Chapter 5
Current
Multinational
Financial
Challenges:
The Credit Crisis
of 2007-2009
The Seeds of Crisis: Sub-Prime Debt
• The origins of the current crisis lie within the
ashes of the equity bubble and subsequent
collapse of the equity markets at the end of the
1990s
• With the collapse of the dot.com bubble, capital
began to flow increasingly toward the real estate
sectors in the United States
• The U.S. banking sector found mortgage lending
highly profitable and saw it as a rapidly expanding
market
5-2
The Seeds of Crisis: Sub-Prime Debt
(cont’d)
• As a result, investment and speculation in the real
estate sector increased rapidly
• As prices rose and speculation continued, a
growing number of the borrowers were of lower
and lower credit quality
• These borrowers, and their associated mortgage
agreements (sub-prime debt), now carried higher
debt service obligations with lower and lower
income and cash flow capabilities
5-3
Deregulation
• Markets were becoming more competitive than
ever as a result of a number of deregulation
efforts in the United States
• The repeal of the Glass-Steagall Act of 1933
eliminated the last barriers between commercial
and investment banks, allowing commercial banks
to enter areas of more risk
• Increased deregulation also put pressure on
existing regulators such as the Federal Deposit
Insurance Corporation (FDIC)
5-4
Exhibit 5.1 U.S. Financial Assets as
a Percent of GDP
[Insert Exhibit 5.1]
5-5
The Housing Sector and Mortgage
Lending
• New market openness and competitiveness
allowed many borrowers to qualify for
mortgages that they would not have
qualified for previously
• Structurally, some mortgages re-set a high
interest rates after a few years or had
substantial step-ups in payments after an
initial period of interest-only payments
5-6
Credit Quality
• Mortgage loans in the U.S. marketplace are
normally categorized (in increasing order of
riskiness) as:
– Prime (or A-paper)
– Alt-A (Alternative A-paper)
– Sub-prime
• The sub-prime category is difficult to define.
• In principle, it reflects borrowers who do not meet
underwriting criteria and have a higher perceived
risk of default normally as a result of credit history
5-7
Credit Quality
• Sub-prime mortgages are nearly
exclusively floating-rate structures, and
carry significantly higher interest rate
spreads over the floating bases such as
LIBOR
• Sub-prime borrowers typically pay a 2%
premium over prime – the subprime
differential
5-8
Credit Quality
• Subprime lending was itself the result of
deregulation
• Growing demand for loans or mortgages
from sub-prime borrowers led more and
more originators to provide the loans at
above market rates
• Sub-prime loans became a growing
segment of the market by the 2003-2005
period
5-9
Asset Values
• One of the key financial elements of this growing
debt was the value of the assets collateralizing the
mortgages – the houses and real estate itself
• As the market demands pushed up prices, housing
assets rose in market value
• The increased values were then used as collateral
in re-financings or second mortgages
• Many mortgage holders became more indebted
and participants in more aggressively constructed
loan agreements
• Mortgage brokers and loan originators, driven by
additional fee income, pushed for continued
refinancings
5-10
The Transmission Mechanism:
Securitization
• The transport vehicle for the growing lower quality
debt was a combination of securitization and repackaging provided by a series of new financial
derivatives
• Securitization, long a force of change in global
financial markets, is the process of turning an
illiquid asset into a liquid saleable asset.
• In finance, a liquid asset is one that can be
exchanged for cash, instantly, at fair market
value.
5-11
Exhibit 5.2 Household Debt as a
Percentage of Disposable Income,
1990-2008
5-12
The Transmission Mechanism:
Securitization
• The 1980s saw the introduction of securitization in U.S. debt
markets, and its growth has been unchecked since.
• In its purest form, securitization essentially bypasses the
traditional financial intermediaries (typically banks), to go
direct to investors in the marketplace to raise funds.
