mortgages.
To sum up in 3 words as noted by Harvard dean:
Leverage(high), Transparency (low) and Liquidity
(abundant)
Terminology 63
Big assumptions & Misaligned incentives
Banks kept on lowering lending standards, since they assumed they could sell the risk on.
A widespread assumption that the process of “slicing and dicing” debt had made the financial system more stable.
Investors barely understood these complex products and believed the credit rating agencies.
Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Terminology 64
Big assumptions Cont..
“Churning” of capital “allows even an institution without a
great amount of fixed capital to make a huge amount of
loans, lending in a year much more money than it has
Securitization conduit divides various lending tasks into Multiple corporate entities—a broker, an originator, a
servicer, a document custodian, etc.
Prevents the accumulation of a large enough pool of at risk
assets.
Source :http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Terminology 65
Good days don’t last forever.
Financial innovations like ARM (adjustable rate mortgage) mechanism led to
complacency. By mid 2006, time to pay bigger amounts comes :--
Household income did not increase in same proportion as house prices
Subprime mortgage owners start defaulting
Rating agencies revise ratings of MBS/CDO as expected number of
defaults turn out higher. Many ratings are lowered
Bewildered investors lost faith in ratings, many stop buying MBS/CDO
altogether.
Terminology 66
Crisis at the door (mid 2006 onwards):
Banks find themselves in non-comfortable position , stop making loans
Housing prices plummet owing to increase in foreclosure, delinquency
and stoppage of loans – prices fall exponentially in vicious cycle
Perfectly good borrowers – Prime/A category – see the value of their
houses also fall. This feeling of loss of wealth makes them spend less,
putting the economy in to a further downturn due to lack of demand.
=> SUBPRIME CRISIS
Terminology 67
Oh ! what a mess….
More frenzy -> more defaults -> again revised ratings -> further
stoppage of funding & loans -> further fall in house prices as demand
and supply mismatch....problem feeding itself in circular fashion. =>
SUBPRIME CRISIS
Most of the player in the market, mortgage brokers, investment banks
were running in debts caught unaware and are in insolvency and start
tumbling down
Central government start pumping in money as last resort but one
thing is surely not returning soon and which is very vital in financial
industry -FAITH.
Terminology 68
CDS
CDS were used to profit from speculation.
The volume of CDS outstanding increased 100-fold from 1998 to
2008.CDS market stated to be $62 trillion.
Market is completely lacking in transparency and unregulated.
Reasons for expansion of CDS market
- Limited capital requirement for CDS
- No need for funds to take risk through CDS
Thus Hedge funds were active participants in CDS
Terminology 69
CDS
Defaults increased the likelihood of “protection sellers” having to pay
counter parties.Thus Insurance Companies ratings downgraded.
“Counter party risk.” loomed large -party providing the insurance
protection does not have the money to pay the insured buyer when
default occurred.
CDS transactions also one of the reasons for the crisis spreading to
the insurance sector, the main victim being AIG.
Terminology 70
In Short
When homeowners default, the
amount of cash flowing into
MBS declines and becomes
uncertain.
Investors and businesses
holding MBS have been
significantly affected.
The effect is magnified by the
high debt levels maintained by
individuals and corporations, ie
financial leverage.
Source :http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm ,
Terminology 71
Crisis Toll
“The Most serious financial crisis since the Great Depression of the
1930”
““Real estate prices collapsed, creditReal estate prices collapsed, creditdried up, house building stopped ...dried up, house building stopped ...
Terminology 72
The Genesis .. . US Mortgage Market
Home Prices were expected to rise forever . . . . .
Home ownership rate reaches an all time high of 65 %
Home mortgage debts as % of PDI rises to 75 %
Overall Household leverage rises over 100%
Weak link in chain : Subprime borrower
Default starts in subprime market
Sales fallExisting home sales nationwide fell 29%
Terminology 73… NOT any more!… NOT any more!
“Any real-estate investmentis a good investment … ”
But Home Prices starts to fall..
Forty-six States Had Falling Prices in the Fourth Quarter 2007
Terminology 74
The Mess . . . .
Surge in Mortgage Loan Fraud leading to record Dollar losses
Leading financial Institution & Investment Bank going bankrupt
All Leading too …
Bear Stearns goes belly up … American International Group (AIG) 85B. bailout
Record delinquencyForeclosure rises
Rising Inventory on books
IndyMac is seized by the FDIC
Terminology 75
Spillover to the Rest of the World
ECB Primary Reaction Function
Federal Reserve Primary Reaction Function
Appreciation of
EuroDecline in Euro-Area Economic
Activity
Deterioration in U.S.
Financial Conditions
Deterioration in Euro-Area
Financial Conditions
Decline in U.S.
Economic Activity
Increase in U.S. Headline
Inflation
Increase in Euro-Area Headline Inflation
Financial Shock
Food and Energy Price
Shock
Federal Reserve
Cuts Its Policy
RateECB
Raises Its Policy
Rate
1
2
3
4
5
FIRE
ICE
Terminology 76
Financial Crises:- A Comparison …
Banking Losses in Constant US$ Terms (and as a Percentage of GDP)
0
200
400
600
800
1000
1200
1400
1600
U.S. S&L Crisis (1986-95)
Japan Banking Crisis(1990-99)
Asia Banking Crisis(1998-99)
US Subprime Crisis(2007-08)
Banking Losses Other Financial Losses
In 2007 U.S. Dollar Terms (US$ bn.)
