Lessons from the Crisis

1. Lessons from the Crisis Peter Elverding November 2010

2. Crisis in Stages • Stage 1: 2007-2008 credit crisis • falling asset prices • banking distress • Stage 2: 2008-2009 economic crisis • economic activity plunges • aggressive and unorthodox policy responses spark recovery… • Stage 3: 2010 political crisis? • politically charged debates over tightening fiscal policy and regulation • recovery faces structural headwinds Systemic InteractionThe economy, asset prices, policy and finance are interdependent REAL ECONOMY FINANCIAL SYSTEM POLICY RESPONSE ASSET PRICES

3. UNDERLYING CREDIT MORTGAGES, LOANS, BONDS SECURITISED CREDIT ABS RE-PACKAGED SECURITISED CREDIT CDO, CLO CREDIT DEFAULT SWAPS (CDS) CDS – cheap ‘insurance’ against default ↔ heavily leveraged investment in ‘tail risk’ Origins of the credit crisis Pyramid in the Fog The modern structure of the credit markets • The earlier stock market bust set the scene • …by giving impetus to the surge of activity in the credit market • an environment of low inflation and sustained growth fostered risk taking. • Financial excess echoed previous crises… • expansionary monetary policy, lax lending standards and regulation, excessive borrowing and financial innovation all played a part • …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. • this was exposed by the bursting of the bubble in the US housing market • 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

6. House prices rose as loan quality plunged

7. The (housing) bubble that burst

8. Unprecedented delinquency…

9. Residential construction activity “ceases”

10. Mortgage-related assets crash

14. Equity (5%) Equity (3%) BB (3%) • A pool of BBB, A and AA notes from RMBS is used to create collateralised debt obligations (CDOs) • The CDOs are again tranched of different levels with credit risk BBB (5%) BBB (3%) AAA (25%) A (7%) A (4%) AA (5%) Super-senior (55%) AA (12%) • The pool is packaged into sub-prime residential mortgage backed securities (RMBS) • The RMBS are tranched into different levels of credit risk Pool of U.S. sub-prime residential mortgages AAA (73%) Mortgages Securitisation RMB CD • Slicing and dicing or mortgage risk Source: Oliver Wyman

15. Banking sector goes into meltdown

16. Credit availability evaporates during crisis

17. Debt deleveraging exacerbates recession

18. 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 1989/90 US S&L and collapse of Japanese stock market Citibank downgraded to BBB+ 2001/2002 Stock markets bubble burst 1995 Mexican ‘Tequila’ crisis 1987 ‘Black Monday’ 1982 Latin loans 1997/98 Emerging Markets crisis Asia/Russia/Brazil

19. The historical perspective of the present crisis: Stock markets European stock market Recent developmentsThe Euro stoxx 600 Index (Aug 08-Jul 10) The historical perspectiveThe Euro stoxx 600 Index (1990-2010) Note to PU: Where data contains more than 4000 rows chart has been inserted as a picture See Source\A20101338_source charts.xls Tab: 4 EU Stock Market

20. The historical perspective of the present crisis: Interest rates Dollar interest rates The Fed funds rate and the US 3M interbank rate

21. The historical perspective of the present crisis: Interest rates Euro interest rates The ECB refinance rate and the German 3M interbank rate

22. The historical perspective of the present crisis: Interest rates Interest rates The 3M interbank rate minus the yield on Treasury Bills – TED Spread

23. The present situation: Credit markets Sovereign spreads over swaps Recent developments10 year government bond spreads over swaps (Jul 08-Jun 2010) The historical perspective10 year government bond spreads over swaps (1999-2010) Note to PU: Where data contains more than 4000 rows chart has been inserted as a picture See Source\A20101338_source charts.xls Page 11

24. The present situation: Credit Markets Investment Grade credit markets The historical perspectiveMerrill Lynch EUR investment grade Bank and Corporate 5 yr Spread Index Investment Grade Spreads (1996-2010)

25. The present situation: The Financial Sector The impact on banks – worldwide Source: Bloomberg as of 26 July 2010

26. Global Recovery and Policy Crisis (Europe)

27. Global Recovery – led by the East • Emerging economies have led the global recovery • Eurozoneto lag behind the US • China resilient as policy is tightened • Asia to outperform Latamand EMEA

28. Developed economies - a big step down

29. Structural Headwinds togrowth • Four medium term challenges: • Credit creation is still dysfunctional • Household deleveraging to continue • Creditor nations are reluctant to spend • Fiscal and monetary consolidation

30. ‘Relief rally’ falters as policy debate rages

31. Eurozone debt crisis weighed on the EUR

32. “Make the bankers’ pay…” 'If They Want a Fight, That's a Fight I'm Willing to Have' (Obama, Jan-10)

33. LOOSER MONETARY POLICY Monetary policy to relieve the squeeze? Systemic InteractionThe economy, asset prices, policy and finance are interdependent REAL ECONOMY FINANCIAL SYSTEM TIGHTER FISCAL POLICY ASSET PRICES TIGHTER REGULATION TIGHTER REGULATION The POLICY SQUEEZE Monetary policy may be loosened to offset the pressure from tighter regulation and fiscal policy

34. 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: • Improved primary budget balance = either lower expenditure or higher taxes • Lower interest rates = loose monetary policy or bullish bond market sentiment • Faster nominal GDP growth = either faster real growth or higher inflation • Reduce existing debt = either sell-off assets or restructure/default on existing debt

35. Eurozone debt – shades of black

36. 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

37. Eurozone positives

38. Eurozone negatives

39. Fiscal tightening to drag from 2011

40. European growth – a Northern bias

41. Growth threat to Southern Europe’s solvency Unit labour cost for total economy (2001=100)

42. Worst case scenario – EMU break-up

43. A Eurozone break up would be painful German output loss relative to base Output effects of Eurozone break up

44. Inflation for periphery, deflation for core Peripheral bond spreads under break up Inflation under Eurozone break up

45. 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

46. 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

47. 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

48. 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)