Beyond Prime Angst | Collateralized Debt Obligation | Loans



JUST MONTHS after we published our “Prime Angst” Intelligent Dialogue paper in May 2008, the tremors of the U.S. subprime crisis
gave way to a full-blown earthquake, shaking the global financial system to its core. And as we all see, aftershocks are spreading fast into the everyday global economy of jobs and purchases and family finances. In keeping with our principles of Intelligent Dialogue, just as we raised questions back in May, we continue to examine the constantly shifting environment and encourage discussion. In this follow-up, we explore the landscape by revisiting questions we asked then, and by looking ahead.

UPDATE: Events since May have
provided dramatic answers to that question, reaching an absolute crisis point in September.
On September 7, as subprime borrowers were defaulting on loans in ever larger numbers, the U.S. government took control of mortgage corporations Fannie Mae and Freddie Mac, which between them accounted for almost half the U.S. home-loan market. Financial services companies that had bought packets of subprime loans bundled into CDOs (collateralized debt obligations) saw the market value of their CDO portfolios plummet, dragging them toward insolvency. The U.S. authorities allowed investment bank Lehman Brothers to go bankrupt on September 15. On the same day, Bank of America acquired troubled investment bank Merrill Lynch. On September 16, vast insurance corporation AIG faced a liquidity crisis and accepted up to $85 billion of Federal Reserve credit in exchange for 79.9% equity in the group. All around the world, big-name banks faced collapse. As we wrote in May, the tiny nation of Iceland was in trouble after its aggressively expanded banks could no longer fund themselves on the money markets; Iceland effectively went bankrupt October 9. The list of woes has grown longer by the day as consumer and business confidence declines. The answer to the question is that when too many people and institutions can’t repay their loans, governments themselves become the only entities strong enough to step in—individually or collectively (through the International Monetary Fund)—with bailouts, cash injections and liquidity guarantees. The U.S. financial system was saved from collapse by a $700 billion Federal bailout plan passed October 3. The U.K. government rescued the British banking system October 8 with a £400 billion package for eight of the country’s biggest banks and mortgage lenders. Other countries such as France, Germany and Switzerland followed suit. The IMF bailed out Ukraine to the tune of $16.5 billion on October 26 and stepped in with $25 billion to rescue Hungary on October 29. The focus so far has been on managing the fallout from mortgage-related debt. But mortgages are only one of the ways households get money on loan. The next household loan crisis brewing is consumer credit, which has been the top-up fuel that’s turbo-charged the booming economy in recent years. At the end of 2007, U.S. consumers alone owed $961 billion in credit card debt. Now that home equity withdrawal has become more difficult or impossible (with house prices falling and equity turning negative) consumers have turned to credit cards to pay for everyday purchases. But with bad home loans mounting, card issuers are anticipating a spike in credit card defaults. They’re becoming much choosier about who they lend to, how much credit they extend and how quickly they expect payment. Consumers are finding that fees and rates can land them deeper in trouble. It’s now increasingly clear that high levels of debt have determined the headlong dynamics of whole markets, national economies and the whole global economy.

How long will it take for more manageable forms of debt and more sustainable dynamics to emerge? Can finance lead the way, or will governments force the issue through intervention and regulation?


UPDATE: We said in May that
all around the world, some of the most profound effects of the crisis will be felt at the beginning and end of adulthood, and this is certainly proving to be the case.
On the education front, expectations of ever-increasing prosperity have pushed up demand for education as well as costs. According to the U.K.’s Daily Telegraph, between 2001 and 2006, average British school fees rose by 39 percent. Parents have squeezed their budgets and taken out loans to give kids a running start in life with private education aimed at getting them into top universities. However, now that credit is drying up and incomes are threatened, many parents are pulling their children out of private education and looking for ways to reduce educational costs. A recent New York magazine article reports that 45 families have informed the 300-year-old competitive-enrollment Trinity School in New York City that their kids will not be returning next year, a huge drop considering the school’s enrollment of only 1,000 for its entire K-12 program. Students are finding it harder to get loans and grants as banks become tighter. This is bad news for private educational institutions because it’s reducing enrollment income at the same time that investments are being hit by falling stock markets. Inevitably some schools won’t make it through the economic crisis. Publicly funded school systems are less directly vulnerable to students’ ability to pay fees, but they too are facing funding problems. Falling tax revenues and rising demands on public funds mean that schools will increasingly struggle with tighter budgets. This raises serious questions about investment in the education of future problem-solvers and wealth-generators: Will economic strain result in a relatively short-term dip in educational provision and output? Or will it inflict longer-term damage that harms nations’ capacity to educate and results in a “lost generation”? No matter what, young people have the expanse of their whole adult life to get back on track. People approaching retirement have no such prospects. Those who made provisions for retirement in pension plans are seeing the value of plans decline as stock markets have fallen. Those who thought their home would fund their pension must think again, realizing home equity won’t be an option unless housing markets pick up, and that could take a long time. Younger people have the consolation of knowing there’s a fair chance that the economy will pick up sooner or later, allowing them to get back to work with a reasonable chance that stock markets and property will gradually start to recoup lost value. But for older people, working beyond their planned retirement may not be an option in a recessionary or stagnant economy.