2.5% of GDP
15% of GDP
10% of GDP
35% of GDP
Losses of over 1.4 trillion USDSource: IMF Global Financial Stability Report, October 2008, Chapter 1, p. 16.
Terminology 77
Impact on US Credit Market
Market for Liquidity FreezesSupply of credit decreased dramatically
Lenders refusing to lend to other banks
Lenders buy only government bonds – the “flight to quality”
Firms, individuals holding money as cash, not loans – the “liquidity trap”
Lenders are afraid of all loan types – subprime bonds, then student loans, then home equity loans, then commercial paper (business, consumer loans), etc.
Terminology 78
Impact on US Credit Market Cont..
Widening Spreads over 10 years treasury bonds:Municipal Bonds rises to a historic high of over 100 basis pts.
Mortgage-Backed & High-yield Bonds rises to a historic high of over 1000 basis pts.
Corporate Yield Spreads rises to over 500 basis pts.
Money Market Spreads Blow up to over 360 basis points ( US LIBOR / OIS) against a normal of 20 basis pts.
Terminology 79
Impact on Markets …
U.S. Equity Market Falls Back to 2003 Levels
Unprecedented rise in Equity market volatility
Financial Stocks Take Big Hits in Subprime Crisis
Financial Conditions Index falls to historic low
Major losses for banks worldwide
Commodity Prices : CRB Index Falls to 2003 Levels
Terminology 80
Impact on Foreign Exchange Market
Till end-July 2008, USD depreciated against major currencies on account of :
Weaker equity markets
Slowing manufacturing productivity growth
Higher unemployment with downward non- farm payroll employment, &
Low housing sales
Lowering consumer confidence
Terminology 81
Deleveraging Starts…..
From early-August 2008, USD’s strength reflected
Liquidation of positions in the overseas equity and bond markets by US investors
Repatriation of the money back to US due to slowing growth in the Euro area
Appreciation (+) / Depreciation (-) of USD vis-à-vis other currencies
Terminology 82
Financial restructuring starts …
Wachovia, the 6th largest bank, taken over by Wells Fargo Bank
Top Investment Bank : Lehman Brothers, Bears Stearns & Merrill
Lynch cease to exist
Goldman Sachs & Morgan Stanley were converted into Bank
Holding Companies
15 Banks declared bankruptcy:- Washington Mutual filed for biggest
ever bankruptcy.
Majors write down were made by Financial Institutions
Terminology 83
Recapitalization of financial system
Economic Stabilization Act was passed on Oct 3,2008
Troubled Assets Relief program, to purchase troubled assets of
USD 700 Billion was passed.
Limit on Deposit insurance was increased from USD 100000 to USD
250,000 per account
Eligible collaterals and the eligible counterparties were expanded
Foreign Exchange Swaps were created with major central banks for
infusing Dollar liquidity ( Made unlimited on October 13 , 2008 )
Terminology 84
Impact on World Markets: Equities
Financial stress sweeps through global markets….
Source: Bloomberg
• MSCI Emerging Market Index is down by over 66 % from their peak
• MSCI US and Euro Index are down by over 50 % from their peak
Terminology 85
Impact on World Markets : Government Bonds
Government bond yields
declines in major advanced economies
•Worsening Growth Expectation
• Falling Inflation Outlook
Terminology 86
Impact on World Markets : Short Term Int. Rate
Short Term Interest showed a mixed trend in major advanced economies reflecting
• Local Liquidity conditions
• Policy Rates
3- Months money market rates
Terminology 87
Macroeconomic risks continue to rise..
Continuous fall in Global Economic Activity
Considerable deteriotion from April 2008 situation
•Credit deterioration broadens
• Market & Liquidity Risk
•Fall in Risk Appetite
•Tighter Monetary & Financial conditions
Terminology 88
Risk of Systemic Default on the rise ..
Terminology 89
Impact of Financial Crisis on Europe . . .
0
50
100
150
200
250
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WORLD GermanyFrance Italy
Payment incident index (*) 12 months moving rate
Scale of sector risk in Western Europe
* Payment incident index 100: World 1995-2000 basis
Terminology 90
United Kingdom Spain
United Kingdom, Spain, Ireland on negative watchPayment incident index (*)
12 months moving rate
3,2% 3,2% 3,0%
3,9%
2,3% 2,1%2,7%
3,3%
1,9%
2,8%3,1%
1,9%
0%
1%
2%
3%
4%
5%
6%
7%
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
(f)
2008
(f)
0
50
100
150
200
250
300
Economic growth Payment incident index
3,9%4,5% 4,7%
4,4%
2,8% 2,7%3,0% 3,2%
3,5%3,9% 3,8%
2,3%
0%
1%
2%
3%
4%
5%
6%
7%
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
(f)
2008
(f)
0
50
100
150
200
250
300
Economic growth Payment incident index
Impact on Europe Cont..
*Payment incident index 100: World 1995-2000 basis
Terminology 91
US Economic Indicator : Snapshot !
GDP falls to less than 1% (YOY) in real termsExpectation 2009 : -1.30 % (YOY)
Inflation : Less than ZERO % in 2008 = Worst in 17 years
Unemployment: Rises to over 7.0 %
Interest Rate: Falls to 0.250 %
Unprecedented fall in economic activity
Terminology 92
Current Status of World Economy
World economy entering a major downturnOECD countries in recession
Enormous financial sector dislocation
Unknown fiscal costs of bailouts
Severe real economy dislocations
Stagflation potential
Developing countries growth rates ex China & India
reduced by half
Terminology 93
Current Status of World Economy Cont..
