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Chapter 5. Current Multinational Financial Challenges: The Credit Crisis of 2007 - 2009. Current Multinational Financial Challenges: The Credit Crisis of 2007 – 2009: Learning Objectives.

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chapter 5

Chapter 5

Current Multinational Financial Challenges: The Credit Crisis of 2007 - 2009

current multinational financial challenges the credit crisis of 2007 2009 learning objectives
Current Multinational Financial Challenges: The Credit Crisis of 2007 – 2009: Learning Objectives

Learn how a variety of economic, regulatory, and social forces led to the real estate market growth and collapse

Examine the various dimensions of defining and classifying individual borrowers in terms of their credit quality

Consider the role that financial derivatives and securitization played in the formation of the international credit crisis

Examine how LIBOR, the most widely used cost of money, reacted to the growing tensions and risk perceptions between international financial institutions during the crisis

current multinational financial challenges the credit crisis of 2007 2009 learning objectives3
Current Multinational Financial Challenges: The Credit Crisis of 2007 – 2009: Learning Objectives

Identify the characteristics and components of a number of the instrumental financial derivatives contributing to the spread of the credit crisis including collateralized debt obligations (CDOs), structured investment vehicles (SIVs), and credit default swaps (CDSs)

Evaluate the various remedies and prescriptions being pushed forward by a variety of governments and international organizations for the infected global financial organism

the seeds of crisis subprime debt
The Seeds of Crisis: Subprime Debt

The Repeal of Glass-Steagall

1933 legislation that separated commercial from investment banking

FDIC had insured commercial bank deposits

SEC had regulated the riskier investment banks

Gramm-Leach-Bliley Financial Services Modernization Act of 1999

Repealed what remained of Glass-Steagall by allowing commercial and investment banks to engage in activities formerly reserved for the other

the seeds of crisis subprime debt5
The Seeds of Crisis: Subprime Debt

The Housing Sector and Mortgage Lending

Many new borrowers now qualified for loans

Prime loans, also known as conventional or conforming loans, meet the requirements for resale to Government Sponsored Enterprises (GSEs) such as Fannie Mae or Freddie Mac

Alt-A loans (Alternative-A paper) are considered low risk but have an initial non-conforming feature

Subprime loans do not meet underwriting criteria and have higher risk of default

the seeds of crisis subprime debt6
The Seeds of Crisis: Subprime Debt

Subprime loans continued

Until 1980 most states prevented sale of subprime securities

DIDMCA (1980) supersedes state laws

Tax Reform Act (1986) eliminates the tax deductibility of many types of consumer debt but keeps the tax deductibility of loans associated with real estate including second mortgages and equity lines of credit

By 2008 subprime loans equal approx 8% of outstanding mortgage obligations but are the source of over 65% of bankruptcy filings by U.S. homeowners

the seeds of crisis subprime debt7
The Seeds of Crisis: Subprime Debt

Exhibit 5.1

Shows that from 1960 – late 1980s almost no change in U.S. financial assets as a percentage of GDP

From late 1980s to 2008 financial assets more than doubled from 450% of GDP to over 900% of GDP

Rising housing prices were used as collateral for mortgage-backed assets and encouraged refinancing of mortgages to provide current income

Exhibit 5.2

Debt obligations rose in a variety of countries and was not limited to the United States

the transmission mechanism securitization and derivatives of securitized debt
The Transmission Mechanism: Securitization and Derivatives of Securitized Debt

Liquidity – the ability to turn an asset into cash quickly at a fair market value

Securitization

The process of turning an illiquid asset into a liquid salable asset

A form of disintermediation, or bypassing traditional financial intermediaries

Mortgage-backed securities (MSBs) by year-end 2007 had increased five-fold from 1990 to a total of $27 trillion

the transmission mechanism securitization and derivatives of securitized debt11
The Transmission Mechanism: Securitization and Derivatives of Securitized Debt

Exhibit 5.3 - shows the growth of U.S. securitized loans

Securitization continued

Asset-backed securities (ABSs) consist of loans such as second mortgages, equity lines of credit, auto loans, and credit card receivables among others

Securitization allows a disconnect between loan originator and borrower

The practice of “originated-to-distribute” (OTD) decreases the ability and the incentive of the loan originator to monitor borrower behavior

the transmission mechanism securitization and derivatives of securitized debt13
The Transmission Mechanism: Securitization and Derivatives of Securitized Debt

Structured Investment Vehicles (SIVs)

Off-balance sheet entity designed to allow banks to invest in long-term higher yielding assets and fund these assets through the sale of commercial paper (CP)

Portfolio theory failed in assessing the risk of SIVs

Banks had guaranteed the backup lines of credit for the CP

Exhibit 5.4 - demonstrates how an SIV works

the transmission mechanism securitization and derivatives of securitized debt15
The Transmission Mechanism: Securitization and Derivatives of Securitized Debt

Collateralized Debt Obligations (CDOs)

Asset-backed securities packaged and passed to an off-shore entity via a special purpose vehicle (SPV) to be sold in the market by security underwriters

Allowed banks to make loans, collect upfront fees, sell the assets and repeat

CDOs are categories in tranches classified as:

Senior – or AAA rated borrowers

Mezzanine - AA – BB rated borrowers

Equity – or below BB rated borrowers

the transmission mechanism securitization and derivatives of securitized debt16
The Transmission Mechanism: Securitization and Derivatives of Securitized Debt

Collateralized Debt Obligations (CDOs) Cont.