• Securitized assets took two major forms, mortgage-backed
securities (MBSs) and asset-backed securities (ABSs).
• Asset-backed securities included second mortgages and
home-equity loans based on mortgages, in addition to credit
card receivables, auto loans, and a variety of others.
5-13
The Transmission Mechanism:
Securitization
• The credit crisis of 2007-2008 renewed much of the debate
over the use of securitization.
• Securitization had historically been viewed as a successful
device for creating liquid markets for many loans and other
debt instruments.
• However, securitization may ultimately degrade credit
quality as lenders or originators of loans would not be held
accountable for the borrower’s ultimate capability to repay
the loans.
• Critics of securitization argue that securitization provides
incentives for rapid and possibly sloppy credit quality
assessment.
5-14
Exhibit 5.3 Securitized Loans
Outstanding (trillions of U.S. dollars)
5-15
Structured Investment Vehicles
• The structured investment vehicle (SIV) was the ultimate
financial intermediation device, filling the market niche as
buyer for much of the securitized non-conforming debt.
• The funding of the typical SIV was fairly simple: using
minimal equity, the SIV borrowed very short (commercial
paper, interbank or medium-term notes).
• SIV’s used these proceeds to purchase portfolio’s of
higher yielding securities which held investment grade
credit ratings (generating an interest margin, acting as
middleman)
5-16
Exhibit 5.4 Structured Investment
Vehicles (SIVs)
5-17
Collateralized Debt Obligations
• One of the key instruments in the growing market of
securitized products was the collateralized debt obligation or
CDO.
• Banks originating mortgage loans, and corporate loans and
bonds, could now create a portfolio of these debt
instruments and package them as an asset-backed security.
• Once packaged, the bank passed the security to a special
purpose vehicle (SPV).
• From there, the CDO was sold into a growing market
through underwriters freeing up the bank’s financial
resources to originate more and more loans, earning a
variety of fees.
5-18
Collateralized Debt Obligations
• CDOs were sold to the market in categories representing the
credit quality of the borrowers in the mortgages – senior
tranches (rated AAA), mezzanine or middle tranches (AA
down to BB), and equity tranches (below BB or junk status).
• The actual marketing and sales of the CDOs was done by the
major investment banking houses.
• CDOs would be rated by rating agencies, often without
undertaking the typical ground-up credit analysis
themselves.
• Further, combinations of bonds were able to achieve higher
ratings than any of the individual bonds – a confounding
issue.
5-19
Exhibit 5.5 The Collateralized Debt
Obligation
5-20
Credit Default Swaps
• The credit default swap (CDS) is a contract, a
derivative, which derived its value from the credit
quality and performance of any specified asset.
• Invented in 1997, the CDS was designed to shift
the risk of default to a third-party.
• In short, it was a way to bet whether a specific
mortgage or security would either fail to pay on
time or fail to pay at all.
• For hedging, it provided insurance against the
possibility that a borrower might not pay.
• It was also a way in which a speculator could bet
against the increasingly risky securities (like the
CDO) to hold their value.
5-21
Credit Default Swaps
• The CDS was completely outside the regulatory
boundaries.
• Participants in the market, protection buyers and
protection sellers, do not have to have any actual
holdings or interest in the credit instruments at
the center of the protection.
• Participants simply have to have a viewpoint.
• CDSs actually allow banks to sever their links to
their borrowers, reducing incentives to screen and
monitor the ability of borrowers to repay.
5-22
Credit Default Swaps
• A buyer of a credit default swap makes regular
nominal premium payments to the seller for the
length of the contract.
• If there is no significant negative credit event
during the term of the contract, the protection
seller earns its premiums over time, never having
to payoff a significant claim.
• If a credit event occurs however, the protection
seller must fulfill its obligation to make a
settlement payment to the protection buyer.