Weakening global trade - world trade likely to decrease in 2009 for the first time since the 1982 recession, remittances dropping Emerging markets witnessing international reserves declining, volatile equity and foreign exchange marketsVolatile commodity prices pose risks for importers & exportersGlobal Inflation Risk Moderated but Volatile
OECD Leading Economic Indicator Points to a Significant Slowdown
Terminology 94
Impact of Financial Crisis on Domestic Financial Markets
Economic Indicator: Snapshot
Impact on financial markets
Impact analysis on key sectors
Terminology 95
Economic Indicator : Snapshot !
GDP for 2008-09 8.0-8.5% (YOY)
Expectation 2009-10 : Less than 7 %
Index of Industrial production fell to less than 1 % in Aug.
Fiscal Deficit expected to touch over 5 % of GDP
Inflation : Over 8.5% in 2008-09
Interest Rate: 10 years G-Sec yield is at less than 5 %
Equities Market down by over 60 % from their peak
Terminology 96
Inflation – Number 1 concern now
Inflation numbers : Rate in May/June 08 vs. (2007)•Japan - 7.1% 27 year record high
•China - 7.7% (4.8%)
•India - 7.8% (4.4%)
•Malaysia - 7.7%, (2.0%)
•Vietnam - 25.2% (8.3%)
•Singapore - 7.5% worst in 26 years
Terminology 97
2009 = slowdown + uneasy financing for companies
An expected slowdown of the World Economy, especially felt in industrialized countries
A more difficult access to financing for Companies because of tougher credit conditions
Terminology 98
Impact on Equity Markets
Global equities market more tightly linkedFall in Asian equities markets even more severe than in the U.S. Equity markets decline (Q3-2008):
Japan - 34% China - 50%India - 45% Singapore - 30%Malaysia - 27%
Reasons Withdrawal of foreign equity funds from Asia to cover losses in U.S
Negative news about the health of financial institutionsChina and India markets over-heatedExtension of credit lossesHigh inflationFears over decline in corporate earnings
Terminology 99
Impact on Financial Markets
In India, Short term Int. rate rose initially and then fell
• Local Liquidity conditions (Initial Rise)
•Policy Measures (Fell)
Terminology 100
Impact on Foreign Exchange Market
Till end-July 2008, USD depreciated against major currencies on account of :lowering consumer confidenceweaker equity markets slowing manufacturing productivity growth higher unemployment with downward non-farm payroll employment, and low housing salesFrom early-August 2008, USD’s strength reflectedliquidation of positions in the overseas equity and bond markets by US investorsrepatriation of the money back to USdue to slowing growth in the Euro area
Appreciation (+) / Depreciation (-) of USD vis-à-vis other currencies
Terminology 101
Impact of Financial Crisis on Japan
Japanese companies suffered from disappointing growth prospects
Payment incident index (*) 12 months moving rate Scale of sectoral risk
0
50
100
150
200
250
300
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95
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june
97
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8de
c-98
june
99
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ne 0
0de
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-07
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WORLD
Japan
*Payment incident index 100: World 1995-2000 basis
Terminology 102
Impact of Financial Crisis on Developing Countries
Massive capital outflows, drastic drop off from previous record highs (from $1 trillion to nearly $500b, from 7.6 to 3 percent of GDP)Many hard hit developing countries already had:– Fiscally precarious positions– High levels of initial poverty and malnutrition– Limited capacity to implement targeted policy response
Impact– Affects wages and employment as inflation passes through
(inflation up 5% in most, >10% in more than half)– Sharp drop in investment, which has been driver of growth– Falling remittances – Long term cost of coping mechanisms, loss of fiscal cushions
Terminology 103
Impact of Financial Crisis on Developing Countries
Financial flows are likely to drop precipitously ……
Net private capital flows to developing countriesNet private capital flows to developing countries
$ billions
0
200
400
600
800
1000
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
e20
08P
2009
P
Possible Possible
20082008--0909
$998 billion in 2007
East Asia CrisisEast Asia Crisis
Source: World Bank staff estimates
Terminology 104
Impact of Financial Crisis on India
Liquidity conditions in Q2-2008 were eased on account of significant reduction in the cash balances of Central Govt. In Q3, liquidity conditions mostly remained in a deficit modeIndian financial markets in Q3 witnessed heightened volatility reflecting uncertain global situation
Interest rates in money market moved in accordance with evolving liquidity conditionsDaily avg. call rate continued to remain above the repo rate reflecting the impact of hikes in CRR and repo rate Indian rupee depreciated against major currencies In credit markets, lending rates of scheduled banks hardened
Liquidity Adjustment Facility and the Call RateYields in govt. securities market decreasedIndian equity markets declined in tandem with trends in major international equity markets as well as edging up of domestic inflation
Terminology 105
Impact of Financial Crisis on India
Foreign Exchange MarketDuring FY2008-09, Indian rupee generally depreciated (from Rs 39.89 to Rs 48.84 per USD ~ depreciated by 18%)Due to FII outflows, bearish stock market conditions, high inflation and higher crude oil prices reflecting higher demand for USD
Movement of Rupee vis-à-vis Major Currencies
5.5%
3.6%
18%
Credit MarketScheduled commercial banks increased their deposit rates for various maturities by 25-150 basis pts (8.25-9.5% in Jun’08 to 8.75-10.25% in Sep’08)Benchmark lending rates of PSBsincreased by 75-125 basis pts from 12.5-14% in Jun’08 to 13.75-14.75% by Sep’08
Deposit & Lending Rates-PSB
Terminology 106
Impact of Financial Crisis on India
Govt. Securities MarketHeightened inflationary expectations emanating from sharp increase in global commodity and crude oil prices led to hardening of yield in Q1-Q2Since Q3, yields have eased due to CRR reduction to 250 basis pts and softening of crude oil prices
