www.guycarp.com

Seán Mooney, Chief Economist

October 2, 2008

The Credit Crisis of 2008 “You Fail, We Bail?”

Southwest Chapter PLUS Educational Seminar

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Guy Carpenter

It’s about time our team started winning!

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Guy Carpenter

Emergency Economic Stabilization Act of 2008RIP September 29

The Act– Treasury buys troubled loans

– Helps lenders by reducing uncertainty about their balance sheets

– Increases flow of credit in the economy

– Insurance of troubled assets

Impact– Overall result not that different from before

• Bail-outs on a case by case basis• Values still dependent on real estate recovery• Given uncertainties, Act could exacerbate the problem in the near-term

- Lenders hold back until they see how current and/or future Treasury Secretary implements the plan

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Guy Carpenter

Emergency Economic Stabilization Act of 2008Insurance of Troubled Assets

Program to guarantee troubled assets, issued prior to March 14, 2008

Treasury collects premiums, set at actuarial level to meet anticipated claims

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Guy Carpenter

Agenda

Overview of the Financial Market Debacle – how the problems developed, implications for the broader

economy

Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O

Possible regulatory responses impacting our industry

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Guy Carpenter

The Evolution of the Crisis

First phase, 2007: The subprime mortgage fiasco.

The figure of $400 billion from Bernanke still appears about correct. About $300 billion of this has been reported.

Second phase, 2008: The broader credit crisis.

As lenders reshaped their finances to meet regulatory and accounting standards credit dried up in lot of areas, e.g., commercial paper, M & A financing and auto loans. The broader risk of Credit Default Swaps (CDS) emerged.

Third phase, August 2008: The insolvency phase.

Broader still. The first two phases create a world wide financial crisis, which, coupled with oil and food crises, triggered a longer term economic downturn.

In Phase Three, but not heading to a depression

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Guy Carpenter

First Phase Subprime Fiasco: Why?

Housing boom

– Investors cycle from tech stocks to housing, following technical bust of 2000

– “Free” money in first half of current decade

– Price of homes has never declined (current dollars)

– Secondary market creates break in link between debtor and ultimate mortgage holders. (Forget Bedford Falls!)

– Hedge funds seeking outsized returns

– Globalization increases flow of funds to the sector

– A positive force, risk classification, turned into a negative, with no docs and option ARMs

A good word about subprime

– Risk classification from an insurance perspective

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Guy Carpenter

First PhaseSubprime Fiasco…By The Numbers

US unemployment rate: 6.1%

GDP: $13 trillion

Financial Assets: $40 trillion+

Financial impact– 2 million foreclosures @ $200,000 =$ 400 billion

– Reported: $280 billion

Economic impact– Housing construction: 6% of economy

– Wealth Effect: 6% of wealth change. • Drop in housing prices: 10% implies GDP cut by 0.5%

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Guy Carpenter

Long Upward Trend in Home Prices

0

25,000

50,000

75,000

100,000

125,000

150,000

175,000

200,000

1980

1985

1990

1995

2000

2005

Price drops 1.4% in 2007, and 9.5% in 2008

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Guy Carpenter

The Evolution of the Crisis

Second phase: The broader credit crisis.

As lenders reshaped their finances to meet regulatory and accounting standards, credit dried up in lot of areas, e.g., commercial paper, M & A financing and auto loans.

The broader risk of Credit Default Swaps (CDS) emerged.

“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Warren Buffett, Letter to Shareholders, 2002

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Guy Carpenter

Second Phase

Pressures on banks Subprime defaults

Credit Default Swaps: Notional Base of $62 trillion, up from $1 trillion in 2001

Problems at GSEs: Debt of $1.5 trillion

Fair-Value Accounting

Off-balance items to on-balance (SIVs)

Other exposures Consumer debt at record levels: $2.5 trillion, 22% of Personal Income

A credit-quality crisis, not a deflationary policy. The Feds are pushing on a string. Last instance in 1990/91.

