Chapter 5

Current Multinational Financial Challenges: The Credit Crisis of 2007-2009

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The Seeds of Crisis: Sub-Prime Debt
• The origins of the current crisis lie within the ashes of the equity bubble and subsequent collapse of the equity markets at the end of the 1990s • With the collapse of the dot.com bubble, capital began to flow increasingly toward the real estate sectors in the United States • The U.S. banking sector found mortgage lending highly profitable and saw it as a rapidly expanding market

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The Seeds of Crisis: Sub-Prime Debt (cont’d)
• As a result, investment and speculation in the real estate sector increased rapidly • As prices rose and speculation continued, a growing number of the borrowers were of lower and lower credit quality • These borrowers, and their associated mortgage agreements (sub-prime debt), now carried higher debt service obligations with lower and lower income and cash flow capabilities

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Deregulation
• Markets were becoming more competitive than ever as a result of a number of deregulation efforts in the United States • The repeal of the Glass-Steagall Act of 1933 eliminated the last barriers between commercial and investment banks, allowing commercial banks to enter areas of more risk • Increased deregulation also put pressure on existing regulators such as the Federal Deposit Insurance Corporation (FDIC)

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The Housing Sector and Mortgage Lending • New market openness and competitiveness allowed many borrowers to qualify for mortgages that they would not have qualified for previously • Structurally, some mortgages re-set a high interest rates after a few years or had substantial step-ups in payments after an initial period of interest-only payments

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S. marketplace are normally categorized (in increasing order of riskiness) as: – Prime (or A-paper) – Alt-A (Alternative A-paper) – Sub-prime • The sub-prime category is difficult to define. 5-6 .Credit Quality • Mortgage loans in the U. it reflects borrowers who do not meet underwriting criteria and have a higher perceived risk of default normally as a result of credit history Copyright © 2010 Pearson Prentice Hall. • In principle. All rights reserved.

and carry significantly higher interest rate spreads over the floating bases such as LIBOR • Sub-prime borrowers typically pay a 2% premium over prime – the subprime differential Copyright © 2010 Pearson Prentice Hall.Credit Quality • Sub-prime mortgages are nearly exclusively floating-rate structures. 5-7 . All rights reserved.

Credit Quality • Subprime lending was itself the result of deregulation • Growing demand for loans or mortgages from sub-prime borrowers led more and more originators to provide the loans at above market rates • Sub-prime loans became a growing segment of the market by the 2003-2005 period Copyright © 2010 Pearson Prentice Hall. 5-8 . All rights reserved.

. driven by additional fee income. All rights reserved.Asset Values • One of the key financial elements of this growing debt was the value of the assets collateralizing the mortgages – the houses and real estate itself • As the market demands pushed up prices. pushed for continued refinancings 5-9 Copyright © 2010 Pearson Prentice Hall. housing assets rose in market value • The increased values were then used as collateral in re-financings or second mortgages • Many mortgage holders became more indebted and participants in more aggressively constructed loan agreements • Mortgage brokers and loan originators.

The Transmission Mechanism: Securitization • The transport vehicle for the growing lower quality debt was a combination of securitization and repackaging provided by a series of new financial derivatives • Securitization. All rights reserved. at fair market value. long a force of change in global financial markets. a liquid asset is one that can be exchanged for cash. • In finance. is the process of turning an illiquid asset into a liquid saleable asset. instantly. 5-10 . Copyright © 2010 Pearson Prentice Hall.

2 Household Debt as a Percentage of Disposable Income. 1990-2008 Copyright © 2010 Pearson Prentice Hall.Exhibit 5. 5-11 . All rights reserved.

and its growth has been unchecked since. to go direct to investors in the marketplace to raise funds. debt markets. All rights reserved. • In its purest form. mortgage-backed securities (MBSs) and asset-backed securities (ABSs). auto loans. • Asset-backed securities included second mortgages and home-equity loans based on mortgages. and a variety of others.S.The Transmission Mechanism: Securitization • The 1980s saw the introduction of securitization in U. • Securitized assets took two major forms. in addition to credit card receivables. Copyright © 2010 Pearson Prentice Hall. 5-12 . securitization essentially bypasses the traditional financial intermediaries (typically banks).

