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Dr Kevin Campbell. CORPORATE FINANCE. LECTURE 2: UNDERSTANDING THE FINANCIAL CRISIS. March 2011. Overview. The causes of the financial crisis What were the key factors? Key consequences of the financial crisis Will future crises be prevented?. International financial crises. - PowerPoint PPT PresentationTRANSCRIPT
1 Dr Kevin Campbell, Corporate Finance, 2011
Dr Kevin Campbell
LECTURE 2: UNDERSTANDING THE LECTURE 2: UNDERSTANDING THE FINANCIAL CRISISFINANCIAL CRISIS
CORPORATE FINANCECORPORATE FINANCE
March 2011
2 Dr Kevin Campbell, Corporate Finance, 2011
Overview
The causes of the financial crisis What were the key factors?
Key consequences of the financial crisis Will future crises be prevented?
3 Dr Kevin Campbell, Corporate Finance, 2011
International financial crises
In recent history ...
The US stock market crash of 1987 The US savings and loans crisis of 1986 -96 The Japanese property and banking crisis of 1990 -2000 The EMS crisis in Europe 1992 The Mexico crisis of 1994-95 The Asian crisis of 1997-98 The Russian crisis of 1998 The dot.com crisis 2000 – 2002 The Argentina crisis of 2001
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What is new today?
All previous financial crises were regional or local crises In all previous financial crises the effects could be
contained The present financial crisis is the first truly global crisis It affected all stock markets in the world at more or less the
same time It affected all internationally operating banks and
institutional investors There are no safe havens
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The day the financial world changed: Monday September 15 2008
From credit crunch to financial crisis
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Source: BBC News, Global downturn: In graphics, 19 March 2009, http://news.bbc.co.uk/2/hi/business/7893317.stm
FINANCIALCRISIS: MAJOR VICTIMS
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Source: BBC News, Follow the Money, 10 September 2009, http://news.bbc.co.uk/1/hi/business/8249411.stm
FINANCIAL CRISIS: THE COST
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Source: The World bank, Global Economic Prospects – Global Headwinds and Recovery, Volume 1, Summer 2010, Washington, D.C., June 2010.
FINANCIAL CRISIS: THE COST
3 month annualized growth rate of industrial production3 month annualized growth rate of industrial production
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The death of the Anglo-American The death of the Anglo-American corporate governance model?corporate governance model?
The nationalisation of Wall Street?
orThe privatisation of
Government?
Socialism for the rich?
Moral Hazard
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Moral Hazard
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Moral Hazard
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September 2007
Made in America …Made in America …
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2004 – a critical year Bush Administration ‘American Dream’ mortgage proposals
introduced helping low-income families to obtain mortgages
Greater capital requirements placed on Fannie Mae and Freddie Mac Opening up the mortgage market to investment banks
SEC allowed investment banks to increase their leverage ratios ... from 15:1 to 40:1 ‘consolidated supervised entities program’
Basel II capital adequacy rules published
Sources of the crisisSources of the crisis
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NINJA
= No Income, No Jobs, No Assets
Sub-prime
Prime mortgages = A paper More risky = Alternative A-paper (Alt-A) Most risky = Sub-prime mortgages Most common subprime mortgage product = Hybrid
Adjustable Rate Mortgage or hybrid ARM (HARM)
EXAMPLE: the 2/28 hybrid
a two-year fixed ‘teaser rate’ followed by a 28-year ARM
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Why did banks take the risk?
