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MASTER’S THESIS IN ACTUARIAL & FINANCIAL SCIENCES

The contagious Effect of the US


Subprime Crisis on Gulf Countries

Presented by
Sana Khelifi
‘When the United States sneezes, the rest of the
world may well catch a cold’ – By Rich Miller

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Presentation Outline

Motivation

 Literature Review

 Contagion channels of the Subprime Crisis

 Evidence of contagion: Gaussian Copula

 Caveats and Conclusion

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Motivation
Since the 1990s, we’ve experienced numerous financial crises:

 The Exchange Rate Mechanism attack – 1992 -93


 East Asian crises – 1997
 Russian Collapse and LTCM – 1998
 Brazilian devaluation – 1999
 IT bubble - 2000-01
 US Sub-prime mortgage crisis – 2007
 Aftermath of sub-prime mortgage crises – Early 2008-09!!

 Each crisis spreads around like a contagious disease


sometimes without any fundamental explanation

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Motivation
Contagion?
 The situation in which a faltering economy in one country
causes otherwise healthy economies in other countries to
have financial problems
 “..a significant increase in cross-market linkages after a
shock to one country (or group of countries)” – Forbes &
Rigobon (2001)

Subprime, Contagion…Gulf?
 The Subprime crisis  although originated in a very
specific and relatively small segment of the US mortgage
market, it has spread across the borders.
 The limited gulf exposure to Subprime instruments (S&P).
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Motivation
Gulf Stock Market Crash

Gulf Stock market


Oil pricesfell over 40 %
KSE fell over
75%DFM
ADI

TASI
 Gulf as an oil-based state?

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Motivation
Subprime Crisis – Oil freefall

Oil prices
KSE fell over
75%DFM
ADI

TASI

 Gulf as an oil-based state?


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Motivation

Is the US Subprime Crisis contagious to Gulf Market??

 What are the potential channels that could move


the US Subprime to Gulf market?
 Assuming the definition of Forbes & Rigobon, is
there any significant change in dependence
structure between US and Gulf market after the
Subprime burst?
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Literature Review
 Fundamental-Based Contagion (non-crisis contingent theories)
 It consists of real linkages and interdependencies that already exist
before crisis:

 Trade links: country crisis effect on its trading partners’


accounts

 Financial links: cross-country investments

 Common and random shocks: interest rate surge, oil prices


volatility…

 Policy coordination: effect of a member country shock on other


members
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Literature Review
 Pure /Psychological Contagion (crisis
contingent theories)

 It consists of channels that differ from those


before crisis:

 Multiple Equilibrium - Change in investor’s

expectation

 Endogenous Liquidity shocks - Portfolio re-allocation

 Political contagion
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Literature Review
Detection method of contagion?

 Fundamental-based contagion measures : Testing the significance of


each fundamental transmission channel using binary probit model -
Eichengreen and al. (1996)
 Pure contagion measures: Testing the structural change in transmission
mechanisms
 GARCH & ARCH models – testing the volatility spillover across market -
Edwards (1998)
 Dependence measures – testing the change in dependencies after
shock
• Pearson’s linear correlation - King and Wadhwani (1990)
• Conditional correlation - shift contagion - Forbes & Rigobon (2000)
• Copula approach – Paulo et al. (2009) & Rodriguez (2006)
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Subprime Contagion: Fundamental-based
contagion
 Financial links – The securitization and its domino effect

Housing Prices Decline Subprime Borrower


ARM resets
Stop Repayment: Mortgage
Loans Mortgage Delinquencies & Foreclosures
Mortgage Cash Flow Subprime Lender
declines
Proceeds Sales of loans Loans

SPV

Securitization

Investors

-Losses on MBS & CDO


-CDS Losses
Banks -Asset Prices Collapse Pension Funds
-Wave of Corporate defaults
Hedge Funds -Meltdown in the "Shadow financial Insurance
system" Companies
-Drying-up of liquidity and capital
=> Vicious circle of losses, capital fall,
and credit tightening forced the liquidation
and fire sales of assets at below
fundamental prices 12
Fundamental-based contagion -
Financial links
GCC real estate price index GCC credit default swaps
IM
IM IM
IM
FF F
F