Will the crisis prove to be a wake-up call for consumers and governments to make more robust provisions for the huge numbers of baby boomers moving toward retirement age? Or is it the early phase of a chronic problem of senior short-funding?

UPDATE: In the short-term, the
impact of the crisis is expected to show up in matters of mental health. The World Health Organization warned on October 9 that the global financial crisis is likely to cause increased mental health issues and even suicides as people struggle to cope with the lack of cash, the prospect of unemployment and even losing their homes.
As we noted in May, 47 million American adults were without health insurance and each percentage-point rise in unemployment will result in an additional 1.1 million people losing their coverage. Inevitably, as the economic effects of the crisis hit jobs and household finances, more families will cut back on medical costs and defer medical attention. Compounding the emotional stress of an economic crisis, this certainly has serious longer-term implications for public health. A major meta-analysis of 293 independent studies published by the American Psychological Association found that people’s immune systems suffer badly from stress-inducing events that change their identities or social roles, are beyond their control and seem endless: “The longer the stress, the more the immune system shifted from potentially adaptive changes … to potentially detrimental changes, at first in cellular immunity and then in broader immune function. Thus, stressors that turn a person’s world upside down and appear to offer no ‘light at the end of the tunnel’ could have the greatest psychological and physiological impact.” People who lived through the Great Depression of the 1930s and other major hardships (war, internment, dictatorship) are evidence that people have survived worse traumas. But quality-of-life expectations are much higher today. Not only that, societies are more complex and interconnected; as the economic crisis has shown, events in one place can set off a chain that travels far and wide.

Will the economic crisis lead to a longer-term problem of more stress-related illnesses? How can the economic crisis be prevented from turning into a health crisis?

UPDATE: Since we raised the
question in May, this has become a very hot topic. In allowing Lehman Brothers to go bankrupt, U.S. authorities may have intended a gesture of punishment; many analysts now contend that the move was a mistake that accelerated the meltdown of the financial system.
In any event, Lehman was the exception; authorities around the world quickly concluded that banks could no longer be allowed to fail, since that would put the global financial system at risk. In fact, far from being punished, other troubled banks have either been rescued with bailouts or guided into the arms of more solvent financial firms; for example Merrill Lynch was bought/rescued by Bank of America in September. There was outrage and opposition to the $700 billion bailout of the U.S. financial system proposed by U.S. Treasury Secretary Henry Paulson in September—a move that prompted the phrase “Capitalism on the way up, socialism on the way down.” In fact the plan was voted down by the House of Representatives on September 29 before it was modified and accepted October 3. Rightly or wrongly, there is a widespread public perception in many countries that the banking and finance industry is to blame. Since banks have been bailed out with taxpayers’ money in the U.S., U.K., France, Germany, Switzerland and the Benelux countries, the media and the public are on alert for any signs that banks are abusing the largesse of citizens by paying themselves too much or by sitting on cash rather than extending badly needed credit. There are plenty of accounts of PR foulups by bankers. On October 24, New York Times journalist Joe Nocera wrote of a conference call with JP Morgan Chase employees, during which the bank reportedly planned to use bailout money to buy weaker banks and grow, rather than to ease the consumer credit crunch. In the U.K., Chancellor of the Exchequer (finance minister) Alistair Darling summoned big bank chiefs to “persuade” them to pass on the benefits of the Bank of England’s historic 1.5 percent point cut in base rates. The banks were reluctant to pass on the cuts. This prompted the chairman of Parliament’s Treasury Select Committee to comment, “They are being short-sighted. Given that they have had copious amounts of money from the taxpayer and are fully guaranteed, it must dawn on them that they have a social responsibility as well. The pressure on them will be maintained until they acknowledge that responsibility.” The net result appears to be a standoff. The financial system is absolutely reliant upon government willingness to step in with bailouts, yet governments are absolutely reliant on banks and financialservices firms to keep money moving through the economy. In May, we asked whether the financial crisis would mean a return to stricter regulation for the banking industry. As of November, there is certainly talk, but the G20 summit of world leaders in Washington resulted in no definitive step forward. A follow-up meeting has been scheduled for April 30, 2009, 101 days after Barack Obama takes office as U.S. President.