1. U.S. house prices were rising» so, if borrowers defaulted, originators repossess houses,
sell them and recoup the loan advanced
2. Banks did not keep the loans » sold them to investors using the originate and distribute
model of securitisation» risk was sliced and diced, allowing many of the Asset
Backed Securities to be classed as AAA credits
Sub-prime
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Traditional model Originate to Hold
Securitised model Originate to Distribute
Models of credit Models of credit intermediationintermediation
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Securitised forms of credit intermediation have existed since the 1970s
Growth greatly expanded in the late 1990s in both the US and the UK
... accompanied by growth in complexity of ‘structured products’
SecuritisationSecuritisation
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Pass the parcel …. Asset Backed Securities
Pool of assets put into separate legal entity - Structured Investment Vehicle (SIV)
Repackaged into “tranches” Each tranche has different coupon
rate and credit rating Loss in total pool of assets will hit
lowest tranche first Sold to investors Approx. 1/4 of Asset Backed
Securities (ABS) pool consists of subprime loans
corporate bondscredit card loans
auto loansmortgage loans(incl. subprime)
Assets
AAA
A BBB
Equity
Liabilities
Loss
AA
How do ‘toxic’ loans get AAA ratings?How do ‘toxic’ loans get AAA ratings?
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Double Bubble
Securitized Residential Mortgages Outstanding
Quarterly change at annual rates
-300
-200
-100
0
100
200
300
400
500
600
90 92 94 96 98 00 02 04 06 08
U.S
.$ b
illio
ns
Source: Federal Reserve, NBF Financial
S&P/Case-Shiller U.S. Home Price Index
-15
-10
-5
0
5
10
15
20
25
87 89 91 93 95 97 99 01 03 05 07
% c
han
ge
year
-ove
r-ye
ar
Source: MacroMarkets LLC
Bubble in Housing and Securitization
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Foreclosure ...Foreclosure ...
Question: how do you spot a repossessed home?
Answer: by the colour of its front lawn
Whenever you see a brown lawn, it’s a foreclosure
Stockton, California, USA sub-prime mortgage capital of
the world
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Mortgages turn toxicMortgages turn toxic
A, AA and AAA tranches of mortgage-backed securities start to suffer losses
..... banks restrict credit
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The sub-prime virusThe sub-prime virus
SOURCE: Bank of England, Financial Stability Report, No. 23, May 2008
Estimated loss of market value of US sub-prime mortgage-backed securities
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A credit default swaps (CDS) is financial instrument for swapping the risk of debt default
CDS may be used for various classes of bonds (corporate, sovereign)
The buyer of a CDS pays a premium for effectively insuring against a debt default» receives a lump sum payment if the debt instrument is defaulted.
The seller of a CDS receives monthly payments from the buyer» If the debt instrument defaults they have to pay the agreed amount
to the buyer of the CDS The CDS market functions over-the-counter (OTC) – this
offers greater flexibility but lacks the regulatory control of exchange trading
A credit default swaps (CDS) is financial instrument for swapping the risk of debt default
CDS may be used for various classes of bonds (corporate, sovereign)
The buyer of a CDS pays a premium for effectively insuring against a debt default» receives a lump sum payment if the debt instrument is defaulted.
The seller of a CDS receives monthly payments from the buyer» If the debt instrument defaults they have to pay the agreed amount
to the buyer of the CDS The CDS market functions over-the-counter (OTC) – this
offers greater flexibility but lacks the regulatory control of exchange trading
Credit Default SwapsCredit Default Swaps
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EXAMPLE Agreed CDS rate is 5% Amount of referenced debt is USD 100 million The annual protection fee is USD 5 million In the event that the named borrower, say Greece, defaults
on its debt, the seller of protection then gives the buyer of protection the difference between the referenced amount of debt and the market value of the defaulted debt
For example, if the referenced USD 100 million in debt defaults and as a result has a market value of only USD 30 million, then the buyer of protection would collect USD 70 million from the seller of protection
EXAMPLE Agreed CDS rate is 5% Amount of referenced debt is USD 100 million The annual protection fee is USD 5 million In the event that the named borrower, say Greece, defaults
on its debt, the seller of protection then gives the buyer of protection the difference between the referenced amount of debt and the market value of the defaulted debt