G ulf Sovereign Wealth Funds Losses Gulf Banks Write-downs GRC


GR
D ec 2008 Estimates
C
Gulf Ba nk, Kuw a it 740
-12% S AM A
Ara b Ba nking Corporation 1200
-30% QIA
Gulf Inte rna tiona l Bank 966

-36% Norw e gia n Oil Fund Gulf Inve stme nt Corp. 446

-40% KIA Abu Dha bi Com me rcial Ba nk 272

-41% ADIA
0 200 400 600 800 1000 1200 1400
-50% -40% -30% -20% -10% 0% M illion $

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Fundamental Based-contagion
Trade Links

1500

1000

500

-500

-1000

-1500

-2000
North Europe Formers Middle East Asia Latin Africa
America Soviet Union America

2007 2008 2009

Oil demand down,…


Source:
Fundamental-based contagion
Common Aggregate shock
 The Fed Interest rate hike

 rising of spreads and finance costs, Loans Defaults –

Credit default swaps hike

 Weak US dollar - GCC currencies peg to US dollar

 Oil prices fall - Gulf as oil-based states

 Growing Inflation

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Pure / Psychological contagion

ChangeInStockMarketIndices IMF

-42% Bahrain

-44% Abu Dhabi

-46% S&P500

-47% Kuwait

-49% Oman

-50% Qatar

-57% Saudi Arabia

-73% Dubai

-80% -70% -60% -50% -40% -30% -20% -10% 0%

 Gulf investors sensitivity to signs of economic


weakness
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Evidence of contagion -
Gaussian Copula
 Data: daily return indices issued from the US stock
market and three other GCC markets: S&P500, DFM, KSE
and TASI index
 Period: 1st of January 2005 to the 05th of February 2009
S&P500 DFM
 Numbers of Observations: KSE TASI
Total Nos. of 1031 1097 1055 1089
Obs.
Pre-crisis. Nos. 649 729 663 715
Crisis Nos. 382 368 392 374

 Programming tool: Matlab (v 7.0)

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Data analysis
Daily return indices

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Data analysis
 Descriptive Statistics
S&P500 DFM KSE TASI
Mean. -0.0003 -0.00029 -0.00017 -0.00012
Std. 0.0146 0.0179 0.0079 0.0186
Kurtosis 16.1492 10.9134 9.4178 9.4983
Skewness -0.345 -0.0132 -0.7957 -0.7822

 Histograms goodness of fit


h
is
tog
ra
mmeD
MF h
is
tog
ra
mmeK
SE
1
00 1
00

8
0 8
0

6
0 6
0

4
0 4
0

2
0 2
0

0 0
-0
.2 -0
.1
5 -0
.1 -0
.0
5 0 0
.0
5 0
.1 0
.1
5 -0
.0
4 -0
.0
3 -0
.0
2 -0
.0
1 0 0
.0
1 0
.0
2 0
.0
3 0
.0
4 0
.0
5 0
.0
6

h
is
tog
ra
mleT
ASI h
is
tog
ra
mmeS
P50
0
1
20 2
00

1
00
1
50
8
0

6
0 1
00

4
0
5
0
2
0

0 0
-0
.1
5 -0
.1 -0
.0
5 0 0
.0
5 0
.1 -0
.1 -0
.0
5 0 0
.0
5 0
.1 0
.1
5

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Methodology

 Select the Univariate Distribution Functions


appropriate for each index: We test the Gaussian & t-
student functions
 Select the appropriate copula to Join the marginal
distributions taken in step1
 Divide the series into two sub-periods: “pre-crisis
period” and “crisis period”
 Estimate the parameters of the selected copula taken
in step 2
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Results
 T-student function has been selected as the adequate
univariate distributions for all of the indices (as shown
the qqplot below and as per the Maximum likelihood
estimations) D
N
M
o
Fd
rma
ata
le
T
ASIdata
N
orma
lT ASI
s
tud
ent 0
.9999
0
.9999 0
.9995 S
tud
entTASI
0
.9
0 9
.99
95
9
0.99
9
0.995 0.99
5
0.99 0.9
9
0.95 0
.95
0.9
Probability

