CORPORATE FINANCE
LECTURE 2: UNDERSTANDING THE
FINANCIAL CRISIS
Dr Kevin Campbell
March 2011
Dr Kevin Campbell, Corporate Finance, 2011
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Overview
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The causes of the financial crisis
 What were the key factors?
Key consequences of the financial crisis
 Will future crises be prevented?
Dr Kevin Campbell, Corporate Finance, 2011
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International financial crises
In recent history ...
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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
Dr Kevin Campbell, Corporate Finance, 2011
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What is new today?
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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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From credit crunch to financial crisis
The day the financial world changed:
Monday September 15 2008
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FINANCIALCRISIS: MAJOR VICTIMS
Source: BBC News, Global downturn: In graphics, 19 March 2009, http://news.bbc.co.uk/2/hi/business/7893317.stm
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FINANCIAL CRISIS: THE COST
Source: BBC News, Follow the Money, 10 September 2009, http://news.bbc.co.uk/1/hi/business/8249411.stm
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FINANCIAL CRISIS: THE COST
3 month annualized growth rate of industrial production
Source: The World bank, Global Economic Prospects – Global Headwinds and Recovery, Volume 1, Summer 2010,
Washington, D.C., June 2010.
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The death of the Anglo-American
corporate governance model?
The nationalisation of
Wall Street?
or
The 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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Made in America …
September 2007
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Sources of the crisis
2004 – a critical year
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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
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Sub-prime
NINJA
= No Income, No Jobs, No Assets
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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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Sub-prime
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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
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Models of credit intermediation
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Traditional model
 Originate to Hold
Securitised model
 Originate to Distribute
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Securitisation
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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’
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How do ‘toxic’ loans get AAA ratings?
Pass the parcel …. Asset Backed Securities
Assets
Liabilities
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corporate bonds
credit card loans
auto loans
mortgage loans
(incl. subprime)
AAA
AA
A
BBB
Equity
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Loss
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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
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Double Bubble
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Bubble in Housing and Securitization
S&P/Case-Shiller U.S. Home Price Index
Securitized Residential Mortgages Outstanding
Quarterly change at annual rates
25
600
500
15
400
U.S.$ billions
% change year-over-year
20
10
300
200
5
100
0
0
-5
-100
-10
-200
-15
87 89 91 93 95 97 99 01 03 05 07
Source: MacroMarkets LLC
-300
90 92 94 96 98 00 02 04 06
Source: Federal Reserve, NBF Financial
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Foreclosure ...
Stockton, California, USA
sub-prime mortgage capital of the world
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Dr Kevin Campbell, Corporate Finance, 2011
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
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Mortgages turn toxic
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A, AA and AAA tranches
of mortgage-backed
securities start to suffer
losses
..... banks restrict credit
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The sub-prime virus
Estimated loss of market value of US sub-prime mortgage-backed securities
SOURCE: Bank of England, Financial Stability Report, No. 23, May 2008
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Credit Default Swaps
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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.
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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
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The CDS market functions over-the-counter (OTC) – this
offers greater flexibility but lacks the regulatory control of
exchange trading
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Credit 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
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Credit Default Swaps
The Monster That Ate Wall Street
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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
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Credit 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
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Credit Default Swaps
Size of the CDS Market
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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
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Credit Default Swaps
Post-crisis regulation of CDS
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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
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Similar measures have been proposed in Europe, under the aegis of
the European Commission and its recently formed European
Securities and Markets Authority (ESMA)
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The Greek Question ...
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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
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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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Credit Default Swaps
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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
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Recommended reading
Dr Kevin Campbell, Corporate Finance, 2011
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Recommended reading
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Koniec
Dziękuję za Uwagę!
kevin.campbell@stirling.ac.uk
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Homework Exercise
The Financial Crisis: who was responsible?
SOURCE: The Observer, Sunday 6 March 2011
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Homework Exercise
The Financial Crisis: who was responsible?
Background
The Financial Crisis Inquiry Commission
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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
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Homework Exercise
The Financial Crisis: who was responsible?
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 Thomas
3. What were the main conclusions of the Republicanappointed Dissenter Peter J. Wallison
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