Financial/Credit Crisis of 2007-2009 Lecture Notes PDF

FINANCIAL/CREDIT CRISIS OF 2007 -2009 AND LESSONS LEARNT TOPIC 4 OUTLINE  1. WHAT IS A FINANCIAL / CREDIT CRISIS  2. WHAT WERE THE CAUSES OF THE USA FINANCIAL / CREDIT CRISIS  3. CATEGORISATION OF USA BANK LOANS  4. LOCAL and GLOBAL TRANSMISSION OF THE USA FINANCIAL / CREDIT CRISIS  5.THE G...

FINANCIAL/CREDIT CRISIS OF 2007 -2009 AND LESSONS LEARNT TOPIC 4 OUTLINE  1. WHAT IS A FINANCIAL / CREDIT CRISIS  2. WHAT WERE THE CAUSES OF THE USA FINANCIAL / CREDIT CRISIS  3. CATEGORISATION OF USA BANK LOANS  4. LOCAL and GLOBAL TRANSMISSION OF THE USA FINANCIAL / CREDIT CRISIS  5.THE GLOBAL CONTAGION  6. REMEDIES TO THE USA FINANCIAL / CREDIT CRISIS FINANCIAL / CREDIT CRISIS  DEF – happens when financial instruments and assets decrease suddenly and significantly in value.  - i.e. any broad variety of situations wherein some financial assets suddenly lose a large part of their nominal value  - Major result – the public and investors lose confidence in the financial markets to continue acting as a venue/conduit for the transaction of fairly valued assets.  Some Financial Crises – there were many major and minor ones, interalia;  Great Depression (1932); International Debt Crisis (1982); East Asian Economic Crisis (1997 – 2001); Latin American Debt Crisis – Mex/Bra/ Arg (1994 – 2002); Global Financial/Credit Crisis (2007 – 2009)  -complexity, number and breadth of financial instruments increased – thus incr length and geographical coverage of crises THE US FINANCIAL / CREDIT CRISIS - CAUSES  (a) The crash/end of “dot.com bubble” in 2000/01 - caused a change in the course of capital flow  - investors/banks withdrew their money from dot.com securities – thus abundant liquidity looking for an investment destination  (b) Econ climate was characterised by low interest rates – @2000/01, US Fed Res, reduced interest rates significantly to stimulate econ activity/growth  (c) The market had gone through significant phases of deregulation: - Gramm- Leach-Bliley (Fin Serv Mod Act) (1999), replaced the Glass-Steagall Act (1933)  Blurred the lines across financial sectors – trad com bank activities could be done by Inv banks  Relaxed regulation even in the most risky of financial sectors  -Increased complexity in the operations of the financial sector  -Increased direct competition THE US FINANCIAL / CREDIT CRISIS - CAUSES  (d) Tax Reform Act (1986) – allowed for tax deductibility on interest charges for both a primary residence and second mortgage loan (speculative investing??)  THEREFORE  The real estate sector in the United States became a favourable destination for the liquidity;  -mortgage backed loans  -banks/investors had been hit before; looking for collateralized investments to park the excess liquidity THE US FINANCIAL / CREDIT CRISIS - CAUSES  Increased scramble for borrowers increased direct competition among lenders  Financial institutions went into overdrive in capitalising on the real estate hype: lenders / loan originators, mortgage brokers, investment banks, speculators, real estate brokers, credit rating agencies, stock brokers, underwriters / insurers  Various innovative schemes were used to lure more borrowers – easier borrowing terms, creative mortgages, creative property valuations, lower credit quality controls  Subprime borrowers – subprime debt SUBPRIME MELTDOWN & CRISIS (2001-2007)  (a) SUBPRIME Environment - a credit classification for borrowers with a tarnished or limited credit history, and for loans made to such borrowers.  - because subprime borrowers are considered riskier than the average borrower, subprime loans are subject to higher than average interest rates.  (b) SUBPRIME BORROWERS – borrowers who have low credit scores & negative information in their credit reports.  - they represent a higher risk to lenders.  - they may find it harder to obtain loans (under normal circumstances), and will usually have to pay higher interest rates when they can access loans.  (c) SUBPRIME LENDERS – institutions that lend to the subprime borrower market  (d) SUBPRIME MELTDOWN - was the sharp increase in high-risk mortgages that went into default beginning in 2007, contributing to the most severe recession in decades.  - caused by housing boom of the mid-2000s; combined with low-interest rates at the time  prompted many lenders to offer home loans to individuals with poor credit. THE US FINANCIAL / CREDIT CRISIS - CAUSES  The pressure of real estate demand caused prices to balloon  Increasing property prices increased the value of assets collateralising the mortgages, i.e. - remortgages (“equity releases”), and thus increased debt  - (headroom for same asset collateralisation)  Second mortgages became the order of the day – speculators  - concentration risk for lenders  Mortgage debt as a percentage of household disposable income soared  Borrowers’ ability to service their debt obligations diminished (@2006) – making the loans held by banks and investment banks “worthless” - the USA was in financial crisis RE – MORTGAGE IMPACT HOUSEHOLD DEBT AS A PERCENTAGE OF DISPOSABLE INCOME, 1990-2008 5-10 BANK ASSETS / LOANS BANK “A” BANK “B”……etc  Real Estate Mortgage Loans  Real Estate Mortgage Loans  Other Asset Backed Loans  Other Asset Backed Loans (MVAF) (MVAF)  Corporate Loan  Corporate Loan  