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Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Chapter 5

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

Copyright © 2010 Pearson Prentice Hall. 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 (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


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)


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


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


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


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



• 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.



• 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.


Exhibit 5.3 Securitized Loans Outstanding (trillions of U.S. dollars)


Structured Investment Vehicles begáIt]bkrN_EdlCarcnasm<½n§

• 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)


Exhibit 5.4 Structured Investment Vehicles (SIVs)


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.


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.


Exhibit 5.5 The Collateralized Debt Obligation


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.



• 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.


Subordination for Credit Enhancement in CDO Tranches

EXHIBIT 5.9 CDO Construction and Credit Enhancement.


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.



• 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.



• 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.


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.

• 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.


Mark-to-Market Accounting emtUtKNnaKittMéltamTIpSar

• 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.


What’s Wrong with LIBOR? ¬[eKx©I sMrab;FnaKar¦• 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.


LIBOR’s Role

• 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.


Exhibit 5.12 LIBOR and the Crisis in Lending


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.


Exhibit 5.13 The U.S. Dollar TED Spread (July 2008–January 2009)


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


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


The Remedy:karBüa)alPrescriptions for an Infected Global Financial Organism ¬mUlFnniym¦

• 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?


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.


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



• 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.



• 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.



• 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.



• 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.


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?

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Additional Chapter Exhibits

Chapter 5


[Insert Exhibit 5.1]

Exhibit 5.1 U.S. Financial Assets as a Percent of GDP


[Insert Exhibit 5.6]

Exhibit 5.6 Global CDO Issuance, 2004–2008 (billions of U.S. dollars)


Exhibit 5.7 Cash Flows under a Credit Default Swap


Exhibit 5.8 Credit Default Swap Market Growth


Exhibit 5.10 USD & JPY LIBOR Rates (September—October 2008)


Exhibit 5.11 Selected Stock Markets during the Crisis


Exhibit 5.14 Three-Month Money Market and Credit Spreads (Bank for International Settlements) in Basis Points

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