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Guy Carpenter

Banking: Tier 1 Risk-Based Capital Ratio (%), Second Quarter 2008

8.8%9.1%9.3%

10.2%10.8%

11.6%

12.4%

8.7%8.3% 8.0%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

MS UBS GS CS DBK JPM HSBC Citi BofA Wach

US standard at 5%. Merrill at 7.6%

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Guy Carpenter

Second Phase:Recent Capital Market Crises

0

2

4

6

8

10

12

Bla

ck M

onda

y

Junk

Bon

d

Mex

ico

Asi

a, R

ussi

a

Dot

com

/Enr

on

Sub

prim

e

Duration in Quarters Severity in Quarters

1987

1990

1994

1997-99

2001

2007

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Guy Carpenter

Phase Three: The insolvency phase

Muddle Through

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%19

91

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

E

2009

F

Recession

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Guy Carpenter

Worst case scenarios

Depression– Not likely because:

• Bernanke wrote the book on causes of the Great Depression. • Among most free market economists, the key cause of the great

depression was a failure of monetary policy. Following the stock market crash of 1929, banks were threatened by runs. The Federal Reserve was limited in the loans it could make to member banks, partly by philosophy, but also because the law required partial gold backing of its credits to member banks. 9,000 banks failed (one third). This theory is supported by Bernanke, including a major academic article published in 1995.

• Other factors: Cheap credit that fueled excess capacity for consumer goods, trade decline, dust bowl, and the Smoot Hawley tariff act. (June 1930). These factors are all well understood by policy makers so the probability of repeating is low.

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Guy Carpenter

Deflation Japanese style

• Japan in 1990s: Economic growth at 1.3%, inflation at 0.2%• The causes of deflation include:

- Aging of the population- By 2020, Japanese working age population will be 10

percent smaller, ours will be 30 % larger.- Young people needed for economic growth.

- Cheap goods from China and other South East Asian nations.

- Deflation as a self fulfilling prophecy (money in mattresses rather than in the bank.)

- Bailout of banks and corporations- Need to rationalize Japanese banking system.

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Guy Carpenter

Oil DemandMillion Barrels Per Day

2002 2008

OECD 48.1 49.8

Non-OECD 29.8 37.7

Total 77.9 87.5

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Guy Carpenter

Agenda

Overview of the Financial Market Debacle – how the problems developed, implications for the broader

economy

Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O

Possible regulatory responses impacting our industry

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Guy Carpenter

Impacts on Insurance

Direct relationships– Credit enhancers ($3,300 billion)– D & O and E & O

Economic relationships– Driving & auto insurance– Employment and WC– Recession and Fraud– Housing bust and arson (?)

Indirect relationships– Stock Market and Surplus– Interest rates and pricing (long tail)

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Guy Carpenter

Subprime Impact on Insurer Capital

0

10

20

30

40

50

60

70

80

90

Andrew WTC KRW Subprime0

5

10

15

20

25

Insured Loss % of industry capital

US

D B

illio

ns

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Guy Carpenter

Miles Traveled Down in 2007 and 2008

Annual VMT

1000

1500

2000

2500

3000

350019

90

1992

1994

1996

1998

2000

2002

2004

2006

2008

Bill

ions

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Guy Carpenter

Commercial LinesCompetition is heating up!

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Guy Carpenter

Rate Decreases Continue for Commercial Lines

Source: Council of Insurance Agents & Brokers 2nd Qtr. 2008 Survey - Chart: Lehman Brothers Equity Research

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Guy Carpenter

Pressures on pricing

Reduced supply

Higher catastrophes in 2008

Reduced investment income, as stock markets weaken

Write-downs for problem assets reduce capital

These pressures may be offset to some extent by concerns of counter party credit quality and by possible increased

move to self-insurance by well capitalized players

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Guy Carpenter

Agenda

Overview of the Financial Market Debacle – how the problems developed, implications for the broader

economy

Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O

Possible regulatory responses impacting our industry

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Guy Carpenter

Regulatory response

Federal regulation– Knee jerk response (Senators Sununo and Johnson)

– New York State action on CDS

Higher capital ratios– Raise costs of doing business

– Disproportionate impact on newer more thinly capitalized ventures, such as Bermuda start-ups

– Search for “Black Swans” • Earthquakes• Liability (Nano, Climate change)

– Pressure on reserves

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Guy Carpenter

The Future

“Fasten your seat belts, it’s going to be a bumpy ride.”

www.guycarp.com

Seán Mooney, Chief Economist

October 2, 2008

Subprime Plus

Southwest Chapter:PLUS

Educational Seminar