Yields on Govt. Securities
Equity Market - Primary MarketWitnessed slackness in resource mobilizationduring Q2-Q3Cumulatively, resources raised through public issues declined sharply to Rs 12,361 crores during Q2 from Rs 31,850 crores during corresponding Q2 of 2007No. of issues declined from 60 to 32 (19 IPOs from Pvt. sector cos. constituting 16% of total resource mobilization)Avg. size of Public issue declined to Rs 386 crfrom Rs 531
Mobilization of Resources – Primary Market
Terminology 107
Impact of Financial Crisis on India
Stock MarketFour distinct Phase- Phase I (Apr 1 & May 21’08) – Mkts staged recovery due to better results of Q4-2007
declared by IT majors, net purchases by FIIs in Indian equity mkt and some easing of international crude oil prices
- Phase II (May 22 & July 16’08) – Mkt sentiment turned cautious on account of increase in in’tl crude oil prices , hike in retail fuel oil prices, rise in domestic inflation rate, rising trade deficit and depreciation of rupee, domestic political uncertainties, downward trend in in’tlequity mkts, etc
- Phase III (Jul 17 & 7 Sep’08) – Mkt recovered on account of restoration of domestic political stability and decline in crude oil prices
Indian Stock Market- Phase IV (7 Sep’08 onwards) – Mkt turned volatile due to decline in international stock mkts triggered by bankruptcy/sell-out/restructuring of some of world’s largest financial inst., heavy net sales by FIIs, sharp fall in value of rupee & slowdown in industrial growthSectoral indices also witnesses downward trendP/E ratios of 30 scrips in BSE Sensexdeclined from 20.1 (end-Mar’08) to 16.2 (at end-Sep’08)
I II III IV
Terminology 108
Impact on India – The Good, Bad and Ugly
Indian companies with big tickets deals in the international market are seeing their profit margins shrinkingTrade finance is drying up and is dragging down exports
Terminology 109
Impact of Financial Crisis on India
Indian Financial ServicesIndian Financial ServicesIndian Financial Services Most ImpactedMost Impacted
The US sub-prime market crisis, which so far caused losses worth $181 billion to the world’s top 45 banks by the end of FY08, has started hitting Indian banks also
India’s largest private sector bank ICICI Bank was the first bank to announce a loss of about Rs. 1,056 crores owing to the sub prime crisis of US in the FY08 results
The public sector banks have had a limited position in the structured products and therefore impact is expected to be minimal. However negative sentiments will hit harder
Punjab national Bank, Bank of India, State Bank of India, Bank of Baroda were major banks having an exposure to the instruments issued by Lehman and Merrill Lynch
However the banking sector in general will have to face tight liquidity conditions apart from further mark-to-market losses. The net non performing assets of entire banking sector is less than 2% and it is well capitalized. The capital adequacy ratio is around 13% as against the statutory requirement of 8 to 9%.
Terminology 110
Impact of Financial Crisis on India
Indian Financial Services Chakra-view…..Exposed??Indian Financial Services ChakraIndian Financial Services Chakra--viewview……..Exposed??..Exposed??
Terminology 111
Impact of Financial Crisis on India
With the sudden collapse of world leading financial houses, the Indian real estate players who were already facing the problem of lack of funds due to economic slowdown & correction in prices are finding difficult in raising further funds
Among the US Financial Houses --- Lehman Brothers was very bullish on Indian Reality Sector and had an investment in excess of US$ 700 mn (maximum amongst peers)
Lehman’s real estate investments at project levels (including the big ones like DLF, Unitech & Future Capital) have been disbursed & it will not affect the ongoing projects
RBI’s directive not to remit investments made by US financial houses in India without permission is also a step in positive direction and would restrict flight of capital
However, stocks of companies in which sunked financial institutions have a direct exposure (as FII investments especially Lehman) would see selling pressure
Real EstateReal EstateReal Estate Most ImpactedMost Impacted
Terminology 112
Impact of Financial Crisis on India
AutomobilesAutomobilesAutomobiles Mildly ImpactedMildly Impacted
Auto companies have been seeing sluggish sales for the past few months due to higher interest rates and higher fuel prices
Two wheelers have shown decent sales growth in the last 2 months, more due to the low base effect
It would get tougher for passenger and commercial vehicles and it might start impacting two wheeler vehicle sales negatively
Exports of auto companies might take some hit, however, the impact on exports might not have significant impact on the top-line of auto companies, as the percentage sales contribution from exports is less for Indian auto companies; but this might cause the auto companies to cut their export targets for the next two or three years
Sales Growth
Description Jul'08 Aug'08
Passenger Vehicles ‐1.40% ‐4.35%
Commercial Vehicles 2.00% ‐6.33%
Three‐wheelers 1.50% ‐3.19%
Two‐wheelers 19.50% 14.24%
Terminology 113
Impact of Financial Crisis on India
Hospitality , Travel and TourismHospitality , Travel and TourismHospitality , Travel and Tourism Mildly ImpactedMildly Impacted
Slowdown in travel demand: Travel budgets of companies have fallen by approx. 40% and a further fall of 10-15% is expected in the next 2 quarters
Hotels face difficulty in maintaining occupancies - falling from the current 75% to 68-70%
Growth in average rooms rates is expected to slowdown from 16-21% to 5-9%
With increasing competition and room tariff wars, hotels facing pressure on their profit margins
Lack of investments in properties will limit the hotels from expansion plans
AIG bailout is likely to impact Indian Aviation as its subsidiary is among the world’s largest aircraft leasers to Indian companies
Terminology 114
Learning & change of the model
What has the crisis been about?
