The Subprime Meltdown

1
The Subprime Meltdown

• Professor Grace S. Ugut, PhD
• Associate Dean, EXCELL

2
GLOBAL IMBALANCES
Lesson learned from past crisis
Country receives a huge and sustainable flow of
foreign lending
Runs the risk of a subsequent financial crisis
because external domestic financial fragility
will grow
3
GLOBAL IMBALANCES

• After Asian Crisis 1997-1998

Emerging economies become massive capital
exporters

• Savings glut

Emerging economies shift into a large surplus of
savings over investment (i.e., in Asian
oil-exporting countries, 2 of world GDP by 2007
according to IMF)
US deficit absorbs 44 of these total surpluses
of the world economy
Other countries with housing bubbles Australia,
Spain, and UK absorbed 19 of the total surplus
Chinas current account surplus in 2007 11 of
its GDP Japans surplus Germanys surplus
Supporting the US currency and financing US
external deficits
Was this caused by deliberate policies?
Consequence is, within 10 years after Asian
crisis, the global reserve of foreign currency
increased by USD 5.2 trillion. Two-thirds of this
is in USD.
Yes, through accumulation of official foreign
exchange reserves, expansion of the sovereign
wealth funds, and easy monetary policy
4
THE BEGINNING
9/11 The Fed begins dropping interest rates
after the terrorist attack
Easy money period

• Low interest rates make mortgages more
  affordable, including for sub-prime borrower with
  shaky credit
• The mortgages are bundled into collateralized
  debit obligation sold to banks and various
  overseas funds
• As a result a housing boom
• To feed the demand, lenders devise even riskier
  mortgages

5
THE BEGINNING
The bubble bursts

• Subprime borrowers begin defaulting on their
  mortgages, when the oil price started to increase
• HOME PRICES FALL
• First casualty mortgage lenders, such as
• New Century Argent

6
THE BEGINNING
Credit crunch

• Lenders stop lending, afraid of losses
• Borrowers with good credit start defaulting on
  mortgages
• The casualty big mortgage lender Countrywide

7
THE BEGINNING
Transmissions to the banking sector

• Banks started breaking down
• Defaults Freddie Mac Fannie Mae
• US government took over mortgage debt of Freddie
  Fannie

8
THE BEGINNING
Transmissions to Stock Markets

• The casualty Lehman Brothers (4th largest
  investment bank huge player in real-estate
  financing)
• Forced Merrill to look for investor (i.e. Bank
  of America)
• Stock market plunges

Disrupted the CP market, affected many IBs
funding with high leveraged IB collapsing
This will have an impact to the companies debt
refinancing
9
GOVERNMENT INTERVENTION 1

• AIG, the worlds largest insurance company a
  big issuer of credit default swaps gets USD 85B
  credit line for 2 years from NY Fed to restore
  liquidity

THIS IS NOT CHEAP

• 3-months LIBOR 850 bps
• commitment fee of 2 of facility
• asset sales
• issuing more debt or equity

10
GOVERNMENT INTERVENTION 1
EARTHQUAKE CONTINUES

• The casualty the last 2 independent investment
  banks Morgan Stanley and Goldman Sachs, share
  prices plunge because of short sellers

Is Universal bank the better model?

• Money markets may be at risk after Reserve
  Primary fund failed to repay in full on Lehman
  debt securities

11
GOVERNMENT INTERVENTION 2
Has been seen as liquidity provider. A classic
problem of asymmetric information.

• Ban on short seller

The bailout package is for buying the distressed
securities (balance sheet) OR to recapitalize the
institutions that are burdened by distressed
securities (equity)

• US Treasury and Federal Reserve unveil plans for
  the creation of taxpayer-funded entity that will
  buy US 700B of trouble mortgages from banks
  (distressed mortgaged securities)

Something like preferred and ordinary stocks with
warrants

• Securities are hard to value
• Sellers know more about them than the buyer
• In any auction process, the treasury would end
  up with the dregs
• What the tax payer gets in return?

Bring private sector to participate in
recapitalizing banking stock

• Limited compensation of executives

There is a need for centralized clearing for CDS
and other OTC products, initiative by CME

• Treasury insures money-market funds

• Change in the MTM rule, FAS 157
• Regulate credit derivatives market

SPILLOVER EFFECT
12
TALKING ABOUT SPILLOVER EFFECT HOW ABOUT THE
EUROPEAN BANKS?

• Contagion effect
• AIGs last annual report reveals US 300B of
  credit insurance for European banks for the
  purpose of providing the banks with the
  regulatory capital relief rather than risk
  mitigation in exchange for a minimum guaranteed
  fee

• Devastating effects on European banks ratings
  and market confidence

The channel of transmissions is high LDR of many
banks which means high dependency on funding from
money market

• High leverage (SHE/ TA) ratio of 35 (US banks
  leverage ratio is less than 20).