CDO ratings were hurried and proved to be difficult and ultimately inaccurate

CDO market grows rapidly from 2001 – 2007 thanks to booming real estate markets, slow equity markets, and low interest rates

CDO value driven by cash flows from the original loan and liquidity

Exhibit 5.5 illustrates how a CDO works

Exhibit 5.6 shows CDO volume from 2004 - 2008

the transmission mechanism securitization and derivatives of securitized debt19
The Transmission Mechanism: Securitization and Derivatives of Securitized Debt

Credit Default Swaps (CDSs)

Initially CDSs were designed as insurance against payment default for purchasers of corporate debt

Subsequently mutated to a form of speculation betting on the ability, or lack thereof, of the debt issuer’s ability to repay

Purchaser of a CDS did not have to have ownership of the underlying asset, nor were there limits on how many speculative contracts could be sold on a particular asset, nor was the market publicly regulated

The CDS market grew to $62 trillion – far larger than the corresponding underlying assets

the transmission mechanism securitization and derivatives of securitized debt20
The Transmission Mechanism: Securitization and Derivatives of Securitized Debt

Exhibit 5.7 explains how CDSs work

Exhibit 5.8 charts the growth of CDSs

Credit Enhancement

Making investments more attractive to investors by reducing their perceived risk

Commonly, ABSs were insured to appear safer

Exhibit 5.9 shows how in the 1990s credit enhancement was provided in the form of subordination

the fallout the crisis of 2007 2009
The Fallout: The Crisis of 2007 - 2009

The housing market slows in 2005 and crashes in the spring of 2007 in several countries

Two hedge funds at Bear Stearns fail in July 2007

Northern Rock Bank is bailed out by the Bank of England

September 2007 sees several bank runs around the globe

Commodity prices skyrocket in 2008 with crude oil peaking at $147/barrel in July

the fallout the crisis of 2007 200925
The Fallout: The Crisis of 2007 - 2009

US Government places Fannie Mae and Fredie Mac into conservatorship on September 7, 2008

Lehman Brothers fails on September 14, 2008

Equity markets plunge on September 15

AIG rescued with an $85 billion bailout September 16

the fallout the crisis of 2007 200926
The Fallout: The Crisis of 2007 - 2009

September 2008 – Spring 2009 corporate lending markets demonstrate the following:

Risky investment banking activities overwhelmed commercial banking activities

Corporate indebtedness was tiered

Corporate balance sheets seem to have predicted the crisis with low levels of debt and high levels of cash and marketable securities

Even low risk marketable securities were now failing

Credit lines and lending was sharply reduced

the fallout the crisis of 2007 200927
The Fallout: The Crisis of 2007 - 2009

September 2008 – Spring 2009 corporate lending markets demonstrate the following: Continued

Commercial paper markets almost stopped operating in September and October of 2008

Traditional commercial bank lending for operating capital was squeezed out by huge investment banking losses

Exhibit 5.10 illustrates a timeline of economic events and the impact on interest rates

the fallout the crisis of 2007 200929
The Fallout: The Crisis of 2007 - 2009

Global Contagion

The collapse of mortgage-backed security markets in the U.S. spread globally

Capital fled from equity markets world wide cash in traditionally stable currencies such as yen, euro, and U.S. dollars

Exhibit 5.11 highlights the fall of equity markets in select countries in September and October of 2008

the fallout the crisis of 2007 200931
The Fallout: The Crisis of 2007 - 2009

Global Contagion continued

In spring 2009 mortgage delinquency rates reach record highs

Domestic firms were favored over MNEs by rating agencies, financial institutions, and government agencies

Credit crisis progresses from the failure of specific mortgage-backed securities to great risk put on commercial and investment banks, to a credit-induced global recession with the potential of a global recession and all that entails

the fallout the crisis of 2007 200932
The Fallout: The Crisis of 2007 - 2009

LIBOR – The London Interbank Offered Rate

Has always traded as a “no-name” market with no differential credit risk among participating institutions

As mortgages and derivatives failed and CDOs started suffering losses, individual banks were treated as risks in themselves

LIBOR was estimated to be used in the pricing of over $350 trillion of assets globally

Dramatic fluctuations and increases in LIBOR were a major course of concern for all

the fallout the crisis of 2007 200934
The Fallout: The Crisis of 2007 - 2009

LIBOR – The London Interbank Offered Rate, cont.

