Credit Markets

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Lessons from the Crisis
Peter Elverding
November 2010
Crisis in Stages
Systemic Interaction
The economy, asset prices, policy and finance
are interdependent
1.Stage 1: 2007-2008 credit crisis
 falling asset prices
 banking distress
REAL
ECONOMY
2.Stage 2: 2008-2009 economic crisis
economic activity plunges
aggressive and unorthodox policy
FINANCIAL
SYSTEM
responses spark recovery…
3.Stage 3: 2010 political crisis?
ASSET
PRICES
POLICY
RESPONSE
politically charged debates over
tightening fiscal policy and regulation
recovery faces structural headwinds
1
Origins of the credit crisis
Pyramid in the Fog
1.
The earlier stock market bust set the scene
 …by giving impetus to the surge of activity in the
credit market
The modern structure of the credit markets
 an environment of low inflation and sustained growth
fostered risk taking.
UNDERLYING
CREDIT
2.
MORTGAGES,
LOANS, BONDS
 expansionary monetary policy, lax lending standards
and regulation, excessive borrowing and financial
innovation all played a part
3.
SECURITISED
CREDIT
ABS
RE-PACKAGED
SECURITISED
CREDIT
…but the structured credit boom gave it
unprecedented scale and complexity
 multiple slicing and reselling of default risk multiplied
the risk to the financial system.
CDO, CLO
 this was exposed by the bursting of the bubble in the
US housing market
CREDIT DEFAULT SWAPS (CDS)
4.
CDS – cheap ‘insurance’ against default ↔ heavily
leveraged investment in ‘tail risk’
Financial excess echoed previous crises…
Overconfidence and overleveraging led to massive
losses
 Collapsing liquidity and evaporating counterparty trust
led exaggerated falls in asset prices which challenged
the solvency of banks
2
’The Great Moderation’ in world GDP growth and inflation
%
3.0
%
6.0
2.5
5.0
2.0
4.0
1.5
3.0
1.0
2.0
0.5
1.0
0.0
0.0
65
67
69
71
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
03
05
07
World GDP growth, 4-year trailing standard deviation, lhs
World inflation (GDP deflator), 4-year trailing standard deviation, rhs
ource: World Bank
3
US stock market and interest rates
%
1600
7
1500
6
1400
1300
5
1200
4
1100
1000
3
900
2
800
1
700
600
0
97
98
99
00
S&P 500, index, lhs
01
02
03
US 10 year yield, rhs
04
05
06
07
08
US Fed Funds target rate, rhs
Source: EcoWin
4
House prices rose as loan quality plunged
($bn)
Sub-prime mortgage origination & issuance
900
800
700
Sub-prime origination
Issuance of residential MBS (subprime
+Alt-A)
600
500
400
300
200
100
0
2001
2002
2003
2004
2005
2006
5
The (housing) bubble that burst
House prices bubble
400
Still some
room to
fall…?
