The Liquidity Crunch Causes and Consequences

10 June 2008

Martyn Hoccom

Lloyds TSB

2

How did we get here?

“They were impelled to it by the seminal lunacy which has always seized people

with the notion they can become very rich. There were many Wall Street

insiders who fostered this insanity…”

The Great Crash 1929 – JK Galbraith

3

The Liquidity storm of 2007

“When the music stops in terms of liquidity things will be complicated. But as long as the music is playing , you’ve got to get up and dance. We’re still dancing”

Chuck Prince Citigroup, July 9th 2007

“This was obviously a very disappointing quarter for us”

Chuck Prince Citigroup, October 1st 2007

4 November 2007 - Chuck Prince resigns

4

Size of the global securities marketSource :Bank of England Stability review

Government/banks$70.7 trillion

Corporate$67.7 trillion

Money Markets$6.4 trillion

Corporate bonds$11.0 trillion

Residential mortgage-backed securities$6.5 trillion

Government debt$25.8 trillion

Investment-grade$10.2 trillion

High-yield$0.8 trillion

Corporate Loans$6.1 trillion

Bank deposits$38.5 trillion

Asset-backed securities$10.7 trillion

Leveraged$0.5 trillion

Commercial mortgage-backed securities$0.7 trillion

Corporate Equities$50.6 trillion

Investment-grade$5.6 trillion

United States$5.8 trillion

Non mortgage asset-backed securities$3.5 trillion

Europe$0.7 trillion

Non-Agency$1.8 trillion

Jumbo$0.5 trillion

Agency$4.0 trillion

Sub-prime$0.7 trillion

Alt-A$0.6 trillion

5

Markit iTraxx Index

Markit iTraxx Europe Crossover Index (series 8)

Source : Bloomberg

200

250

300

350

400

450

500

550

600

650

700

bps

6

Credit Pricing

1 Year Bond Spread over UK Gilts by Rating: 2003 to 2008

0

50

100

150

200

250

May

03

Aug 0

3

Nov 0

3

Feb 0

4

May

04

Aug 0

4

Nov 0

4

Feb 0

5

May

05

Aug 0

5

Nov 0

5

Feb 0

6

May

06

Aug 0

6

Nov 0

6

Feb 0

7

May

07

Aug 0

7

Nov 0

7

Feb 0

8

May

08

Bas

is P

oin

ts

AAA

AA

A+

A

A-

BBB

7

UK Macro – Market Background

UK – Sterling Liquid Assets relative to total asset holdings of UK banking sector

Source : Bank of England

8

UK Macro – Market Background

UK-resident banks' and building societies' net sterling lending to UK households and non-financial companies

Source : Bank of England

Notes:It is the difference between household's and PNFCs' M4 lending and M4M4 Lending is the lending made by banks and building societies to the personal sector

-50

0

50

100

150

200

250

300

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

£ billions

9

Days of August 2007

Sub prime mortgages were the trigger – amongst the underlying causes were:

– Take away the modern terminology and you have something very old fashioned - Banks lost money on fuelling a speculative asset boom -

– In a period of remarkable stability and low credit spreads a “search for yield” – this is why mortgages originated in Paris Texas ended up on the balance sheet of banks in Paris France

– Weakened Credit Standards as a result of dislocation between originators and investors

– Increasing Sophistication of products whose “ model to market” became very misaligned from “mark to market” under stress

– The herd mentality and extreme difficulty to stand against the crowd

10

The Market Story

USD - OIS, 1m Libor, 3m Libor - since 2/10/06

1.90

2.40

2.90

3.40

3.90

4.40

4.90

5.40

5.90

6.40

03/1

0/06

03/1

1/06

03/1

2/06

03/0

1/07

03/0

2/07

03/0

3/07

03/0

4/07

03/0

5/07

03/0

6/07

03/0

7/07

03/0

8/07

03/0

9/07

03/1

0/07

03/1

1/07

03/1

2/07

03/0

1/08

03/0

2/08

03/0

3/08

03/0

4/08

03/0

5/08

USD LIBOR 1 MONTH USD LIBOR 3 MONTHS USD 1 MONTH Overnight Index Swap

11

ABCP Market

DROUGHT

US asset-backed commercial paper outstanding - $ Trillions

0.70

0.80

0.90

1.00

1.10

1.20

1.30

Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08 Feb 08 Mar 08 Apr 08

$ Trillions

12

ABCP Market

Asset Backed commercial paper spreads

One-month top-tier ABCP versus one-month Libor (basis points)

-20

0

20

40

60

80

100

120

140

Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08 Feb 08 Mar 08 Apr 08

13

CDS Spreads

5 Year SENIOR CDS Spread Curves

0

50

100

150

200

250

300

24 A

pr 08

04 A

pr 08

17 M

ar 0

8

26 F

eb 0

8

06 F

eb 0

8

17 J

an 0

8

28 D

ec 0

7

10 D

ec 0

7

20 N

ov 07

31 O

ct 0

7

11 O

ct 0

7

21 S

ep 0

7

03 S

ep 0

7

14 A

ug 07

25 J

ul 07

05 J

ul 07

15 J

un 07

Bas

is P

oin

ts

BarclaysHBOSHSBCLloyds TSBRBS

14

What has the Liquidity Crisis Changed ?