Is it possible to design and enforce a global financial system that is more stable than the current one? Will banks cooperate to foster greater stability, or are the interests of global financial institutions now decoupled from the interests of the global economy?

UPDATE: It’s very early to talk
about benefits from a crisis that’s a long way from finished. However, history will likely say that the crisis definitively tipped the 2008 U.S. presidential election in favor of Barack Obama. The more the crisis spiraled, the more commanding Obama’s lead in the polls became.
In May we noted a comment from Roger Martin-Fagg of Henley Business School at the University of Reading in the U.K.: “Power and ownership are shifting eastward.” As developed-world economies of the United States and the European Union struggle to find cash for bailouts, all eyes turn to countries with big cash piles. China and the Gulf States have trillions of dollars in reserves that could enable the IMF to help smaller countries withstand the present turmoil. British Prime Minister Gordon Brown, one of the most proactive world leaders in this crisis, toured the Gulf States in early November to bolster funding for the IMF. At the very least, Gulf economies and China are likely to wield much more authority in global trade and finance talks. In the meantime, down on Main Street it’s hard to see who will benefit from the crisis in the short term, apart from insolvency practitioners and bargain hunters short on debt and long on cash. Still, with auto sales falling dramatically, consumers driving less and economic activity slowing, the environment may be one unintentional beneficiary.

In the meantime the questions on everybody’s mind are: How much worse will it get before it gets better, and how long will that take? And how will we know when the crisis is over?

DURING THE YEARS of economic boom, everyone came to expect high rates of growth, especially in business. Many businesses were
expected by analysts and investors to deliver double-digit growth year in, year out. In many cases, 10 percent annual growth was seen as disappointing, even though that means doubling in size every 10 years. It’s now clear that much of that growth was dependent upon credit, which has now become drastically less available. As long as the downturn continues, it’s highly unlikely that many businesses will be able to achieve even minimal growth. In fact, maintaining business at previous levels will be a major achievement for many. And once economies emerge from the crisis, consumers will need time to regain their confidence. Who will be quick to risk the sort of credit-fueled spending that delivered the big growth in the boom years? This begs the question: Will consumer-focused industries lead the way out of the recession? Which industries will drive future economic growth? U.S. President-elect Barack Obama has a clear view on this issue: “The engine of economic growth for the past 20 years is not going to be there for the next 20. That was consumer spending. … There is no better potential driver that pervades all aspects of our economy than a new energy economy.” In the economies that emerge from the recession, where there is no easy credit to fuel business, what rates of growth will be regarded as reasonable and sustainable? Will the business culture become more prudent and cautious, or will it revert to the harddriving pre-crisis attitudes? And finally, how will the crisis shape the attitudes of Millennials and the generation behind them? They have never experienced a serious economic downturn, let alone one that has generated such widespread fear and angst. Will the experience traumatize them into being cautious and avoiding risk, or will they shrug it off and get back to the future?

The Porter Novelli INTELLIGENTDIALOGUE Principle
WHAT PORTER NOVELLI UNIQUELY OFFERS can be summed up in two words: Intelligent Influence. The basis for

Intelligent Influence is Intelligent Dialogue. As yesterday’s mass media morph into today’s interactive media, people expect to talk back at journalists and opinion leaders. Yesterday’s way was set-piece monologues broadcast to passive audiences by powerful brands and media owners. Today’s way is fluid, evolving dialogues conducted across multiple, linked channels. Ongoing dialogue is now possible and is truly the best basis of dynamic long-term relationships. Easy sound-bite answers are seductive; they give a comforting but illusory sense of resolution. Instead, we need to cultivate open, questioning minds that ask smart, creative questions. Smart questions spark Intelligent Dialogue, open up thinking and tap into the power of many minds.


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