index, Jan 1987 = 100
350
primary rents - CPI
source
House prices, S&P
Case Schiller
300
250
200
150
House price deviation massively
exceeds previous cycles
100
87
89
91
93
95
97
99
01
03
05
07
09
11
6
Unprecedented delinquency…
% o f to tal
Mortgage delinquencies
% o f to tal
8
28
26
7
6
24
22
P rime mo rtgages, lhs
20
5
Sub-prime mo rtgages, rhs
18
16
4
14
12
3
10
2
M ar-98
8
M ar-00
M ar-02
M ar-04
M ar-06
M ar-08
M ar-10
7
Residential construction activity “ceases”
000s
New Home sales and housing starts
000s
2000
2000
1800
1800
1600
1600
1400
1400
1200
1200
1000
1000
800
800
600
400
Housing starts - single unit
New Home sales
600
400
200
200
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
8
Mortgage-related assets crash
bp
Mortgage related securities crash
120
A A A series 7-1
100
A A A series 7-2
B B B series 7-1
80
B B B series 7-2
60
40
20
0
01/07 05/07 09/07 01/08 05/08 09/08 01/09 05/09 09/09 01/10
9
Global issuance of asset-backed securities (ABS)
US$ billion
800
Sub-prime Residential MBS
700
Prime Residential MBS
Commercial MBS
Other*
600
500
400
300
200
100
0
00
01
02
03
04
05
06
07
*Other includes auto, credit card and student loan ABS
Source: Bank of England’s 2008 Financial Stability Report
10
Global Credit Default Swaps (CDS), gross outstanding: 2001-2007
US$ trillion
70
60
50
40
30
20
10
1H01
2H01
1H02
2H02
1H03
2H03
1H04
2H04
1H05
2H05
1H06
2H06
1H07
2H07
Source: ISDA
11
Global issuance of collateralised debt obligations (CDO)
US$ bn
200
180
160
140
120
100
80
60
40
20
0
2004
2005
2006
2007
Source: SIFMA
12
Slicing and dicing or mortgage risk
100%
Equity (3%)
BBB (5%)
A (7%)
A pool of BBB, A and AA notes from
RMBS is used to create collateralised
debt obligations (CDOs)
different levels with credit risk
80%
AA (12%)
AAA (25%)
The CDOs are again tranched of
Equity (5%)
BB (3%)
BBB (3%)
A (4%)
AA (5%)
Super-senior
(55%)
The pool is
60%
Pool of U.S. subprime residential
mortgages
packaged into subprime residential
mortgage backed
securities (RMBS)
The RMBS are
tranched into different
levels of
credit risk
40%
AAA (73%)
20%
0%
Mortgages
Securitisation
RMB
CD
Source: Oliver Wyman
13
Banking sector goes into meltdown
bp
Financial distress indicators
400
Lehman's,
M errills
350
3m interbank o ver
3m o vernight
index swap spread
300
250
200
Citigro up,
SIVs
150
Co untrywide
100
B ear
Stearns
50
0
06/07
12/07
06/08
12/08
06/09
12/09
06/10
14
Credit availability evaporates during crisis
(YoY%)
(YoY%)
Lending standards and lending growth
30
-40
25
-20
20
15
0
10
20
5
0
40
-5
-10
60
Commerical & Industrial loan
growth (lhs)
-15
80
SLOS - banks tightening
lending standards on C&I
loans (rhs inverted 12M lead)
-20
-25
99
01
03
05
100
07
09
15
Debt deleveraging exacerbates recession
($)
160,000
140,000
120,000
100,000
($)
The US debt burden*
160,000
* debt per person of
working age
Federal & local
government debt
Household
140,000
120,000
100,000
Average salary
80,000
60,000
80,000
Household debt
accumulation accelerates
60,000
40,000
40,000
20,000
20,000
0
0
52 56 60 64 68 72 76 80 84 88 92 96 00 04 08
16
The historical perspective of the present crisis
The historical perspective
2007/09
Subprime and related
solvency/funding crisis in
the global financial sector
Dow Jones Industrial Index
16.000
1989/90
US S&L and collapse of
Japanese stock market
Citibank downgraded to BBB+
14.000
2001/2002
Stock markets bubble burst
12.000
1995
Mexican ‘Tequila’ crisis
10.000
8.000
1987
‘Black Monday’
6.000
4.000
1982
Latin loans
1997/98
Emerging Markets crisis
Asia/Russia/Brazil
2.000
0
1980
1982
1985
1987
1990
1992
1995
1997
2000
2002
2005
2007
July
2010
17
The historical perspective of the present crisis: Stock markets
European stock market
Recent developments
The historical perspective
The Euro stoxx 600 Index (Aug 08-Jul 10)
The Euro stoxx 600 Index (1990-2010)
450
310
400
290
350
300
270
250
250
200
230
150
210
100
190
50
170
0
Jan-90
Feb-94
Mar-98
Apr-02
Jun-06
Jul-10
150
Aug-08
Feb-09
Aug-09
Feb-10
Aug-10
18
The historical perspective of the present crisis: Interest rates
Dollar interest rates
