080529 credit crunch_ causes, effects and implications

8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications

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Credit Crunch:

Causes, Effects & Implications

Ian Clarke, 29 th May 2008


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Credit Crunch2

A review of the causal process

Impact of the Credit Crunch

Longer term implications ?

Credit Crunch: Causes, Effects and Implications


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Credit Crunch3

The Credit Crunch: Causal Process

Background

Sustained low-interest environment and liquidity

Residential asset bubble in U.S. (subprime)

Originate-and-hold mortgages to originate-and-sell

Mispricing of risk/Conflicted ratings agencies

US sub-prime residential mortgage market

Problems began as early as Feb 2007

Initially unknown exposures


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Credit Crunch4

Sub-prime debt: The simple mechanics

Regular repayments Problems in repayments

Source: BBC Source: BBC


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Credit Crunch5

Impact of the Credit Crunch on the Debt Market

Liquidity

Interbank lending, Bond issuance, Bank lending, Leveraged borrowing,

Leverage Lending moves to a more conservative basis

Cost of Funds

Easier to assess based on pricing of pre-existing debt such as bonds Asset Backed Debt


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Credit Crunch6

Impact of the Credit Crunch: Irish Stock Market

1997-2007 Irish stock market consistently returned 8% p.a.

Lost 26bn in value during 2007

Why was the Irish stock market so badly affected?

Further volatility in the market as a result of speculation


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Credit Crunch7

Impact of the Credit Crunch: LiquidityReflected in Interbank lending margins

3.5

4

4.5

5

5.5

6

6.5

7

28/05/2007 23/07/2007 17/09/2007 12/11/2007 07/01/2008 03/03/2008 28/04/2008

Date

I n t e r e s

t R a t e ( % )

UK12 M LIBORUK 1yr Govt Bonds

LIBOR Risk Free Differential


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Credit Crunch8

Impact of the Credit Crunch: LeverageLeverage squeeze


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Credit Crunch9

Impact of the Credit Crunch: LeverageStill a huge volume of Sub-Investment Grade debt in market (primarily US)


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Credit Crunch10

Impact of the Credit Crunch: Leverage And even some sub-investment grade bonds still being issued


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Credit Crunch11

Impact of the Credit Crunch: Cost of FundsImportant to place increased cost of funds in historical context

US$ BB 5Y Spreads ov er time

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

31/05/2000 31/05/2001 31/05/2002 30/05/2003 31/05/2004 31/05/2005 31/05/2006 31/05/2007

Date

S p r e a

d a

b o v e

U S t r e a s u r y s

t r i p s

%


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Credit Crunch12

Impact of the Credit Crunch: Cost of Funds

US$ BBB 5Y Spreads over time

0.0

0.5

1.0

1.5

2.0

2.5

3.0

01/06/00 01/06/01 01/06/02 01/06/03 01/06/04 01/06/05 01/06/06 01/06/07 01/06/08

Date

S p r e a

d a

b o v e


t r i p s

%


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Credit Crunch13

Impact of the Credit Crunch: Cost of FundsBut we have witnessed more than a doubling of the risk margins which have appliedin recent years

US$ BB 5Y Spreads over t ime

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

28/05/2007 09/07/2007 20/08/2007 01/10/2007 12/11/2007 24/12/2007 04/02/2008 17/03/2008 28/04/2008

Date

S p r e a

d a

b o v e


t r i p s

%


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Credit Crunch14

0

1

2

3

4

5

6

7

AAA: AA: A+: A: A-: BBB+: BBB: BBB-: BB+: BB: BB-: B+: B: B-:

Credit r ating

1 w a v e r a g e

s p r e a

d %

Flight to Quality can be seen in risk margins for various ratings

Impact of the Credit Crunch: Cost of Funds

US Industrial : Average Risk Margins (Week to 26 May 2008)

Investment Grade


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Credit Crunch15

Longer Term Implications

What will be the economic impact?

Other Implications

Capital Adequacy Levels in Banking industry

Credibility of LIBOR

Rating Agencies

Risk Modelling as a whole?


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Credit Crunch16

Longer Term ImplicationsCapital Adequacy Levels in Banking industry

Tier 1 capital ratio of 8% (6% on a core Tier 1 basis) is increasingly seen as the comfort

level for European banks.

In April Royal Bank of Scotland announced Europes biggest ever rights issue (12bn).

Irish banks have so far resisted undertaking rights issues

5.7%Bank of Ireland7.5% AIB8.5% Anglo Irish

Ireland4.5% (pre rights issue)Royal Bank of Scotland5.1%Barclays

UK

Core Tier 1 Capital Adequacy RatioMarch/April 2008

Bank


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Credit Crunch17


LIBOR

Questions in the market regarding the credibility of LIBOR.

LIBOR calculated as an average of what 16 banks think their own funding

costs are rather than on the basis of actual deals.

As long-term funding deals dried up, banks increasingly relying on estimation

when submitting their figures.

No evidence that banks kept LIBOR low but there is at least a perception in

the market that some banks have an incentive to report lower figures.

EURIBOR?


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Credit Crunch18


Rating agencies

Agencies act as market regulators and as a sales force while providing

independent opinions

Did rating agencies methodologies keep up with increasingly sophisticated

debt instruments issued by banks?


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Credit Crunch19


Risk Modelling

A really complicated model must be right

Endogenous risk

So what is the point of (say) Basel II Guidelines requiring a greater and

greater degree of modelling?

080529 credit crunch_ causes, effects and implications

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