Short answer – Everything !!

– Originate and Distribute Model

– Conduit Vehicles

– Liquid asset definition

– Cost of funding

– Basel 2 and ratings

– Transfer pricing

– Balance sheet structure

– Value of Retail Deposits

– SIVS

– CP Markets……etc etc

15

Risk Appetite Design

Clear Articulation and measurement system so Board can know under stress how institution is performing

Governance linkage from Board approved limits to operational activities

Resolution of potential conflicts of interest over treating liquidity management as a cost resource versus a profit centre

Measurement and allocation mechanism of costs of liquidity

Operational risk tolerance – problems very visible in “ real time” world of settlements

Consistency across measures and clear definition

16

What is Liquidity Management ?

A profit centre ?

Fully costed and allocated operation with cost recognised and allocated across business lines ?

Something treasury and the money markets desk do ?

Integrated part of financial plan ?

Driving strategy

17

What is a Liquid asset ?

Not an issue greatly discussed prior to August 2007 !!

AAA securities ??

Secured Repo- Issuer / Collateral / Haircuts/Relationship

Eligible at central Bank in normal operations-back to the 1980’s ?

New arrangements with Bank , Fed , ECB – how enduring-how act in a future market dislocation

18

Stress Testing

“ Liquidity Stresses are low-frequency , but extreme severity , events that are not well understood”

FSA Section 3.5 DP07

“ Stress tests and contingency funding plans funding plans have not generally assessed impact of simultaneous disruption to securitisation and interbank markets “

Bank of England - April 2008

19

Stress Testing

Well defined and granular stress testing against a range of events

A continual process not a one off piece of analysis as markets and business profile changes

Flexible and interactive so scenarios can be rapidly changed and updated

Comprehensive across the institutions on and off balance sheet exposures

Judgement ; business sense-not spitting out dozens of unchecked data sheets

20

Stress Testing

Liquidity Commitments

Conduits

Data Money Markets

Medium Term Market

Retail

Off Balance Sheet

Nature of Stress

Central bank actions

Assumptions Market Capacity

Behavioural Assumptions

Time & Speed

Rollover Vector

Stress Model

Negative Cash

time months0

Positive Cash

21

Secured Funding under Stress

Assesses the amount of secured funding that could be lost in a crisis

Partners Large and Stable Trading Counterparty

Government Bonds

T1 Equities

T3 Equities

EMG Debt

Structured Debt

Col

late

ral T

ype

Secured Funding Counterparties

Source : Lehman Brothers

22

Contingency Planning

Asset Inventory

Use/Availability of Central Bank Facilities

Depth of Repo/Funding Market

Assessment of Collateral

Reputational / Market signalling Impact

Backup Liquidity Lines

Funding Relationships

Negative Cash

time months

0

Positive Cash

Stress Impact

Contingency Action Impact

23

Pricing for Liquidity

“ Off balance sheet contingent liquidity exposures appear not to have been priced adequately into internal models at firms ”

Bank of England April 2008

Pricing of on balance sheet lending need to address impact on bank costs of the credit crunch

Credit Crunch has put more focus on ability to fund growth

Value of long term deposits

Market characterised by increased focus on aligning internal funds transfer pricing for Liquidity premia with external market conditions

24

Pricing for liquidity

The “nice decade “ is over

Asset led income targeted planning assuming an limitless supply of close to Libor wholesale funding is over

Not aligning the true market costs of funding to assets may lead to excessive non value generating activity

Words are easy-establishing the Governance, MI and culture to live the story of economic value is a challenge

25

Commitments/ Liquidity facilities

Effectively liquidity options written to clients

Charging often “bundled” into overall product offering

Credit crunch, Mono line rating issues etc have highlighted risks

Pricing needs to reflect risks of draw - a function of market spread movements ; drawn margins , collateralisation etc …

26

Valuation of Deposits

Deposit gathering the non-glamorous / non sexy

The value of strong deposits are now much more widely appreciated

More focus going forward on the value of the “Funding Franchise” too often neglected in the recent asset boom.

27

Closing thought

“ The squall became a hurricane…plain folk will ask. Why should we trust anyone?”

Philip Stephens FT - 21 September 2007