The Fed funds rate and the US 3M interbank rate
20
(%)
20
18
18
16
16
14
14
Fed funds target rate
12
12
US 3M interbank rate
10
10
8
8
6
6
4
4
2
2
0
0
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
19
The historical perspective of the present crisis: Interest rates
Euro interest rates
The ECB refinance rate and the German 3M interbank rate
10
(%)
10
9
9
8
8
German 3M interbank rate
7
7
ECB refi rate
6
6
5
5
4
4
3
3
2
2
1
1
0
0
89
91
93
95
97
99
01
03
05
07
09
20
The historical perspective of the present crisis: Interest rates
Interest rates
The 3M interbank rate minus the yield on Treasury Bills – TED Spread
350
(bp)
350
300
300
250
3M Euribor less 3M Bubil
250
200
US 3M interbank rate less 3M T-bill
200
150
150
100
100
50
50
0
0
-50
-50
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
21
The present situation: Credit markets
Sovereign spreads over swaps
Recent developments
The historical perspective
10 year government bond spreads over swaps
(Jul 08-Jun 2010)
10 year government bond spreads over swaps
(1999-2010)
800
1,000
700
800
600
600
400
(bp)
(bp)
500
400
300
200
200
100
0
0
(100)
aug-99
okt-01
Germany
Italy
dec-03
feb-06
Greece
Portugal
apr-08
jun-10
Ireland
(200)
Jan-08
Jul-08
Germany
Italy
Dec-08
Jun-09 Dec-09
Greece
Portugal
Jun-10
Ireland
22
The present situation: Credit Markets
Investment Grade credit markets
The historical perspective
Merrill Lynch EUR investment grade Bank and Corporate 5 yr Spread Index
Investment Grade Spreads (1996-2010)
700
600
500
(bp)
400
300
200
100
0
(100)
(200)
dec-96
mrt-98
jun-99
sep-00
A rated EUR Bank Index
dec-01
mrt-03
mei-04
A rated EUR Corporate Index
aug-05
nov-06
feb-08
mei-09
jul-10
BBB rated EUR Corproate Index
23
The present situation: The Financial Sector
The impact on banks – worldwide
Writedowns and credit losses
3Q 2007 – June 2010
(EURbn)
Worldwide
Capital raised
3Q 2007 – June 2010
(EURbn)
1,391
1,177
Americas
922
628
Europe
436
440
33
109
Asia
Source: Bloomberg as of 26 July 2010
24
Global Recovery and
Policy Crisis (Europe)
Global Recovery – led by the East
• Emerging economies have led the
Global growth 1998-2010
12
12
2008
09
global recovery
10F
10
10
• Eurozone to lag behind the US
8
8
• China resilient as policy is tightened
6
6
• Asia to outperform Latam and EMEA
4
4
2
2
0
0
-2
-2
-4
-4
-6
-6
US
Eurozone Japan
Latam
EMEA
Asia ex
Japan,
China
China
26
Developed economies - a big step down
104
1Q08 = 100
GDP profiles
Australia
104
103
103
102
102
101
101
100
Canada
99
98
97
Eurozone GDP profiles
Eurozone
95
96
101
99
100
99
Greece
98
98
Belgium
97
97
97
96
France
96
Spain
NL
96
95
94
UK
93
92
98
1Q08 = 100
100
100
99
US
101
94
93
Japan
92
91
91
Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10
95
94
Eurozone
Germany
95
94
Italy
93
93
Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10
27
Structural Headwinds to growth
Bank lending to non-financial corporates
(YoY%)
(YoY%)
25
25
20
20
15
15
10
10
5
5
0
0
-5
1. Credit creation is still dysfunctional
2. Household deleveraging to continue
3. Creditor nations are reluctant to spend
-5
US commerical and industrial loans
-10
-15
Four medium term challenges:
-10
Eurozone loans to non-financial
corporate sector
-20
4. Fiscal and monetary consolidation
-15
-20
Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan05 05 06 06 07 07 08 08 09 09 10
28
‘Relief rally’ falters as policy debate rages
US equities & government bonds
(%)
14000
10 year peripheral spreads over Bunds
4.5
1000
450
13000
400
4.0
800
3.5
600
12000
350
300
11000
250
10000
3.0
9000
200
400
150
100
200
8000
2.5
Dow Jones (lhs)
7000
US 10Y Treasury (rhs)
6000
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
50
ECB bond purchases begin
2.0
Jul-10
0
Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10
Greece (LHS)
Italy
Ireland
Spain
0
Jul-10
Portugal
29
Eurozone debt crisis weighed on the EUR
EUR/USD versus 10 year Greek-Bund spread
0
1.53
1.48
250
1.43
1.38
500
1.33
1.28
750
1.23
1.18
Oct-09
1000
Dec-09
Feb-10
Apr-10
Jun-10
EUR/USD
10 year Greek-Bund spread (RHS Inverted bp)
30
“Make the bankers’ pay…”
31
Monetary policy to relieve the squeeze?