India’s long term growth story
remains intact
Strong long term growth prospects
Lessons from sub-prime crisis
Controlling the crisis
Terminology 115
What has the crisis been about
This crisis is about three things:
Too much liquidity.
Fundamental structural problems in the credit industry, including the almost-total
lack of regulation.
Lack of transparency of complex financial instruments for which there is no public
market, making them tough to value and nearly impossible to trade.
There is fair distance to travelBanks have recognized only a fraction of the overall potential losses –
approximately $50 billion to $75 billion so far on sub-prime debt alone.Total
bailout cost is around $1 trillion (IMF estimate)
Source: Three Ways to Know When the Credit Crisis Hits Bottom, Keith Fitz-Gerald,Investment Director,Money Morning/The Money Map Report
Terminology 116
India’s long term growth story remain intact
India’s GDP growth is expected to continue as 85% comes from
domestic marketIndia a country of savers – low credit dependenceStrong base of trained manpower
Terminology 117
Strong long term growth prospects
Growing insurable population in 20-60 years bracket
Increasing disposable income
Terminology 118
Lessons from sub-prime crisis
Importance of observing prudent underwriting standards, verification of
documents, and an ongoing monitoring of the borrowers affairs
Liquidity Risk - Close link between market liquidity and an individual bank’s
funding liquidity
Importance of reliable valuations and transparency of risk exposures.
Inappropriately optimistic valuation and modeling methodologies
Technology does not obviate the need to assess a borrower carefully.
Insufficient recognition of residual risks in the structured products
Lack of transparency due to insufficient disclosure.
Compensation systems rewarded very short-term employee performance.
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Terminology 119
Lessons from sub-prime crisis
Conflict of interest in the role of rating agencies
Rating agencies are paid for their rating exercise by the issuers of
securities and not by the investors in those securities.
Appropriate mechanisms should be evolved to ensure that the
information received by the rating agencies is reliable;
Closer attention to the liquidity risks faced by the rated entity / product
should be mandated for the rating agencies in their rating process;
Road map for the rating agency reforms, should be evolved to address
the weaknesses revealed as also to promote competition in the rating
industrySource s , : Financial Time http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Terminology 120
Controlling the crisis- better warning signals in future
Strengthened Prudential oversight of capital, liquidity risk management
Phased implementation of the Basel II norms
Minimum capital requirement prescribed at higher levels of 9% .
Banks exposure to sensitive sectors and their liquidity position monitored on a
regular basis
Broad guidelines for asset – liability management have been put in place and
banks develop risk management policies under broad guidelines
Overnight unsecured market for funds has been restricted only to banks and
primary dealers
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Terminology 121
Controlling the crisis- better warning signals in future
Enhancing transparency and valuation
Strengthened the valuation norms and market discipline in respect of
complex financial products including issuance of guidelines on valuation
of various instruments
Comprehensive guidelines on derivatives incorporating risk
management and corporate governance aspects, suitability and
appropriateness policy.
Set of disclosure requirements developed to enable assessment on
capital adequacy, risk exposure, risk assessment processes and key
business parameters
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-6187-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Terminology 122
Controlling the crisis- better warning signals in future
Changes in the role and uses of credit ratings
Norms developed to ensure consistency in credit rating agencies by banks
disallowing banks to cherry pick the assessments provided by different credit
rating agencies
Strengthening the authorities responsiveness to risks:
A working group has been constituted to lay down a road map for adoption of a
suitable frame work for cross border supervision and supervisory cooperation
Robust arrangements for dealing with stress in the financial system
Institutional arrangements have been put in place for liquidity management
facilities, and open market operations, and market stabilisation schemes
RBI has been empowered under existing legal framework to deal with the
resolution for the weak and failing banks
Source: Financial Times , http://www.ft.com/cms/s/0/a09f751e-618-11dd-af94-000077b07658,dwp_uuid=698e638e-e39a-11dc-8799-0000779fd2ac.html
Terminology 123
Conclusion
Risk of sub-prime Housing loan transferred : commercial bank ->
investment bank -> investors through securitization
Mortgagor defaults created havoc in real estate and in turn financial markets
and leveraged financial institutions
Models were too fragile to value complex financial instruments since they
ignored vital variables like Black Swans , liquidity,leverage & correlated
risks etc.
Crisis is GLOBAL (geographically market-wise , sector-wise , etc.)
