the financial crisis - what fuelled the storm v2

7/31/2019 The Financial Crisis - What Fuelled the Storm v2

1/19

THE FINANCIAL CRISIS

what the$$$$

went so wrong


2/19

what the went so wrong

When you start thinking that you can

create something out of nothing, it is veryhard to resist.

Lee Hsien LoongPrime Minister, Singapore


3/19

HISTORICAL CONTEXTs: Great Depression

Thursday, October ,


4/19

HISTORICAL CONTEXTs: Great Depression

Decline in USs industrial production (1929-32)

Foreign trade decline - US, UK, Fra, Ger (1929-32)

Increase in US unemployment (1929-32)

23%

46%

>54%

607%

Crash in Dow Jones in 2 days in October 1929


5/19

HISTORICAL CONTEXTs: Great Depression led to strict financial regulation

Banking Act & Glass-Steagall Act passed1932-33

Commercial & Investment banks separated (eg

JPMorgan)a)

Fed empowered to regulate savings account interest ratesb)

Federal Deposit Insurance Corporation (FDIC) establishedc)

Expanded range of assets rediscounted by the Fedd)


6/19

CAUSES OF THE CRISISDeregulation: ended largely crisis-free period

Reagan signed into Act providing for adjustable-rate

mortgage loans, marking onset of financial deregulation

Glass Steagall repeal sought by bankers culminated inGramm-Bliley Act repealing separation of ownership

Legislation passed to thwart regulation of derivatives

backed by key Government officials

SEC relaxed net capital rule, effectively allowing over-

leveraging

1982

1990s

2000

2004


7/19

HISTORICAL CAUSESDeregulation: laying the foundations of the crisis

Expanded credit availability created unstable bubbles in

several markets in the US economy

1980s

onwards

Financial sector consolidated into a handful of XL (a.k.a.

too big to fail) firms1990s

Dot-com bubble burst, leading to $5tn investor losses

(nearly 3x Indias current GDP)2001

Housing prices increased c.194%1996-2006

Savings & loan crisis cost taxpayers c.$124bnEnd-1980s-

1990s


8/19

THE FINANCIAL BUBBLEDeregulation & technology led to growth of derivatives

Unregulated derivatives market already worth $50tnLate 1990s

Under Bush administration, large FIs created asecuritisation food-chain

2001

Commodity Futures Modernisation Act banned

regulation of derivatives2000


9/19

THE FINANCIAL BUBBLEDerivatives utilised to engender a financial bubble

Loans combined with other loans into Collateralised

Debt ObligationsSecuritisation

Since risk of default no longer with lender, loans got

riskier, and hence more profitable

Change in risk

profile

Big banks now mandated mortgage brokers to sell

primarily sub-prime loans to get higher interest rates

Predatory

lending

Banks borrowed to purchase risky & profitable loans,

leading to leverage ratios up to 33:1

Over-

leveraging


10/19

OVER-LEVERAGINGAll major investment banks severely over-leveraged

2003 2004 2005 2006

LB

35x

30x

25x

20x

15x

10x

Source: Company Annual Reports (SEC Form10K)

BS

ML

GS

MS

2007


11/19

THE HOUSING BUBBLELarge increase in sub-prime lending led to housing bubble

Ability to package risky loans into CDOs led to predatory lending

AAA rating maintained despite most sub-prime lending being

equivalent to 99.3% of house price on average

Credit rating of AAA (as safe as US Government bonds) generatedsufficient demand for these CDOs

As a result, sub-prime lending as a % of total mortgage lending

skyrocketed between 2004-06

In absolute value, sub-prime lending increased from c.$30bn p.s. to

more than $600bn p.a. in 10 years


12/19

THE HOUSING BUBBLEWall Street excesses rewarded short-term profits

Conflicts of interest existed as most Fed regulators were drawn from

the largest financial institutions

Wall Street bonuses grew 3x between 2002-06

Countrywide made $11bn profits by lending $97bn worth of sub-prime mortgages

Lehman (biggest underwriter) CEO took home $485m

All along, the Fed under Greenspan avoided intervening even though

existing regulation allowed it to


13/19

THE HOUSING BUBBLEIncreased subprime lending made mortgages riskier

25%

Source: US Census Bureau, Harvard State of the Nations Housing Report2008

20%

15%

10%

5%

0%

70%

69%

68%

67%

66%

64%

65%

Home ownership rates

Subprime % of mortgage origination


14/19

INSURING THE BUBBLEInsurance of derivatives spread risk even further

AIG began issuing CDSs to insure against CDOsCredit Default

Swaps

Speculators allowed to purchase CDSs led to bigbanks betting against their own CDOs in downturn

Speculation

CDS market unregulated so no cover maintained for

potential lossesUnregulated

Contract signing led to bonuses, but no penalty

imposed if CDO were defaulted on

Lop-sided

incentives

AIGs London division issued $500bn worth of CDSs,

many for CDOs backed by sub-prime mortgages

Amount


15/19

THE BUBBLE BURSTCollapse of the housing market led to financial epidemic

1/3 of all mortgages defaulted by 2007, most others

headed down the same routeDefaults

Leading to several big banks betting against their ownCDOs, worsening the situation

Conflicts ofinterest

Increased from c.300k in 1Q07 to c.900k by 3Q09Foreclosures

Lenders couldnt sell their sub-prime loans anymore,

hence they failedMeltdown

Investment banks were also left with CDOs, real estate

that they couldnt finance or sell

Meltdown


16/19

ONSET OF THE CRISISCollapse of housing market sparked financial collapse

Bear Sterns declares bankruptcy; acquired by JPMorganMar08

Fed Governor Mishkin retires leaving 3 (of 7) seats vacantAug08

Federal takeover of Freddie Mac & Fannie May7 Sep08

Lehman Brothers reported record $3.2bn losses9 Sep08

Fed officers met top bankers to consider Lehman bailout13 Sep08

Lehman Brothers ran out of cash12 Sep08

Lehman Brothers filed for Chapter 11 bankruptcy in US15 Sep08


17/19

ONSET OF THE CRISISCrisis spreads like wild fire in globalised world

AIG too didnt have money to pay CDS holders16 Sep08

AIG taken over by the Federal Government17 Sep08

Paulson & Bernanke ask Congress for $700bn bailout toprevent catastrophic collapse of the system18 Sep08

Bush signs bailout bill, but stock markets continue to fall4 Oct08

Dow crashed 777 points among largest single drops everEnd-Sep08

Raise US & EU unemployment to 10%After

And the rest, as they say, is historyAfter

Recession soon spread to globalised developing nationsAfter


18/19

The crisis was not a natural disaster, but the

result of high-risk, complex financial products,

undisclosed conflicts of interest, and the failure ofregulators, credit rating agencies and the market

itself to rein in the excesses of Wall Street.United States Senates

Levin-Coburn Report


19/19

The crisis was avoidable and caused by

widespread failures in financial regulation,

including the Feds failure to stem the tide oftoxic mortgages and systemic breaches in

accountability and ethics at all levelsUS Financial Crisis Inquiry Commission

January 2011 Report

the financial crisis - what fuelled the storm v2

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