0.9

Probability
0.75 0
.75
0.5
0
.5
0.25
0.1 0
.25
0.05
0.1
00.0
.001
5 0
.05
0
0.0
.00
0
01
5 0.0
1
0
.00
01
0.00
5
0.00
1
0
.0005
0
.0001

-0
.1 -0
.0
5 0 0
.0
5 0
.1
D
ata -0
.1 -0
.0
8 -0
.0
6 -0
.0
4 -0
.0
2 0 0
.0
2 0
.0
4 0
.0
6 0
.0
8
D
ata

SPd ata K
SEd a ta
Norma lS
P S
tud
ent
stud
en tSP N
ormal
0
.9999
0
.9
0 9
.99
95
9
0
.9999
0
.9
0 9
.99
95
9 0.995
0.995 0.9
9
Probability
Probability

0.9
9
0.95 0
.95
0.9 0.9
0.75 0
.75
0.5
0
.5
0.25
0.1 0
.25
0.05
0.01 0.1
0.005 0
.05
0
0.
.00
001
0
5
0
.00 0
1 0.0
1
0.005
0
0.0
.000
01
5
0
.0001

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-0
.08 -0
.06 -0
.04 -0
.02 0 0
.02 0
.04 0
.06 0
.08 0
.1 -0
.03 -0
.02 -0
.01 0 0
.01 0
.02 0
.03 0
.04 0
.05
Data D
ata
Results
 Gaussian Copula has been selected as per the scatter plot
of indices.
SP500 vs DMF SP500 vs TASI

15.00% 15.00%

10.00% 10.00%

5.00% 5.00%

TASI
DMF

0.00% 0.00%

-5.00% -5.00%

-10.00% -10.00%

-15.00% -15.00%
-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00%

SP500 SP500

SP500 vs KSE

10.00%

• The set of points is highly


5.00%
concentrated and centered
KSE

0.00%
•The scatter of the points seems to
-5.00%
-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00%
be relatively alike in the left and
SP500
upper tail 22
Results
 Based on the fundamental event (burst of the subprime
bubble) and the empirical perception shown below, the 1st
of August 2007 has been chosen as the structural break
date separating between the pre-crisis period and the crisis
period.

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Results
Estimated copula parameters
Whole period Pre-crisis period Crisis period

DFM 0.0257 -0.037 0.0772

KSE 0.0379 0.0044 0.0772

TASI 0.0505 -0.0119 0.1285

 Copula parameters have increased significantly from the


pre-crisis to crisis period for all the indices under
investigation.

 Saudi Market displays stronger signs of contagion

 There is an evidence for the presence of contagion 24


between the American Market and the Gulf markets
Caveats and Conclusion
 This study tests for financial contagion impact of the US Subprime

crisis on Gulf economies both theoretically and empirically.

 Theoretically, it investigates the possible connections that could

move the Subprime crisis to the Gulf market, by identifying the

bridge of channels between the US and GCC countries.

 Fundamental channels: the securitization, oil channel and some

other commons shocks like the Fed interest rate and the US dollar.

 Psychological channels: the herding behavior due to the shift in

investor sentiment which is manifested by the massive liquidation

and capital outflows.

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Caveats and Conclusion
 Empirically, Gaussian Copula has been used to analyze the
change in dependence structure from the pre-crisis to the crisis
period. Results show significant level of contagion in Kuwait,
Dubai stock markets and Saudi market which displays the
strongest level.
 Contagion signs should be taken into consideration by the
portfolio managers (ineffectiveness of the diversification
strategies)
 Our results can be handy for Gulf central banks who decide for the
bailout.
 Some limits:
Theoretically: Lack of transparency and sophistication in gulf
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markets