The Transmission Mechanism: Securitization • The credit crisis of 2007-2008 renewed much of the debate over the use of securitization. • Securitization had historically been viewed as a successful device for creating liquid markets for many loans and other debt instruments. Copyright © 2010 Pearson Prentice Hall. securitization may ultimately degrade credit quality as lenders or originators of loans would not be held accountable for the borrower’s ultimate capability to repay the loans. • However. All rights reserved. 5-13 . • Critics of securitization argue that securitization provides incentives for rapid and possibly sloppy credit quality assessment.

dollars) Copyright © 2010 Pearson Prentice Hall.Exhibit 5. 5-14 . All rights reserved.3 Securitized Loans Outstanding (trillions of U.S.

• The funding of the typical SIV was fairly simple: using minimal equity. the SIV borrowed very short (commercial paper. filling the market niche as buyer for much of the securitized non-conforming debt.Structured Investment Vehicles • The structured investment vehicle (SIV) was the ultimate financial intermediation device. 5-15 . acting as middleman) Copyright © 2010 Pearson Prentice Hall. interbank or medium-term notes). All rights reserved. • SIV’s used these proceeds to purchase portfolio’s of higher yielding securities which held investment grade credit ratings (generating an interest margin.

4 Structured Investment Vehicles (SIVs) Copyright © 2010 Pearson Prentice Hall. All rights reserved. 5-16 .Exhibit 5.

earning a variety of fees. • Banks originating mortgage loans. • Once packaged. All rights reserved. and corporate loans and bonds. could now create a portfolio of these debt instruments and package them as an asset-backed security. 5-17 . the CDO was sold into a growing market through underwriters freeing up the bank’s financial resources to originate more and more loans. the bank passed the security to a special purpose vehicle (SPV). • From there. Copyright © 2010 Pearson Prentice Hall.Collateralized Debt Obligations • One of the key instruments in the growing market of securitized products was the collateralized debt obligation or CDO.

combinations of bonds were able to achieve higher ratings than any of the individual bonds – a confounding issue. • The actual marketing and sales of the CDOs was done by the major investment banking houses. and equity tranches (below BB or junk status). All rights reserved. often without undertaking the typical ground-up credit analysis themselves. • Further. • CDOs would be rated by rating agencies. Copyright © 2010 Pearson Prentice Hall. 5-18 . mezzanine or middle tranches (AA down to BB).Collateralized Debt Obligations • CDOs were sold to the market in categories representing the credit quality of the borrowers in the mortgages – senior tranches (rated AAA).

All rights reserved.5 The Collateralized Debt Obligation Copyright © 2010 Pearson Prentice Hall. 5-19 .Exhibit 5.

• Invented in 1997. • In short. 5-20 Copyright © 2010 Pearson Prentice Hall. a derivative. All rights reserved. which derived its value from the credit quality and performance of any specified asset. it was a way to bet whether a specific mortgage or security would either fail to pay on time or fail to pay at all. the CDS was designed to shift the risk of default to a third-party. it provided insurance against the possibility that a borrower might not pay. • For hedging. .Credit Default Swaps • The credit default swap (CDS) is a contract. • It was also a way in which a speculator could bet against the increasingly risky securities (like the CDO) to hold their value.

Credit Default Swaps • The CDS was completely outside the regulatory boundaries. • Participants simply have to have a viewpoint. Copyright © 2010 Pearson Prentice Hall. reducing incentives to screen and monitor the ability of borrowers to repay. 5-21 . • CDSs actually allow banks to sever their links to their borrowers. All rights reserved. do not have to have any actual holdings or interest in the credit instruments at the center of the protection. protection buyers and protection sellers. • Participants in the market.