5-23
Credit Default Swaps
• As a result of the CDS market growth in a completely
deregulated segment, there was no real record or registry of
issuances, no requirement on writers and sellers that they
had adequate capital to assure contractual fulfillment, and
no real market for assuring liquidity – depending on one-toone counterparty settlement.
• New proposals for regulation have centered first on requiring
participants to have an actual exposure to a credit
instrument or obligation, eliminating outside speculators,
and the formation of some type of clearinghouse to provide
systematic trading and valuation of all CDS positions at all
times.
5-24
Exhibit 5.6 Global CDO Issuance,
2004–2008 (billions of U.S. dollars)
[Insert Exhibit 5.6]
5-25
Exhibit 5.7 Cash Flows under a
Credit Default Swap
5-26
Exhibit 5.8 Credit Default Swap
Market Growth
5-27
Subordination for Credit
Enhancement in CDO Tranches
EXHIBIT 5.9 CDO Construction and Credit Enhancement.
5-28
Credit Enhancement
• A final element quietly at work in credit markets beginning in
the late 1990s was the process of credit enhancement.
• Credit enhancement is the method of making investment
more attractive to prospective buyers by reducing their
perceived risk.
• Bond insurance agencies were utilized as guarantors in the
case of default.
• Beginning in 1998 a more innovative approach to credit
enhancement was introduced in the form of subordination.
• This was the process of combining different asset pools of
differing credit quality into different tranches by credit
quality.
5-29
The Crisis of 2007 and 2008
• The housing market began to falter in late 2005,
with the bubble finally bursting in 2007.
• Global in scope, a domino effect ensued with
collapsing loans and securities being followed by
the funds and institutions which were their
holders.
• Starting with hedge funds at Bear Stearns and the
rescue of Northern Rock, the global financial
markets slid toward near panic.
• 2008 proved even more volatile, with oil and
commodity prices peaking, then plummeting.
5-30
The Crisis of 2007 and 2008
• In September 2008, the US government
announced it was placing Fannie Mae (the Federal
National Mortgage Association) and Freddie Mac
(the Federal Home Loan Mortgage Corporation)
into conservatorship.
• Over the following week, Lehman Brothers, one of
the oldest investment banks on Wall Street
struggled to survive, eventually filing for the
largest single bankruptcy in American history on
September 14.
5-31
The Crisis of 2007 and 2008
• The following day, equity markets plunged and US dollar
LIBOR rates shot skywards as a result of the growing
international perception of financial collapse by US banking
institutions.
• The following day, American International Group (AIG), who
had extensive credit default swap exposure, received an
$85billion injection from the US Federal Reserve in exchange
for an 80% equity interest.
• Periods of collapse and calm followed with the credit crisis
beginning in full force as the worlds credit markets – lending
of all kinds – nearly stopped.
5-32
Global Contagion
• Although it is difficult to ascribe causality, the
rapid collapse of the mortgage-backed securities
markets in the United States definitely spread to
the global marketplace.
• Capital invested in equity and debt instruments in
all major financial markets fled not only for cash,
but for cash in traditional safe-haven countries
and markets.
• Equity markets fell worldwide, emerging markets
were hit particularly hard.
• Currencies of the more financially open emerging
markets felt a significant impact.
5-33
Global Contagion
• By January 2009, the credit crisis was having additionally
complex impacts on global markets – and global firms.
• The crisis, which began in the summer of 2007 had now
moved to a third stage, that of potential global recession of
depression-like depths.
• Constricted lending had impacted borrowing and importantly
investing.
• Prospects for investment returns of all types were dim;
corporates failed to see returns on investments.
• As a result there was widespread retrenchment among
industrialized nations as corporates slashed budgets and
headcount.
5-34
Mark-to-Market Accounting
• One of the continuing debates about the global credit crisis is
whether the use of mark-to-market accounting contributed
significantly to the failure of financial institutions.
• A long-term practice of the futures markets, the method
requires that a financial institution re-value all financial
assets and derivatives daily, even though there is no
intention to liquidate the asset at that time.