July and August 2008 the TED spread is approximately 80 basis points (where the TED spread is the difference between the U.S Treasury Bill rate and the Eurodollar futures market)

The TED spread leapt to 359 basis points at times during the next two months before the market somewhat returned to more normal differences

the remedy prescriptions for an infected global financial organism
The Remedy: Prescriptions for an Infected Global Financial Organism

Debt – originate-to-distribute behavior combined with poor credit assessment but be addressed

Securitization – risk assessment is not properly evaluated by portfolio theory

Derivatives – some became so complex they were difficult to evaluate and were outside the oversight of regulators

Deregulation – new legislation is already in effect but the proof is in the implementation

the remedy prescriptions for an infected global financial organism36
The Remedy: Prescriptions for an Infected Global Financial Organism

Capital Mobility – greater openness will result in greater opportunity and more and bigger crises

Illiquid Markets – without liquidity markets soon fail

Troubled Asset Recovery Plan (TARP) - $700 billion to bail-out banks and other entities deemed “too big to fail”. Much of these funds have already been repaid

Liquidity vs. Capital – as asset values fell due to loan defaults banks suffered massive equity losses

the remedy prescriptions for an infected global financial organism37
The Remedy: Prescriptions for an Infected Global Financial Organism

Golden Parachutes – top executives resigned but were well-compensated due to earlier termination agreements

Financial Reform Law of 2010 – Key Features:

Established an Office of Financial Research

FDIC insurance increased to $250,000 per account

SEC can sue professionals who knew about deceptive acts even if they did not instigate the acts

Treasury to modernize and monitor state insurance regulators

Institutions must disclose the amount of short selling in each stock

the future
The Future

Exhibit 5.14 shows how cross-border capital flow fell by more than 80% due to the crisis

Questions remain about how long until and how capital will return to international markets

summary of learning objectives
Summary of Learning Objectives

The seeds of the credit crisis were sown in the deregulation of the commercial and investment banking sectors in the 1990s.

The flow of capital into the real estate sector in thepost-2000 period reflected changes in social and economic forces in the U.S. economy.

Mortgage loans in the U.S. marketplace are normally categorized as prime (A-paper), Alt-A Alternative-A paper), and subprime, in increasing order of riskiness.

summary of learning objectives42
Summary of Learning Objectives

Subprime borrowers, historically not considered creditworthy for mortgages, became an acceptable credit risk as a result of major deregulation initiatives.

The transport vehicle for the growing distribution of lower-quality debt was a combination of securitization and re-packaging provided by a series of new financial derivatives.

Securitization allowed the re-packaging of different combinations of credit-quality mortgages in order to make them more attractive for resale to other financial institutions; derivative construction increased the liquidity in the market for these securities.

summary of learning objectives43
Summary of Learning Objectives

The structured investment vehicle (SIV) was the ultimate financial intermediation device: It borrowed short and invested long.

The SIV was an off-balance sheet entity designed to allow a bank to create an investment entity that would invest in long-term and higher yielding assets such as speculative grade bonds, mortgage-backed seucrities (MBSs) and collateralized debt obligations (CDOs), while funding itself through commercial paper (CP) issuances.

summary of learning objectives44
Summary of Learning Objectives

The CDO, collateralized debt obligation, is a portfolio of debt instruments—mortgages—which are re-packaged as an asset-backed security. Once packaged, the bank passes the security to a special purpose vehicle (SPV).

The credit default swap (CDS) is a contract, a derivative, which derived its value from the credit quality and performance of any specified asset. 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.

summary of learning objectives45
Summary of Learning Objectives

LIBOR, although only one of several key interest rates in the global marketplace, plays a critical role in the interbank market as the basis for all floating rate debt instruments of all kinds. This includes mortgages, corporate loans, industrial development loans, and the multitudes of financial derivatives sold throughout the global marketplace.

summary of learning objectives46
Summary of Learning Objectives

With the onset of the credit crisis in September 2008, LIBOR rates skyrocketed between major international banks, indicating a growing fear of counterparty default in a market historically considered the highest quality and most liquid in the world.

The U.S. Congress passed the Troubled Asset Recovery Plan (TARP), which authorized the U.S. government to use up to $700 billion to bail out the riskiest large banks.

summary of learning objectives47
Summary of Learning Objectives

The U.S. Federal Reserve purchased billions in mortgage-backed securities, CDOs, in the months following the credit crisis in an attempt to inject liquidity into the credit markets.

As a result of the massive write-offs of failed mortgages by the largest banks, the banks suffered weakened equity capital positions, making it necessary for the private sector and the government to inject new equity capital into the riskiest banks and insurers.