All rights reserved. the protection seller must fulfill its obligation to make a settlement payment to the protection buyer. • If there is no significant negative credit event during the term of the contract. Copyright © 2010 Pearson Prentice Hall.Credit Default Swaps • A buyer of a credit default swap makes regular nominal premium payments to the seller for the length of the contract. the protection seller earns its premiums over time. never having to payoff a significant claim. • If a credit event occurs however. 5-22 .

there was no real record or registry of issuances.Credit Default Swaps • As a result of the CDS market growth in a completely deregulated segment. • New proposals for regulation have centered first on requiring participants to have an actual exposure to a credit instrument or obligation. and no real market for assuring liquidity – depending on one-toone counterparty settlement. no requirement on writers and sellers that they had adequate capital to assure contractual fulfillment. All rights reserved. Copyright © 2010 Pearson Prentice Hall. 5-23 . and the formation of some type of clearinghouse to provide systematic trading and valuation of all CDS positions at all times. eliminating outside speculators.

• Bond insurance agencies were utilized as guarantors in the case of default. • Credit enhancement is the method of making investment more attractive to prospective buyers by reducing their perceived risk. 5-24 . • Beginning in 1998 a more innovative approach to credit enhancement was introduced in the form of subordination. All rights reserved. • This was the process of combining different asset pools of differing credit quality into different tranches by credit quality. Copyright © 2010 Pearson Prentice Hall.Credit Enhancement • A final element quietly at work in credit markets beginning in the late 1990s was the process of credit enhancement.

All rights reserved. 5-25 .9 CDO Construction and Credit Enhancement. Copyright © 2010 Pearson Prentice Hall.Subordination for Credit Enhancement in CDO Tranches EXHIBIT 5.

5-26 . Copyright © 2010 Pearson Prentice Hall. All rights reserved. with oil and commodity prices peaking.The Crisis of 2007 and 2008 • The housing market began to falter in late 2005. with the bubble finally bursting in 2007. then plummeting. • 2008 proved even more volatile. • Global in scope. • Starting with hedge funds at Bear Stearns and the rescue of Northern Rock. the global financial markets slid toward near panic. a domino effect ensued with collapsing loans and securities being followed by the funds and institutions which were their holders.

one of the oldest investment banks on Wall Street struggled to survive. 5-27 .The Crisis of 2007 and 2008 • In September 2008. Lehman Brothers. • Over the following week. eventually filing for the largest single bankruptcy in American history on September 14. the US government announced it was placing Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) into conservatorship. All rights reserved. Copyright © 2010 Pearson Prentice Hall.

who had extensive credit default swap exposure. Copyright © 2010 Pearson Prentice Hall. • The following day. American International Group (AIG). received an $85billion injection from the US Federal Reserve in exchange for an 80% equity interest. • Periods of collapse and calm followed with the credit crisis beginning in full force as the worlds credit markets – lending of all kinds – nearly stopped. equity markets plunged and US dollar LIBOR rates shot skywards as a result of the growing international perception of financial collapse by US banking institutions. All rights reserved. 5-28 .The Crisis of 2007 and 2008 • The following day.

• Capital invested in equity and debt instruments in all major financial markets fled not only for cash.Global Contagion • Although it is difficult to ascribe causality. but for cash in traditional safe-haven countries and markets. the rapid collapse of the mortgage-backed securities markets in the United States definitely spread to the global marketplace. Copyright © 2010 Pearson Prentice Hall. • Equity markets fell worldwide. • Currencies of the more financially open emerging markets felt a significant impact. All rights reserved. emerging markets were hit particularly hard. 5-29 .

Global Contagion • By January 2009. All rights reserved. corporates failed to see returns on investments. the credit crisis was having additionally complex impacts on global markets – and global firms. • As a result there was widespread retrenchment among industrialized nations as corporates slashed budgets and headcount. • Constricted lending had impacted borrowing and importantly investing. • The crisis. Copyright © 2010 Pearson Prentice Hall. which began in the summer of 2007 had now moved to a third stage. • Prospects for investment returns of all types were dim. that of potential global recession of depression-like depths. 5-30 .