• The problem is that many instruments do not trade in
markets, or trade only in very thin markets.
• When markets are in crisis, establishing a value can be a
very difficult task.
5-35
What’s Wrong with LIBOR?
• The global financial markets have always
depended upon commercial banks for their core
business activity.
• The banks in turn have depended on the interbank
market for liquidity which had historically operated
on a “no-names” basis but rather a tiered basis
with respect to individual banks.
• In the summer of 2007 however, much of this
changed, increasing focus on each individual
institution and its particular credit risk profile.
5-36
Exhibit 5.12 LIBOR and the Crisis in
Lending
5-37
LIBOR’s Role
• The British Bankers Association, the organization charged
with the daily tabulation and publication of LIBOR Rates,
became worried about the validity of its own published rate.
• The growing stress in the financial markets had actually
created incentives for banks surveyed for LIBOR calculation
to report lower rates than they were actually paying.
• As the crisis deepened, many corporate borrowers began to
publicly argue the LIBOR rates published were in fact
understating their problems.
• In its role as the basis for all floating rate debt instruments
of all kinds, LIBOR rates have the potential to cause
significant disruptions when they skyrocket as they did in
September 2008.
5-38
LIBOR’s Elements
• Amidst the credit crunch of 2007 and 2008,
the Bank for International Settlements in
Basle, Switzerland, had published a study of
the LIBOR market’s behavior of late.
• The study described the risk premium added
to interbank quotes as:
Risk Premium =
Term Premium + Credit Premium + Bank
Liquidity + Market Liquidity + Micro
5-39
LIBOR’s Elements
• The term premium is a charge for maturity
• The credit premium is a charge for the
perceived risk of default by the borrowing
bank
• Bank liquidity premium is the access of the
individual lending bank to immediate funds
• The market liquidity premium is a measure of
general market liquidity
• A micro premium is a charge representative of
the market micro-structure of how banks
conduct interbank lending
5-40
Exhibit 5.10 USD & JPY LIBOR
Rates (September—October 2008)
5-41
Exhibit 5.11 Selected Stock Markets
during the Crisis
5-42
Exhibit 5.13 The U.S. Dollar TED
Spread (July 2008–January 2009)
5-43
Exhibit 5.14 Three-Month Money Market and
Credit Spreads (Bank for International
Settlements) in Basis Points
5-44
The Remedy:
Prescriptions for an Infected Global
Financial Organism
• So where now for the global financial
markets?
• Dismissing the absolute extremes, on
one end that capitalism has failed, and
on the other end that extreme
regulation is the only solution, what
practical solutions fall in between?
5-45
The Remedy:
Prescriptions for an Infected Global
Financial Organism
• Debt
– Was the mortgage boom the problem?
– The market boom was caused as a result of the
combination of few competing investments with the
low cost and great availability of capital.
– Of greater concern was the originate-to-distribute
behavior combined with questionable credit
assessments and classifications.
– New guidelines for credit quality and access to
mortgages is already underway.
5-46
The Remedy:
Prescriptions for an Infected Global
Financial Organism
• Securitization
– Was the financial technique of combining assets into
packaged portfolios for trading the problem, or the lack
of transparency and accountability for the individual
elements within the portfolio?
– Portfolio theory had been constructed on the basis of
assets with uncorrelated movements
– In the case of mortgage-backed securities, the
portfolio components were so similar that the only
benefit was that the holder hoped that all the same
securities would not fall into delinquency
simultaneously
5-47
The Remedy:
Prescriptions for an Infected Global
Financial Organism
• Derivatives
– This is not the first time that derivatives have been
at the source of substantial market failures.
– However, derivatives are the core of financial
technological innovation.
– The creation of complex mortgage-backed assets
and derivative structures which ultimately made the
securities nearly impossible to value, particularly in
thin markets, was in hind-sight a very poor choice.