For example, if the referenced USD 100 million in debt defaults and as a result has a market value of only USD 30 million, then the buyer of protection would collect USD 70 million from the seller of protection
Credit Default SwapsCredit Default Swaps
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The Monster That Ate Wall Street CDS were invented in the mid 1990s by JP Morgan The Problem: JP Morgan client Exxon needed to open a line of credit to cover
potential damages of five billion dollars (later reduced to one billion) resulting from the 1989 Exxon Valdez oil spill
The deal would tie up a lot of JP Morgan’s reserve cash to provide for the risk of the loans going bad under the Basel capital adequacy rules: banks were required to hold eight per cent of their capital in reserve against the risk of outstanding loans
But, if the risk of the loans could be sold, it logically followed that the loans were now risk-free; and, if that were the case, what would have been the reserve cash could now be freely loaned out
The Solution: the first CDS The credit risk was sold to the European Bank of Reconstruction and
Development (EBRD) which received a fee in return from J. P. Morgan Thus: Exxon got its credit line, J. P. Morgan got to honour its client relationship
with Exxon but also to keep its credit lines intact for other activities
The Monster That Ate Wall Street CDS were invented in the mid 1990s by JP Morgan The Problem: JP Morgan client Exxon needed to open a line of credit to cover
potential damages of five billion dollars (later reduced to one billion) resulting from the 1989 Exxon Valdez oil spill
The deal would tie up a lot of JP Morgan’s reserve cash to provide for the risk of the loans going bad under the Basel capital adequacy rules: banks were required to hold eight per cent of their capital in reserve against the risk of outstanding loans
But, if the risk of the loans could be sold, it logically followed that the loans were now risk-free; and, if that were the case, what would have been the reserve cash could now be freely loaned out
The Solution: the first CDS The credit risk was sold to the European Bank of Reconstruction and
Development (EBRD) which received a fee in return from J. P. Morgan Thus: Exxon got its credit line, J. P. Morgan got to honour its client relationship
with Exxon but also to keep its credit lines intact for other activities
Credit Default SwapsCredit Default Swaps
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Naked CDS vs covered CDS A naked CDS is a CDS in which the buyer does not own
the underlying debt Estimated to be up to 80% of the CDS market Critics argue that naked CDS should be banned –
analagous to buying fire insurance on your neighbour’s house … which creates a huge incentive for arson
There are concerns about the size of the CDS market - there is no limit to how many CDS can be sold» The gross amount of CDS far exceeds all “real” bonds and loans
outstanding» As a result, the risk of default is magnified leading to concerns
about systemic risk
Naked CDS vs covered CDS A naked CDS is a CDS in which the buyer does not own
the underlying debt Estimated to be up to 80% of the CDS market Critics argue that naked CDS should be banned –
analagous to buying fire insurance on your neighbour’s house … which creates a huge incentive for arson
There are concerns about the size of the CDS market - there is no limit to how many CDS can be sold» The gross amount of CDS far exceeds all “real” bonds and loans
outstanding» As a result, the risk of default is magnified leading to concerns
about systemic risk
Credit Default SwapsCredit Default Swaps
27 Dr Kevin Campbell, Corporate Finance, 2011
Size of the CDS Market
By 1998, the total size of the credit default swap market was a relatively small $180 billion
The credit default swap market has grown enormously since then, although there is no definitive measure of how much
Total notional amount of the CDS market
$6 trillion in 2004
$57 trillion by June 2008
$41 trillion by the end of 2008
Based on survey data from the Bank for International Settlements (BIS) at http://www.bis.org/statistics/derstats.htm
Size of the CDS Market
By 1998, the total size of the credit default swap market was a relatively small $180 billion
The credit default swap market has grown enormously since then, although there is no definitive measure of how much
Total notional amount of the CDS market
$6 trillion in 2004
$57 trillion by June 2008
$41 trillion by the end of 2008
Based on survey data from the Bank for International Settlements (BIS) at http://www.bis.org/statistics/derstats.htm
Credit Default SwapsCredit Default Swaps
28 Dr Kevin Campbell, Corporate Finance, 2011
Post-crisis regulation of CDS