• When markets are in crisis. establishing a value can be a very difficult task.Mark-to-Market Accounting • One of the continuing debates about the global credit crisis is whether the use of mark-to-market accounting contributed significantly to the failure of financial institutions. the method requires that a financial institution re-value all financial assets and derivatives daily. • The problem is that many instruments do not trade in markets. 5-31 . All rights reserved. • A long-term practice of the futures markets. or trade only in very thin markets. Copyright © 2010 Pearson Prentice Hall. even though there is no intention to liquidate the asset at that time.

All rights reserved. increasing focus on each individual institution and its particular credit risk profile. • In the summer of 2007 however. Copyright © 2010 Pearson Prentice Hall. 5-32 .What’s Wrong with LIBOR? • The global financial markets have always depended upon commercial banks for their core business activity. • The banks in turn have depended on the interbank market for liquidity which had historically operated on a “no-names” basis but rather a tiered basis with respect to individual banks. much of this changed.

5-33 . • The banks in turn have depended on the interbank market for liquidity which had historically operated on a “no-names” basis but rather a tiered basis with respect to individual banks.LIBOR’s Role • The global financial markets have always depended upon commercial banks for their core business activity. All rights reserved. • In the summer of 2007 however. increasing focus on each individual institution and its particular credit risk profile. Copyright © 2010 Pearson Prentice Hall. much of this changed.

5-34 .12 LIBOR and the Crisis in Lending Copyright © 2010 Pearson Prentice Hall. All rights reserved.Exhibit 5.

LIBOR rates have the potential to cause significant disruptions when they skyrocket as they did in September 2008. Copyright © 2010 Pearson Prentice Hall. the organization charged with the daily tabulation and publication of LIBOR Rates.LIBOR’s Role • The British Bankers Association. 5-35 . many corporate borrowers began to publicly argue the LIBOR rates published were in fact understating their problems. • The growing stress in the financial markets had actually created incentives for banks surveyed for LIBOR calculation to report lower rates than they were actually paying. • In its role as the basis for all floating rate debt instruments of all kinds. • As the crisis deepened. became worried about the validity of its own published rate. All rights reserved.

Dollar TED Spread (July 2008–January 2009) Copyright © 2010 Pearson Prentice Hall.S.Exhibit 5.13 The U. All rights reserved. 5-36 .

the Bank for International Settlements in Basle. • The study described the risk premium added to interbank quotes as: Risk Premium = Term Premium + Credit Premium + Bank Liquidity + Market Liquidity + Micro Copyright © 2010 Pearson Prentice Hall. Switzerland. 5-37 . had published a study of the LIBOR market’s behavior of late.LIBOR’s Elements • Amidst the credit crunch of 2007 and 2008. All rights reserved.

All rights reserved. 5-38 .LIBOR’s Elements • The term premium is a charge for maturity • The credit premium is a charge for the perceived risk of default by the borrowing bank • Bank liquidity premium is the access of the individual lending bank to immediate funds • The market liquidity premium is a measure of general market liquidity • A micro premium is a charge representative of the market micro-structure of how banks conduct interbank lending Copyright © 2010 Pearson Prentice Hall.

5-39 . on one end that capitalism has failed. what practical solutions fall in between? Copyright © 2010 Pearson Prentice Hall. and on the other end that extreme regulation is the only solution.The Remedy: Prescriptions for an Infected Global Financial Organism • So where now for the global financial markets? • Dismissing the absolute extremes. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. 5-40 . All rights reserved. – Of greater concern was the originate-to-distribute behavior combined with questionable credit assessments and classifications. – New guidelines for credit quality and access to mortgages is already underway.The Remedy: Prescriptions for an Infected Global Financial Organism • Debt – Was the mortgage boom the problem? – The market boom was caused as a result of the combination of few competing investments with the low cost and great availability of capital.

The Remedy: Prescriptions for an Infected Global Financial Organism • Securitization – Was the financial technique of combining assets into packaged portfolios for trading the problem. 5-41 . the portfolio components were so similar that the only benefit was that the holder hoped that all the same securities would not fall into delinquency simultaneously Copyright © 2010 Pearson Prentice Hall. All rights reserved. or the lack of transparency and accountability for the individual elements within the portfolio? – Portfolio theory had been constructed on the basis of assets with uncorrelated movements – In the case of mortgage-backed securities.