Systemic Interaction
The economy, asset prices, policy
and finance are interdependent
REAL
ECONOMY
FINANCIAL
SYSTEM
ASSET
PRICES
TIGHTER
REGULATION
The POLICY
SQUEEZE
Monetary policy may be loosened to offset the pressure
from tighter regulation and fiscal policy
32
The mechanics of debt sustainability
Drivers of the change in Public Debt (as %GDP)
Change in Debt = Primary Budget Deficit + [(Interest rate – GDP growth) x Debt]
(public debt and deficits expressed as %GDP)
The growth in public debt can be reduced in the following ways:
1. Improved primary budget balance = either lower expenditure or higher taxes
2. Lower interest rates = loose monetary policy or bullish bond market sentiment
3. Faster nominal GDP growth = either faster real growth or higher inflation
4. Reduce existing debt = either sell-off assets or restructure/default on existing debt
33
Eurozone debt – shades of black
% of GDP
Eurozone Debt-to-GDP
Debt % GDP
0
Italy
Greece
0
Belgium
-2
Who's in the naughty corner?
25
50
LUX
75
FIN
100
125
150
AU
GER
EU16
-4
France
-6
Portugal
Germany
decreasing SLO
stress
MAL
NL
SLK
FRA
Austria
POR
-10
2009
Neth.
-12
2010F
Spain
2011F
BEL
CY
-8
Ireland
ITA
EU16
SPA
increasing
stress
GR
-14
Finland
IRL
0
20
40
60
80
100
120
140
-16
deficit % GDP
(2009 stats, EC)
34
EUR – emergency repairs
The measures
• Greece receives EUR110bn financing package
• Eurozone establishes European Financial
Stablisation Mechanism and combined with IMF
resources creates a EUR750bn back stop
• ECB buys peripheral debt in secondary market
• ECB cuts collateral requirements for Greek debt
and extends longer term refinancing operations
• Fed re-introduces USD swap lines
• EU agrees to publish bank stress test results
Will they work?
• That depends on whether Greece is ready to stick to its commitments….