The Dodd-Frank Wall Street Reform & Consumer Protection Act (2010) does not ban naked CDS but does require the central clearing of CDS and thus significantly reduces counterparty risk
Similar measures have been proposed in Europe, under the aegis of the European Commission and its recently formed European Securities and Markets Authority (ESMA)
Post-crisis regulation of CDS
The Dodd-Frank Wall Street Reform & Consumer Protection Act (2010) does not ban naked CDS but does require the central clearing of CDS and thus significantly reduces counterparty risk
Similar measures have been proposed in Europe, under the aegis of the European Commission and its recently formed European Securities and Markets Authority (ESMA)
Credit Default SwapsCredit Default Swaps
29 Dr Kevin Campbell, Corporate Finance, 2011
The Greek Question ... Criticism of the role of hedge funds and investment banks during the EU
Sovereign debt crises Argument: creation of a downward spiral due to CDS trading
EXAMPLE: Bets against Greek bonds made the country’s situation appear worse than it really was, creating fear
This in turn made the CDS market more nervous about Greece, with more people buying insurance against the possibility of a Greek default
This made it even harder for Greece to raise money in the bond market, exacerbating the problem further
On March 7 2011 the European Parliament's economic and monetary affairs committee approved a measure which could lead to an EU-wide ban on uncovered shorting of CDS on sovereign debt of EU member states
Under the measure as currently drafted, investors would be permitted to short a "naked" sovereign CDS if it held a proxy "asset or portfolio of assets" whose prices have a "high correlation" with government bond prices
But Italy, Britain, Sweden, the Netherlands, Spain are against the ban …
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Almost all banks are interwoven with CDS If default should occur the institution issuing the CDS will
have to make good on the difference but may not have the pool of capital assets necessary to back up a systemic wave of defaults
Lehman Brothers was a key player in the CDS market and its demise triggered a whole set of obligated payments leading to the bailout of AIG, the world’s largest insurance company
The Lehman bankruptcy also triggered a series of national crises in countries whose banks had overextended during the boom times
Almost all banks are interwoven with CDS If default should occur the institution issuing the CDS will
have to make good on the difference but may not have the pool of capital assets necessary to back up a systemic wave of defaults
Lehman Brothers was a key player in the CDS market and its demise triggered a whole set of obligated payments leading to the bailout of AIG, the world’s largest insurance company
The Lehman bankruptcy also triggered a series of national crises in countries whose banks had overextended during the boom times
Credit Default SwapsCredit Default Swaps
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Recommended reading
32 Dr Kevin Campbell, Corporate Finance, 2011
Recommended reading
33 Dr Kevin Campbell, Corporate Finance, 2011
[email protected]@stirling.ac.uk
Dziękuję za Uwagę!
KoniecKoniec
34 Dr Kevin Campbell, Corporate Finance, 2011
Homework Exercise
The Financial Crisis: who was responsible?The Financial Crisis: who was responsible?
SOURCE: The Observer, Sunday 6 March 2011
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Background
The Financial Crisis Inquiry Commission
Established by the U.S. Congress and President in May 2009 to "examine the causes, domestic and global, of the current financial and economic crisis in the United States."
It comprised 10 members - private citizens with experience in areas such as housing, economics, finance, market regulation, banking and consumer protection
Six members were appointed by the Democratic leadership of Congress and four by the Republican leadership
In January 2011 the Commission delivered its report to the President, Congress and the American people
Homework Exercise
The Financial Crisis: who was responsible?The Financial Crisis: who was responsible?
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Homework Exercise
Task: Review the materials available on the website of the Financial Crisis Inquiry Commission (FCIC) at http://www.fcic.gov/ and answer the following questions:
QUESTIONS:1.What were the main conclusions of the six Democrat-appointed members of the FCIC?2.What were the main conclusions of the three Republican-appointed Dissenters Keith Hennessey, Douglas Holtz-Eakin and Bill Thomas3.What were the main conclusions of the Republican-appointed Dissenter Peter J. Wallison
The Financial Crisis: who was responsible?The Financial Crisis: who was responsible?