Credit Card Receivables  Credit Card Receivables  etc  etc THE LOCAL AND GLOBAL TRANSMISSION MECHANISM  HOW DID THE CRISIS SPREAD – within USA and abroad  The transport vehicle for the growing lower quality debt was a combination of securitization and/or debt re-packaging provided by a series of new financial derivatives  - asset mgrs. / wealth managers / wealthy investors – bought these new derivatives  The 1980s saw the introduction of securitization in U.S. debt markets, and its growth has been unchecked since THE LOCAL AND GLOBAL TRANSMISSION MECHANISMS  1. SECURITISATION – TRADITIONAL PASS-THROUGH-SECURITIES  Def – the process of packaging the cashflows from individual mortgage loans into portfolios of various financial securities  -makes these securities more tradable/saleable on the financial/security markets  -primarily derivative “debt instruments”  -traditional “pass-through” securities – c.f.s move from mortgage loan holder to trad pass- through sec holder  - giving chance of ownership to people who could not afford (HNWI’s), or be allowed to hold such (Pension Funds, etc)  - p-t sec holders got pro-rated portion of princ & interest repayments on underlying mortgages  - the cheapest tranches at the time were @US$100k THE LOCAL AND GLOBAL TRANSMISSION MECHANISM  Securitized financial assets were made from two major underlying assets;  a. Mortgage-backed securities (MBSs) – these were tranches created purely out of securitized mortgage-backed real estate loans  b. Asset-backed securities (ABSs) - mortgages, second mortgages, corporate loans, asset backed loans (MVAF), credit card receivables, etc  - 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.  Critics of securitization argued that securitization provides incentives for rapid and possibly sloppy credit quality assessment. THE LOCAL AND GLOBAL TRANSMISSION MECHANISMS  Came from 1980’s, but gained momentum in 2000-8  Main Risks for “traditional p-t-s holders” – early loan repayment (missing out on future interest c.f.s); outright default by mortgage holders  - when such happens it causes p-t-sec value to deteriorate abruptly – onset of “credit/financial crisis” SECURITISATION VIA TRADITIONAL PASS-THROUGH- SECURITIES - MECHANICS THE SECURITISATION PROCESS  Asset origination: The process begins with a lender, such as an investment bank, issuing loans to borrowers.  Credit enhancement: The SPV may use various credit enhancement techniques to make the securities more These loans can be in business lines of credit, mortgages, auto loans, credit card receivables, or other types of attractive to investors. These can include over-collateralization (i.e., putting more collateral in the pool than the credit. value of the securities issued), reserve accounts, or third-party guarantees.  Create asset pools: The lender selects a pool of loans with similar characteristics, such as loan type, maturity,  Rating: The SPV hires credit rating agencies to assess the creditworthiness of each tranche. The rating and credit quality. This pool of loans will serve as collateral for issuing securities. agencies assign ratings to the tranches based on their perceived risk, with the senior tranches receiving the highest ratings and the junior tranches receiving the lowest.  Create the special purpose vehicle (SPV): The lender establishes a separate legal entity called an SPV) or a special purpose entity. The SPV is designed to be bankruptcy-remote, meaning that if the lender goes bankrupt,  Marketing and sale: The securities, now backed by the pool of loans, are marketed and sold to investors the assets held by the SPV won't be affected. through investment banks. Investors can invest in different tranches based on risk tolerance and investment objectives.  Transfer the assets: The lender sells the pool of loans to the SPV, effectively removing the assets from its balance sheet. In return, the SPV pays the lender for the assets, often using funds raised from issuing  Distribute cash flows: As borrowers of underlying loans make payments, the cash flows are collected by a securities. servicer and distributed to the investors according to the terms of the securities. The senior tranches get priority over junior tranches in receiving payments.  Tranching: The SPV divides the pool of loans into different risk classes, known as tranches. Each tranche has a different level of risk and return, catering to different investor risk appetites. The tranches are typically  Monitoring and reporting: Throughout the life of the securities, the servicer monitors the performance of the considered senior, mezzanine, and junior (or equity). underlying loans and provides regular reports to the investors. THE LOCAL AND GLOBAL TRANSMISSION MECHANISMS  2. SECURITISATION - COLLATERALISED DEBT/MORTGAGE OBLIGATIONS (CDOs)  DEF - derivative securities created from bank originated mortgages and loans, combined according to some criteria into a portfolio, then resold through inv banking underwriters to various investors  - basically involved further financial engineering of dividing the securitised p-t-sec / instruments into “stratified” tranches  - stratification could take diff forms, viz – credit quality; residual risk bearing (or payment pecking order); etc  - E.g. Cr quality – using cr rating agencies to rate the robustness of the