In India: Banks,financial Services,IT,real estate & infrastructure are worst
affected whereas pharma , FMCG , Media & Entertainment least affected
Strengthening capital & liquidity risk management, Enhancing transparency
and valuation , CRA’s overhaul & legal framework is important to avert
these kind of crises
Terminology 124
References
1. Financial Crisis 2008 - Parshwadeep Lahane2. Annual Policy Review, RBI monthly bulletin November
20093. Where Did the Risk Go? How Misapplied Bond Ratings
Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Mason & Rosner, Drexel University
4. Three Ways to Know When the Credit Crisis Hits Bottom, Keith Fitz-Gerald,Investment Director,Money Morning/The Money Map Report
5. The Black Swan, Nassim Nicholas Taleb6. Fooled by Randomness, Nassim Nicholas Taleb7. Global Financial Stability Report, Oct 20088. World Economic Outlook
Terminology 125
Thanks
Questions
Terminology 126
Hyperlink Slides
Terminology 127
A Longer-Term Perspective on Home Prices
60
80
100
120
140
160
180
200
220
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
100
120
140
160
180
200
220
WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
1890=100
60
80
100
120
140
160
180
200
220
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
100
120
140
160
180
200
220
WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
60
80
100
120
140
160
180
200
220
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
100
120
140
160
180
200
220
WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
1890=100
60
80
100
120
140
160
180
200
220
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
100
120
140
160
180
200
220
WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
60
80
100
120
140
160
180
200
220
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
100
120
140
160
180
200
220
WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
1890=100
60
80
100
120
140
160
180
200
220
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
100
120
140
160
180
200
220
WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
60
80
100
120
140
160
180
200
220
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
100
120
140
160
180
200
220
WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
1890=100
80
60
Source: Robert J. Shiller, 2006.
Terminology 128
Homeownership Rate Reaches Historic High in 2004
62
63
64
65
66
67
68
69
70
1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005
Percent 69.2% in September 2004
67.8% in March 2008
2008
Source: U.S. Census Bureau.
Terminology 129
Home Mortgage Share of Household Liabilities : New High in 2007
55
60
65
70
75
1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007
Percent
Source: Federal Reserve.
Terminology 130
Ratio of Median Home Price to Median Household Income Surges
2.5
3.0
3.5
4.0
4.5
5.0
'68 '70 '72 '74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06
Median Home Price/Median Household Income
Terminology 131
Median Existing Single-family Home Price:Too Good to Last
20082007200620052004200320022001200019991998
20
15
10
5
0
-5
-10
-15
Percent change, year ago
Sources: National Association of Realtors, Moody’s Economy.com.
Terminology 132
History Repeats Itself: Home Prices Don’t Just Go Up
Change in Home Prices in 100 plus years
-20%
-10%
0%
10%
20%
30%
40%
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
WorldWar I
GreatDepression
WorldWar II
1970’sBoom
1980’sBoom
CurrentBoom
Percentage change, year ago
Source: Robert J. Shiller, 2006.
Terminology 133
Existing Home Sales Are Down Everywhere Over the Past Two Years
Percent change in existing home sales Fourth-quarter 2005 through fourth-quarter 2007
Existing home sales nationwide down 29%Source: Freddie Mac.
Terminology 134
Forty-six States Had Falling Prices in the Fourth Quarter 2007
United States: - 9.3% (fourth-quarter annualized growth)
Source: Freddie Mac.
Terminology 135
OECD Leading Economic Indicator Points to a Significant Slowdown
2001-02 Worldwide Recession
2007-08 Financial Crisis
Terminology 136
Impact of Financial Crisis on United States
Payment incident index (*) 12 months moving rate Scale of sector risk
0
50
100
150
200
250
300
june
93
dec-
93ju
ne 9
4de
c-94
june
95
dec-
95ju
ne 9
6de
c-96
june
97
dec-
97ju
ne 9
8de
c-98
june
99
dec-
99ju
ne 0
0de
c-00
june
01
dec-
01ju
ne 0
2de
c-02
june
03
dec-
03ju
ne 0
4de
c-04
june
05
dec-
05ju
ne 0
6de
c-06
june
-07
déc-
07
WORLD
United States
*Payment incident index 100: World 1995-2000 basis
Terminology 137
Inflation Expectations Are Trending Downward
TIPS/10-Year Implied Breakeven Inflation Rate
Terminology 138
Unemployment Expectation
4.4 % Oct. 2006
6.1 % Oct. 2008
7%-8%2009
Forecasts
Terminology 139
Commodity Prices
CRB Commodity Price Index
Terminology 140
Baltic Dry Index
Terminology 141
Mortgage Loan Fraud Surges
Source: Financial Crimes Enforcement Network.
0
10
20
30
40
50
60
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Thousands
Terminology 142
S & P 500 Index
Terminology 143
Equity Market Volatility
S&P 500 Volatility
Terminology 144
Bloomberg’s Financial Conditions Index
Terminology 145
Market for Liquidity Freezes
Thirty-Day AA Rated Commercial Paper Rates
Nonfinancial Commercial
Paper
Financial Commercial
Paper
Asset-backed Commercial
Paper
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
May07
Jun07
Jul07
Aug07
Sep07
Oct07
Nov07
Dec07
Jan08
Feb08
Mar08
Apr08
May08
Percent
Source: Federal Reserve.
Terminology 146
Widening Spreads: Municipal Bonds
ML municipal master index yield spread
-80
-40
0
40
80
120
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08
Basis point spread over 10-year treasury bond
ML municipal master index yield spread
-80
-40
0
40
80
120
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08
Basis point spread over 10-year treasury bond
Source: Bloomberg.
Terminology 147
Widening Spreads :Mortgage-Backed & High-yield Bonds
Source: Bloomberg.
