LN05Eiteman743464 13 MBF LN05

Chapter 5
The Continuing
Global Financial
Crisis
2013 Pearson Education, Inc. All rights reserved. 5-2
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

The Seeds of Crisis: Sub-Prime Debt
(contd)
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

Deregulation
Markets were becoming more competitive than
ever as a result of a number of deregulation efforts
in the United States
The Gramm-Leach-Bliley Financial Services
Modernization Act of 1999 completed the repeal of
the Glass-Steagall Act of 1933 and 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) and the Securities
and Exchange Commission (SEC)

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 to high
interest rates after a few years or had
substantial step-ups in payments after an
initial period of interest-only payments

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 consists of borrowers who do not
meet underwriting criteria and have a higher perceived risk of
default
With DIDMCA (1980) federal law superseded state usury laws
Tax Reform Act (TRA) of 1986 eliminated tax deductibility of
consumer loans, but allowed tax deductibility on interest charges
associated with both a primary residence and a second mortgage
loan
Exhibit 5.1 illustrates post 2000 run-up and subsequent crash
of mortgage and total domestic U.S debt

Exhibit 5.1 U.S. Credit Market
Borrowing, 1995-2010
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

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

The Transmission Mechanism:
Securitization
The transport vehicle for the growing lower quality
debt was a combination of securitization and re-
packaging 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.

Exhibit 5.2 Household Debt as a
Percentage of Disposable Income,
1990-2008
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.
Growth was rapid. As illustrated in Exhibit 5.3, mortgage-
backed securities (MBS) issuances rose dramatically in the
post-2000 period. By end of year 2007, just prior to the crisis,
MBS totaled $27 trillion and represented 39% of all loans
outstanding in the U.S. marketplace.

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 borrowers ultimate capability to repay the
loans.
Critics of securitization argue that securitization provides
incentives for rapid and possibly sloppy credit quality
assessment.

Exhibit 5.3 Annual Issuances of
MBSs, 1995-2009
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).
SIVs used these proceeds to purchase portfolios of higher
yielding securities which held investment grade credit
ratings (generating an interest margin, acting as
middleman)

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 banks financial resources to
originate more and more loans, earning a variety of fees.

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 Really?!
The actual value of the CDO was no better or worse than its two
primary value drivers. The first was the performance of the debt
collateral it held, the ongoing payments made by borrowers; the
second was the willingness of institutions to make a market in
CDOs.
Exhibit 5.4 illustrates how in 2007 the CDO market collapsed.

Exhibit 5.4 Global CDO Issuance,
2004-2008 (billions of U.S. dollars)
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.

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.
Exhibit 5.5 shows how the CDS market grew to
many times larger than the value of the underlying
securities.

Exhibit 5.5 Credit Default Swap
Market Growth
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.

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-to-one
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.

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.

Credit Crisis
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.

Credit Crisis
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.
Exhibit 5.6 shows LIBOR market reaction to the
perception of financial collapse by U.S. financial
institutions.

Exhibit 5.6 USD and JPY LIBOR
Rates, September-October 2008
Credit Crisis
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 $85
billion 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.

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.

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.
Exhibit 5.7 illustrates clearly how markets fell in September
and October 2008, and how they remained volatile in the
months that followed.
Constricted lending had impacted borrowing and importantly
investing.
Prospects for investment returns of all types were dim;
corporations failed to see returns on investments.
As a result there was widespread retrenchment among
industrialized nations as corporations slashed budgets and
headcount.

Exhibit 5.7 Selected Stock Markets
During the Crisis
Whats 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.

LIBORs Role
The global financial markets have always depended
upon commercial banks for their core business
activity. See Exhibit 5.8
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.

Exhibit 5.8 LIBOR and the Crisis in
Lending
LIBORs 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.
Exhibit 5.9 shows this disruption via the TED spread in
October 2008
Exhibit 5.9 The U.S. Dollar TED
Spread (July 2008January 2009)
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
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

U.S. Credit Crisis Resolution
The European Debt Crisis of 2009-
2012
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 2009-
2012
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

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Chapter 5

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