The Remedy: Prescriptions for an Infected Global Financial Organism • Derivatives – This is not the first time that derivatives have been at the source of substantial market failures. was in hind-sight a very poor choice. derivatives are the core of financial technological innovation. All rights reserved. 5-42 . – Renewed regulatory requirements and increased transparency in pricing and valuation will aid in pulling derivatives back from the brink. – The creation of complex mortgage-backed assets and derivative structures which ultimately made the securities nearly impossible to value. Copyright © 2010 Pearson Prentice Hall. particularly in thin markets. – However.

– Certain corrections have clearly been needed from the beginning. many argue over the degree and type of regulation that should be imposed on financial markets. 5-43 . and deregulation has the tendency to put very dangerous tools and toys in the hands of the uninitiated.The Remedy: Prescriptions for an Infected Global Financial Organism • Deregulation – Regulation itself is complex enough in today’s rapidly changing financial marketplace. – Today. Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Copyright © 2010 Pearson Prentice Hall. All rights reserved. – Dilemmas of countries such as Iceland and New Zealand are only the beginning of this phenomena. 5-44 .The Remedy: Prescriptions for an Infected Global Financial Organism • Capital Mobility – Capital is more mobile today than ever before. – The combination of global capital markets of size never seen before combined with more and more economic systems around the globe which are pursuing market economic solutions to both wealth and social ills will continue to act as the elephant in the row boat.

– Most of the mathematics and rational behavior behind the design of today’s sophisticated financial products. – When the trading of highly commoditized securities or positions as clean as overnight bank loans between banks becomes the core source of instability in the system then all traditional knowledge and assumptions of finance have indeed gone out the window. 5-45 .The Remedy: Prescriptions for an Infected Global Financial Organism • Illiquid Markets – This finally. and investment vehicles are based on principles of orderly and liquid markets. derivatives. All rights reserved. Copyright © 2010 Pearson Prentice Hall. will be the most troublesome.

not less. Government treated some financial institutions differently during the crisis? What that appropriate? • Many experts argue that when the government bails out a private financial institution it creates a problem called “moral hazard. What do you think? • Do you think that the U. it actually has an incentive to take on more risk. 5-46 .S. government should have allowed Lehman Brothers to fail? Copyright © 2010 Pearson Prentice Hall.S.” meaning that if the institution knows it will be saved. All rights reserved.Mini-Case: Letting Go of Lehman Brothers • Do you believe that the U.

. All rights reserved.Chapter 5 Additional Chapter Exhibits Copyright © 2010 Pearson Prentice Hall.

Exhibit 5. All rights reserved.S.1 U.1] Copyright © 2010 Pearson Prentice Hall. Financial Assets as a Percent of GDP [Insert Exhibit 5. 5-48 .

dollars) [Insert Exhibit 5. All rights reserved.6 Global CDO Issuance.Exhibit 5.6] Copyright © 2010 Pearson Prentice Hall. 5-49 . 2004–2008 (billions of U.S.

5-50 .Exhibit 5.7 Cash Flows under a Credit Default Swap Copyright © 2010 Pearson Prentice Hall. All rights reserved.

All rights reserved.8 Credit Default Swap Market Growth Copyright © 2010 Pearson Prentice Hall. 5-51 .Exhibit 5.

Exhibit 5. All rights reserved. 5-52 .10 USD & JPY LIBOR Rates (September—October 2008) Copyright © 2010 Pearson Prentice Hall.

Exhibit 5. 5-53 . All rights reserved.11 Selected Stock Markets during the Crisis Copyright © 2010 Pearson Prentice Hall.

14 Three-Month Money Market and Credit Spreads (Bank for International Settlements) in Basis Points Copyright © 2010 Pearson Prentice Hall.Exhibit 5. All rights reserved. 5-54 .

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