ML High-Yield Bond Index
ML BBB Mortgage-Backed Securities Index
0
200
400
600
800
1000
1200
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08
Basis point spread above 10-year treasury bond
ML High-Yield Bond Index
ML BBB Mortgage-Backed Securities Index
0
200
400
600
800
1000
1200
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08
Basis point spread above 10-year treasury bond
Terminology 148
Money Market Spreads : U.S. Libor/OIS Spread
U.S. Libor/OIS Spread
Terminology 149
Credit Spreads : Baa Corporate/ Treasury Spread
Terminology 150
The Dollar in 2007-08
January-August 2007From 1.30 to 1.35
Sept.-Nov. 2007From 1.35 to 1.45
Dec.Jan.Pause
Feb.-April 2008From 1.45 to 1.60
May-July2008.Pause
July.-Oct. 2008From 1.60 to 1.36
Terminology 151
Financial Stocks
-11%-17%
-18%-29%
-32%-40%
-52%-52%-53%
-56%-56%
-63%-77%
-87%-94%
-1 -0.8 -0.6 -0.4 -0.2 0
JP Morgan & ChaseGoldman SachsWells FargoBank of AmericaMorgan StanleyAIGLehman BrothersUBSWachoviaFannie MaeMerrill LynchFreddie MacWashington MutualCountrywideBear Stearns
Source: Bloomberg.
Percentage change in price, December 2006–March 2008
Terminology 152
Major losses for banks worldwide
Source: Bloomberg.
38.237.0
19.516.1
15.414.8
12.69.89.7
9.18.4
7.77.0
42.9CitigroupUBS
Merrill LynchHSBC
IKB Deutsche Royal Bank of Scotland
Bank of AmericaMorgan Stanley
JPMorgan ChaseCredit Suisse
Washington MutualCredit AgricoleDeutsche Bank
Wachovia
Losses/write-downs through May 27, 2008, US$ billions
Terminology 153293
225
429
1,014
813
946
0
200
400
600
800
1,000
1,200
2002 2003 2004 2005 2006 2007
US$ Millions
Dollar Losses in Reported Cases of Mortgage Fraud
Source: Federal Bureau of Investigation.
Terminology 154
Market share shifted from 2003 to mid 2006
76
43
24
57
0
20
40
60
80
100
2003 mid-2006
%
Year
Mortgage market % share
Government sponsered Private( Wall Street firms)
• Government share fell by 43%where as private share rose sharply by 138% over a period of 3 years
Between sub-prime and prime
• Subprime lending increased by massive 205% over 3 years
• Alternative–A similarly expanded by 384%
• Increase in Prime was mere 16.7%
Terminology 155
Global pool of money
Source:http://www.rbnz.govt.nz/speeches/2968727.html
• After 1997/98 financial crisis – Developing countries focus on export-driven growth and the associated accumulation of foreign exchange reserves• The strength of exports relative to domestic demand has seen saving outstrip investment in most of these economies
• Accordingly, we have the ironic situation whereby a range of developing countries are (in net terms) the providers of capital to some of the world’s most developed economies.
• This rapidly rising “savings glut” has been a principal source of increased global liquidity.
Terminology 156
Rise of Global Liquidity (1998 onwards)
• The flow of increased global liquidity through markets has provided the impetus for many changes
• To generate a return on this liquidity has spurred massive growth in securitization of debt and the development of a vast array of derivatives. The propagation of these instruments can itself be seen as a source of liquidity growth. From a monetary policy perspective, this implies a very big increase in the liquidity that is not directly controlled by central banks. ••Bank for International Settlements, highlighted a number of important new features:
• the unbundling and re-pricing of risk through major advances in financial engineering, resulting in improved ability to lever lending via new markets such as for credit transfer products;• the emergence of new financial players such as hedge funds and private equity firms that have not been traditional intermediaries;• more reliance of financial firms on markets to handle growing complexity;• a reliance on market liquidity even in stress situations; and• a surge in volume and value of transactions.
Source:http://www.rbnz.govt.nz/speeches/2968727.html
Terminology 157
FED interest rate
• To catch up with dot com bust FED kept interest rate low for too long
•This indirectly resulted in investors looking for other safe heavens
• They got attracted to housing market
Terminology 158
High Banks leverage ratio’s to fund MBS/CDO
Terminology 159
Building up of the housing bubble
Terminology 160
Housing prices and Income
• Housing prices were increasing
•Income slope was almost flat
Source: http://varbuzz.com/meltdown/
Terminology 161
Starting 2006 housing bubble busted
Terminology 162
LIBOR rate
Terminology 163
Credit rating of complex financial instruments
Source: IMF and WSJ
Terminology 164
Speedy Foreclosures
Terminology 165
Top 10 Bankruptcies
Terminology 166
The American way of debt
Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070
Terminology 167
Average debt of American in 2004
Source: http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?ei=5070
Terminology 168
VaR
With 95% confidence, we expect that our worst daily loss will not exceed 4%.
If we invest $100, we are 95% confident that our worst daily loss will not exceed $4 ($100 x -4%).