– Renewed regulatory requirements and increased
transparency in pricing and valuation will aid in
pulling derivatives back from the brink.
5-48
The Remedy:
Prescriptions for an Infected Global
Financial Organism
• Deregulation
– Regulation itself is complex enough in today’s rapidly
changing financial marketplace, and deregulation has
the tendency to put very dangerous tools and toys in
the hands of the uninitiated.
– Certain corrections have clearly been needed from the
beginning.
– Today, many argue over the degree and type of
regulation that should be imposed on financial
markets.
5-49
The Remedy:
Prescriptions for an Infected Global
Financial Organism
• Capital Mobility
– Capital is more mobile today than ever before.
– The combination of global capital markets of size never
seen before combined with more and more economic
systems around the globe which are pursuing market
economic solutions to both wealth and social ills will
continue to act as the elephant in the row boat.
– Dilemmas of countries such as Iceland and New
Zealand are only the beginning of this phenomena.
5-50
The Remedy:
Prescriptions for an Infected Global
Financial Organism
• Illiquid Markets
– This finally, will be the most troublesome.
– Most of the mathematics and rational behavior behind
the design of today’s sophisticated financial products,
derivatives, and investment vehicles are based on
principles of orderly and liquid markets.
– When the trading of highly commoditized securities or
positions as clean as overnight bank loans between
banks becomes the core source of instability in the
system then all traditional knowledge and assumptions
of finance have indeed gone out the window.
5-51
U.S. Credit Crisis Resolution
• Market solutions are preferred by U.S.
Treasury and Federal Reserve
• Immediate market solutions include
mergers and bankruptcy
• Government aid came in the form of the
Troubled Asset Recovery Plan (TARP) 2008
– $700 billion to support financial institutions and
insurers deemed too big to fail
U.S. Credit Crisis Resolution
• Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010
– Establish an Office of Financial Research
– FDIC insurance increased from $100,000 to
$250,000 per account
– Institutions must disclose amount of short selling
Chapter 5
The European
Debt Crisis of
2009-2012
Euro Zone
55
The European Debt Crisis of 20092012
• Most governments today run budget
deficits – European countries are no
exception
• Late 2009 the global financial crisis is
winding down but it fostered two realities
– Money was cheaper than ever
– Banks sharply reduced lending thus slowing
economies that needed growth to repay existing
debt levels
Sovereign Debt
• Government (sovereign) debt typically considered to
be of the highest quality due to ability to manage
fiscal (tax) policy and monetary policy
• Eurozone members control fiscal policy for their own
countries but not monetary policy
• Different levels of debt are incurred by each of the
eurozone countries as seen in Exhibit 5.10
• Greece with a debt/GDP ratio of 166% is the highest
Exhibit 5.10 European Sovereign Debt
in 2011
The European Debt Crisis of 20092012
• October 2009 the newly elected Greek
government discovers the previous administration
has systematically under-reported the government
debt
• Greek financial instruments are down graded
• Financial markets fear Greek default and financial
contagion to other financially weak eurozone
countries
• March 2010 the IMF helps establish a plan to
stabilize the Greek economy
The European Financial Stability
Facility (EFSF)
• EFSF designed to raise €500 billion to
extend credit to distressed member states
• Ireland:
– Unlike Greece, their problems are similar to
those in the U.S., a property bubble and the
failure of the banking system
• Portugal
– Problems may actually be contagion as their
financial problems did not appear to be as
serious as Greece or Ireland
Transmission
• Greek, Irish, and Portuguese government debt
was held by many European banks
• These banks were considered too big to fail
• The risky sovereign debt was trading at deep
discounts and with high yields
• Further bailouts of Greece and others were
becoming necessary
• Exhibit 5.11 illustrates what happened to interest
rates
• Who would buy such risky debt? See Exhibit 5.12
Exhibit 5.11 European Sovereign Debt
and Interest Rates
Example 5.12 Holders of Sovereign
Debt
Moving Ahead in Europe
• How much money is needed in the coming
years for eurozone countries? Exhibit 5.13
• Solutions to the debt crisis
– Greece needed immediate capital to manage
debt obligations and run their government
– European banks needed to be protected from
the plunging value of the sovereign debt of
Greece, Ireland, Portugal and the like
– Address the long-term fundamental issues of
government deficits with ...in some cases
austerity measures
Exhibit 5.13 Selective Eurozone
Financing Needs
Alternative Solution to the Eurozone
Debt Crisis
• The Brussels Agreement - a failed attempt to write
down sovereign debt values, increase funds in the
EFSF, and increase required bank equity capital –
contingent upon Greek acceptance of new
austerity measures, but the Greeks hesitated
• Debt-to-Equity Swaps – these come at a cost as
the debt value is trimmed before conversion to
equity
• Stability Bonds – Issued with the full backing of
every eurozone country rather than individual
sovereign debt – resisted by the stronger
countries
Currency Confusion
• Has the sovereign debt crisis put the euro
at risk?