13
TALKING ABOUT SPILLOVER EFFECT HOW ABOUT THE
EUROPEAN BANKS?
GLOBAL LIQUIDITY COORDINATION
Ted Spread

• Shows risk aversion through the gap between 3
  months-LIBOR and T-bill rate.
• Has been 20x higher than early 2007 level of
  less than 20 bps to 400 bps in September 2008.

14
IMPACTS OF THE CRISIS TO EMERGING MARKETS

• For some (e.g. Korea, Hong Kong, Taiwan), its
  all about the ability of emerging markets to cut
  interest rates, boost demand with fiscal policy
  and intervene to bail out shaky financial systems
  and recapitalize the bank.
• For others high inflation, volatile commodity
  prices, shaky fiscal positions and the need to
  attract foreign capital to finance current
  account deficits constraints their responses.
• Falling commodity prices (particularly oil) have
  improved the outlook on inflation in many
  emerging countries, but many frazzled investors
  still want to get high interest rates, which
  sends the currencies down, make it impossible for
  many emerging countries to cut the interest
  rates.

15
IMPACTS OF THE CRISIS TO EMERGING MARKETS

• Case in point or emerging markets China and
  India
• China has cut interest rates without too much
  risk.
• Can India do the same without risk? NO.
• Rupee has weakened uncomfortably against the USD
  (i.e. in 6 months until October 2008, Rupee has
  depreciated by 26 against USD)
• Inflation is running about 12, above the main
  policy interest rate of 9, which means that
  India real interest rates are -3
• The Reserve Bank of India in the first week of
  October has changed the capital requirements to
  inject more liquidity into the banking system but
  did not cut the interest rates.
• The cost of running food and fuel subsidies at a
  time of high commodity prices has pushed Indias
  effective fiscal deficit much higher (i.e. 10 of
  India GDP), increasing the risk of capital
  outflow and fall in asset prices if investors
  lose confidence.
• If India fiscal position worsens, Indias
  sovereign rating could be under threat.

16
POLICY IMPLICATIONS OF THE SUBPRIME PROBLEM

• The difficulty lies not so much in developing
  new ideas as in escaping the old ones. John
  Maynard Keynes
• The world economy is changing. Sticking with
  the solutions of the past is not an option.
  Alistair Darling, UK Chancellor of the Exchequer

17
POLICY IMPLICATIONS OF THE SUBPRIME PROBLEM

• Corporate governance
• Compensation High bonuses for irresponsible
  risk-taking action
• Proposal 1 Imposing additional capital charges
  for banks where rewards are not sufficiently
  correlated with long-term results.
• Proposal 2 Deferring compensation or forfeiting
  it if performance worsened.
• Nomination
• Internal audit
• Risk management

Fairness, Accountability, and Transparency
Disclosure
18
POLICY IMPLICATIONS OF THE SUBPRIME PROBLEM

• Blanket Government Guarantee vs. National
  Insurance
• Is there any moral hazard?
• National Deposit Insurance has also to increase
  the fee it charges Bank if the losses of banking
  failures will be higher, which means that banks
  will be hit with higher fee during the worst
  possible time
• National Deposit Insurance has to adopt
  risk-based assessment and risk-based pricing
• (FDICs fee in the US at the moment ranges
  from 10 cents per USD 100 to 43 cents per USD
  100)

19
POLICY IMPLICATIONS OF THE SUBPRIME PROBLEM

• Does government have to abandon inflation
  targeting?
• How can monetary policy respond to the negative
  shock to the economy from the financial crisis,
  when inflation targeting requires a commitment to
  reduce inflation back to its target?
• What is needed at the moment Inflation targeting
  with flexibility.
• When shocks to the economy are sufficiently
  large, inflation might have to approach the
  target gradually over time and this could be
  longer than 2 years that is usually assumed as a
  reasonable time horizon.
• To get inflation down to the target quickly will
  weaken the credibility of central bank and
  increase volatility.

20
POLICY IMPLICATIONS OF THE SUBPRIME PROBLEM

• A New Global Monetary Authority
• Separate proposals by Jeffrey Garten (Yale) and
  Alistair Darling (UK Chancellor of Exchequer)
• For overseeing the financial system
• For setting the tone for capital markets that
  supports capital formation, achieve the goal of
  economic growth and development, rather than
  trading for its own sake
• Act as a re-insurer or discounter for certain
  obligations held by central banks
• Monitor global risks and establish an effective
  early warning system
• Act as bankruptcy court for financial
  restructuring of global company above a certain
  size
• Managing global imbalances of current account
  surpluses and deficits, turn excess savings into
  either high-return investment or consumption by
  Worlds poor, development of local currency
  finance

21
POLICY IMPLICATIONS OF THE SUBPRIME PROBLEM

• What roles do rating agencies play in this crisis
  and post-crisis?
• Credit rating agencies, whose lucrative work in
  advising banks on how to structure complex
  products, like CDO, have endorsed proposals that
  they be banned from advisory on structural
  products.
• Credit rating agencies are considering
  recommendations to adopt a different ratings
  scale for complex finance products than corporate
  or government bonds.