Source :http://www.investopedia.com/articles/04/092904.asp
Terminology 169
Effect of correlation
Financial MeltdownSource: Where Did the Risk Go by Mason & Rosner
∑∑ ∑== =
+=n
jijjiji
n
i
n
iiip rwww
11 1
22 σσσσ
Synthetics (e.g. ABX)
Property
Property
Property
Property
Property
Mortgage pool
AAA
AA
A
BBB
BB
Mortgage
$ for purchase or refiMortgage P&I Buy security
purchasedSecurity P&I
paid
Higher priority of
repayment
Lower priority of repayment
Lower yield
Higher yield
Mortgages are originated… And pooled together into a
trust
A series of securities (tranches) are created backed by the pool of
mortgages…
Which have different priorities in repayment, and thus different
levels of risk and yields
B
Unrated
Investors buy the individual securities
CDO Pool
Other RE and non-RE obligations
AAAAAA
BBBBBB
Unrated
Terminology 170
Black Swans
Classical metaphor: A Turkey is fed for a
1000 days—every days confirms to its
statistical department that the human
race cares about its welfare "with
increased statistical significance". On
the 1001st day, the turkey has a
surprise.
The fate of close to 1000 financial institutions (includes
busts such as FNMA, Bear Stearns, Northern Rock,
Lehman Brothers, etc.). The banking system
(betting AGAINST rare events) just lost > 1 Trillion
dollars (so far) on a single error, more than was
ever earned in the history of banking.
Turky Economics : we are in a new era of safety", and back-it up
with thorough and "rigorous" analysis and so package of sub-prime
loans (leveraged) gets sold on grounds that "30 years of history show
that the trade is safe
Source: The Black Swan, Nassim Nicholas Taleb
Terminology 171
Fourth Quadrant
passage from theory to the real world presents two distinct difficulties
• Inverse problem compounded by the small sample properties of rare events
• Many asymptotic properties do’nt work well pre-asymptotically
Source: The Black Swan, Nassim Nicholas Taleb
Terminology 172
Volatility as an indicator of stability
Random Walk—Characterized by volatility. You only find these in textbooks and in essays on probability by people who have never really taken decisions under uncertainty.
Random Jump process—It is not characterized by its volatility. Its exits the 80-120 range much less often, but its extremes are far more severe.
Fooled by Randomness: humans are hard-wired to demand an explanation for everything, even when there is none, leading us to be fooled into thinking that something is not random when it really is.
Sources: The Black Swan, Nassim Nicholas Taleb
Fooled by Randomness , Nassim Nicholas Taleb
Terminology 173
Fooled by Randomness
An evil investment advisor sends letters to a thousand or so prospective clients, telling half that a particular stock will go up and the other half that it will go down. The second month, repeat the same mailing to the half of the list where the prediction happened to be correct. Keep repeating each month and at the end of ten months he'll have a (short) list of peoplewho think he was correct for ten months in a row. Apply the same math to the world's pool of actual investment advisors and mutual fund managers and you'll find that the number of people with 10 year successful track records is about what you'd expect from pure chance!
Source: Fooled by Randomness , Nassim Nicholas Taleb
Terminology 174
Moody’s Fiasco
Moody’s discovered in February 2007 that the models used to
rate CDO’s had a mistake that provided ratings up to four
notches higher than they should have been.
Key problems in modeling of CDO’sIncorrect assessments of correlations between the individual assets
An AAA CDO tranche does not have the same risk characteristics as an
AAA corporate. The average probabilities of defaults may have been
similar, but the tails of the distribution are much fatter for CDOs.
Credit spreads on high-grade corporate obligations tend to narrow in a crisis
because of flight to quality. We see the opposite with CDOs.
Why would an AAA rated SIV earn 200 basis points above an AAA rated
corporate bond?
Source: Blame the Models by Jon Daniielson , London School of Economics
Terminology 175
SF Pool Losses don’t recover%
Los
s on
Ass
et P
ool
Time: zero to maturity
Cumulative Loss Level
Corporate Investments
Mortgage Pool
ExpectedActual
Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.
Terminology 176
SF Pool losses are Distributionallyskewed
Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.
Terminology 177
Moving,Increasing,Skewed SF Pool Loss distribution narrows over time
% L
oss
on A
sset
Poo
l
Cumulative Corporate Investment Performance
Time: zero to maturity
Cumulative Loss Level
µ µ µ µ µ µ µ µ µ µ µ
% L
oss
on A
sset
Poo
l
Cumulative Mortgage Pool Performance
Time: zero to maturity
Cumulative Loss Level
µ
µ
µµ µ µ µ
µµ
µ
Source: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, Joseph R. Mason, Associate Professor of Finance, Drexel University & Joshua Rosner, Managing Director, Graham Fisher & Co.
Terminology 178
Investments devalued across the Globe
Source: BBC News, http://news.bbc.co.uk/2/hi/talking_point/7644574.stm
Terminology 179
Impact of Financial crisis-felt across the globe
Source: Reuters, http://www.reuters.com/news/globalcoverage/creditcrisis
Terminology 180
Mortgage Loan Fraud Surges
Source: Financial Crimes Enforcement Network.
0
10
20
30
40
50
60
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Thousands
Terminology 181
The Dollar in 2007-08
January-August 2007From 1.30 to 1.35
Sept.-Nov. 2007From 1.35 to 1.45
Dec.Jan.Pause
Feb.-April 2008From 1.45 to 1.60
May-July2008.Pause
July.-Oct. 2008From 1.60 to 1.36
Terminology 182
U.S. and Euro-Area Credit Default Swaps During the 2007-08 Financial Crisis
September 17, 2007 =100
U.S. CDS
Europe CDS
Terminology 183
U.S. and Euro-Area Swap Spreads During the 2007-08 Financial Crisis
September 17, 2007 =100
U.S. Swap Spreads
Europe Swap Spreads