instrument  - AAA (snr tranches) vs BBB (mezzanine tranches) vs Equity-like Tranches/Junk Bond status  - BUT – cr rating agencies did a substandard job of this exercise ; used issuing org rather than underlying mortgage holder strength for rating  - relied on info provided by the Inv Banker/ Mortgage Brokers, rather than their own due diligence THE LOCAL AND GLOBAL TRANSMISSION MECHANISMS  Also created out of;  a. Mortgage Backed Securities (MBS)  b. Asset Backed Securities (ABS)  Sold through SPVs – off balance sheet financing  2001 - 2007 – CDOs had/were moving globally across world financial markets  - passed to banking/other orgs in Europe and Asia; i.e. London, Paris, Tokyo; Hong Kong  By 2007/8 the CDO value/mkt was collapsing, viz;  a. holders of underlying mortgages/ loans were unable to pay their debt obligations  b. due to (a), “institutions” no longer had appetite for CDOs; Bear Sterns Hedge Funds collapse in July 2007 (largely exposed to CDOs) THE TRANSMISSION MECHANISM - COLLATERALIZED DEBT OBLIGATION EXAMPLE – MECHANICS OF SECURITISATION / CDO’S EXAMPLE – MECHANICS OF PROPER “CDO” SECURITISATION  Apply same mechanics as for Trad P-T-S; BUT tranched based on some criterion  E.g. – using credit quality of EACH loan going into the reference portfolio  - would require that 400 due diligences should be done per bank  - i.e. putting them into portfolios based on their individual credit ratings, rather than that of the loan originating bank  RESULT – BULK BREAKING and greater salability EXAMPLE – MECHANICS OF PROPER “CDO” SECURITISATION (CONT)  PROBLEM – done the “FINANCIAL CRISIS WAY” (2001-2007)  - Cr. rating was done for the issuing bank rather than the individual loans going into the “reference portfolio” ; should rate the underlying borrowers and not the loan originating bank  E.g. for MBS portfolios  Senior MBS Tranche – 80 CDO’s @ P100k  Mezzanine MBS Tranche - 120 CDO’s @ P100k  Junk/Equity MBS Tranche – 100 CDO’s @ P100k  -diff tranches would pay diff interest rates THE USA FINANCIAL CRISIS OF 2007 AND 2008  The housing market began to falter in late 2005, with the bubble finally bursting in 2007.  Was “global” in scope, a domino effect ensued with collapsing loans and securities (and the securitized instruments therefrom), being followed by the funds (investment pools) and institutions (e.g. Bear Stearns) which were their holders.  (2008 proved even more volatile, with oil and commodity prices peaking, then plummeting.) 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 (e.g Germany).  - Equity markets fell worldwide, emerging markets were hit particularly hard.  - Currencies of the more financially open emerging markets felt a significant impact. GLOBAL CONTAGION  2007 to 2009, the credit crisis was having additionally complex impacts on global markets – and global firms.  The crisis, which began in the June- August of 2007 in the USA, had now moved to being a 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. THE REMEDIES (USA)  -most of the available remedies are both private sector and government led  -a joint effort from all national players concerned  -a multi-pronged approach is required  1. GOVT PURCHASE OF THE COLLAPSING SECURITISED ASSETS  -the main objective is to inject liquidity into the financial markets  - will aid the continuation of making loans to private sector by affected fin institutions to invest in profitable opportunities and sustain the economy THE REMEDIES (USA)  2. ENCOURAGE MERGERS/ACQUISITIONS BETWEEN MAJOR AFFECTED PLAYERS IN THE FINANCIAL SECTOR  -the equity values of these institutions were weakened by the erosion of the value of their investments; loans and securitised pass-through securities  -these affected players could not make secondary issues of equity/DEBT on the markets, due to their unattractiveness to the “public”  -the major players were; comm banks/ inv banks/ asset or fund managers/ security dealers  -allows a consolidation of their equity values of these institutions, and allows for their restructuring to position them for recovery  -E.g. Wachovia Bank was merged into Wells Fargo; Merrill Lynch “Brokerage” was merged into Bank of America  - achieved economies of scale in operations THE REMEDIES (USA)  3. OUTRIGHT TAKEOVER or BAILOUT OF AFFECTED PLAYERS BY GOVERNMENT  - this is done as a last resort to stop the failure of systemically significant players on the market failing (closing down)  - Fannie Mae (Fed Nat Mortgage Assoc) & Freddie Mac (Fed Home Loan Mortg Corp) were put under “judicial management” by the USA government; to reorganise the running of the organisation  -orgs were “insolvent”  - Govt also bailed out the large players in the industry, by taking equity positions in these players….e.g 85% stake in AIG (insurer - issuer of CDS –financially engineered securities) THE REMEDIES (USA)  4. ISSUE NEW REFORM ORIENTED LEGISLATION FOR THE AFFECTED SECTOR(S)  - issue legislation that corrects the wrongs that caused the collapse in the first place ; Dodd-Frank Act (2010)  - ensure safety; regulation; confidence in the market  -setting Fin Research Office  - make regulatory reach more expanded  -e.g…..stipulate strict regulatory requirements for loan issuance and securitisation processes  - disallowed short selling –aggravates collapse of security prices SUMMARY THANK YOU