• ….and whether the market is willing to see value in peripheral debt at these prices
• Restructuring of Greek debt looks a real risk in 2011
35
Eurozone positives
(YoY%)
30
Eurozone exports & IP (YoY% )
April 2008 =100
Eurozone exports & IP (levels)
30
105
105
20
20
100
100
95
95
10
10
90
90
85
85
80
80
0
0
-10
Exports
-10
-20
Industrial
production
-20
-30
75
75
Industrial production
70
Exports
70
-30
Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan05 05 06 06 07 07 08 08 09 09 10
65
65
Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan05 05 06 06 07 07 08 08 09 09 10
36
Eurozone negatives
(YoY%)
(YoY%)
30
15
(000s)
1050
20
10
1000
10
5
950
Car registrations & construction
Car registrations & construction (levels)
Dec 2006 = 100
100
95
90
0
0
900
85
-10
-5
850
-10
800
-15
750
car registrations (lhs)
-20
car registrations (lhs)
80
Construction (rhs)
Construction output (rhs)
-30
Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan05 05 06 06 07 07 08 08 09 09 10
75
Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan05 05 06 06 07 07 08 08 09 09 10
37
Fiscal tightening to drag from 2011
Change in balance 2010-2012 (% of GDP)
2010 budget balance (% of GDP)
FI
FI
IT
IT
BE
NL
AT
JP
GE
BE
NL
AT
Eurozone
GE
FR
Eurozone
PT
IE
UK
FR
GR
UK
JP
PT
ES
ES
US
US
IE
GR
0%
-2%
-4%
Structural
-6%
-8%
Cyclical
-10%
-12%
0%
1%
2%
Policy change
3%
4%
5%
6%
Cyclical change
38
European growth – a Northern bias
Europe GDP growth forecasts (YoY% )
Poland
Sweden
Germany
France
Netherlands
Belgium
Eurozone
UK
Italy
2009
Spain
2010
2011
Greece
-6
-5
-4
-3
-2
-1
0
1
2
3
4
39
Growth threat to Southern Europe’s solvency
Unit labour cost for total economy (2001=100)
150
150
140
140
130
130
120
120
110
110
100
100
90
90
2001
2002
2003
2004
GR
GER
2005
2006
IT
PT
2007
2008
2009
SP
40
Worst case scenario – EMU break-up
41
A Eurozone break up would be painful
German output loss relative to base
Output effects of Eurozone break up
Cumulative o utput lo ss 2010-2012 (in % relative to base)
German GDP (level, 2009 = 100)
Greece
Ireland
108
106
104
Spain
Italy
P o rtugal
102
-10%
100
98
96
B elgium
94
Netherlands
92
France
Germany
-15
-10
Greek exit
-5
To tal break-up
0
90
88
2009
2010
B ase
2011
Greek exit
2012
To tal break-up
42
Inflation for periphery, deflation for core
Peripheral bond spreads under break up
Inflation under Eurozone break up
Inflatio n in to tal euro break-up scenario (CP I, % yo y)
Germany
12
Netherlands
10
France
Spread 10-year go vernment bo nd relative to
Germany in EM U break-up scenario (in %-po ints)
end year fo recasts
8
B elgium
6
Spain
4
Ireland
2
P o rtugal
0
Greece
07
-5
0
5
2012
10
2011
15
20
08
Greece
09
P o rtugal
10
Spain
11
Ireland
12
Italy
2010
43
Summary
 Crisis has developed in three stages
 Main cause of Financial crisis: unprecedented scale and complexity of credit boom
 Recession in historical perspective was very deep and not over yet
 Unprecedented policy stimulus has fuelled the recovery over the past year
 Europe looks to be recovering too…but there are big differences within the region (north-south)
 The emergence of sovereign risk is forcing fiscal tightening in Europe and the US
 Government borrowing has replaced private borrowing – on an alarming scale
 The unintended consequence of tougher regulation may be added to the headwinds to the cyclical
recovery
 Monetary policy may have to remain looser for longer in the developed world
 …where fortunately inflation remains tame...
 ...and growth in the emerging world looks more solidly based
44
Lessons learned
Companies
 Trees don’t grow into heaven
 Long term orientation
 Avoid following fashion of the day
 Be very conservative in financing: strong balance sheet is key
 Corporate social responsibility should be part of strategy and culture
 Be aware of low probability, high impact risks
45
Additional lessons learned
Financial Institutions
 Trust/confidence (society, customers and competitors) is key
 Stronger solvency and liquidity
 Accept to be highly regulated and to have international supervision
 Know your customers; understand your products and related risks
 More holistic risk management
46
Lessons learned
Governments Europe
 Become and remain competitive
 Budget discipline especially in good times
 North Europe has to support South Europe (no choice)
 Explain people the interdependencies in Europe
 Create credible strong systems to uphold agreements (a.o. stability pact)
47
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