• YES
– Too much euro-denominated sovereign debt
could raise significantly the cost of financing as
could the failure of eurozone countries to meet
convergence standards
• No
– Bad sovereign debt should affect each country
more than the group of euro nations
– Very little empirical evidence thus far that the
crisis has really devalued the currency
Sovereign Default
• Exhibit 5.14 provides a brief history of
sovereign defaults since 1983, and their
relative outcomes.
• U.S. response to the 2008-2009 credit
crisis was: write-offs by holders of bad
debt, government purchase of debt
securities, and government capital
injections to support liquidity
• Europe has chosen a similar path as the
last technique, banks are not participating
to the same extent as in the U.S.
Exhibit 5.14 Selected Significant
Sovereign Defaults
The Asian Currency Crisis, 1997-1998
Mexican peso Crisis in 1994
71
Russia’s currency crisis, 1998
Russia’s stock market value
(Dec 1995 = 1.0; in rubles)
Currency value: $/ruble
(Dec 1995 = 1.0)
Daily Exchange Rates: Argentine Pesos
per U.S. Dollar
The Ecuadorian Sucre/U.S. Dollar Exchange
Rate, November 1998-March 2000
28/2011
14/2009
/1/2008
20/2007
/5/2005
23/2004
/9/2003
27/2001
15/2000
/1/1999
Value of the Euro in U.S. Dollars
1.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
75
Mini-Case: Letting Go of Lehman Brothers
• Do you believe that the U.S. Government treated some
financial institutions differently during the crisis? What
that appropriate?
• Many experts argue that when the government bails out
a private financial institution it creates a problem called
“moral hazard,” meaning that if the institution knows it
will be saved, it actually has an incentive to take on
more risk, not less. What do you think?
• Do you think that the U.S. government should have
allowed Lehman Brothers to fail?
5-76
Chapter 5
Additional
Chapter Exhibits
History of the International
Monetary System
• Eurocurrencies
– These are domestic currencies of one country
on deposit in a second country
– The Eurocurrency markets serve two valuable
purposes:
• Eurocurrency deposits are an efficient and convenient
money market device for holding excess corporate
liquidity
• The Eurocurrency market is a major source of shortterm bank loans to finance corporate working capital
needs (including export and import financing)
3-78
History of the International
Monetary System
• Eurocurrency Interest Rates: Libor
– In the Eurocurrency market, the reference rate
of interest is the London Interbank Offered Rate
(LIBOR)
– This rate is the most widely accepted rate of
interest used in standardized quotations, loan
agreements, and financial derivatives
transactions
3-79
Exhibit 3.1 U.S. Dollar-Denominated
Interest Rates, June 2005
3-80
Recent History: Stock Market
(“The Dow”) and Housing Market
81
Recent History: Yield Spreads
82
International Investment Positions