Lessons from the Crisis

Peter Elverding November 2010

2

Crisis in Stages

Systemic InteractionSystemic Interaction The economy, asset prices, policy and finance

are interdependent

REAL ECONOMY

FINANCIAL SYSTEM

POLICY RESPONSE

ASSET PRICES

1.Stage 1: 2007-2008 credit crisis

falling asset prices

banking distress

2.Stage 2: 2008-2009 economic crisis

economic activity plunges

aggressive and unorthodox policy responses spark recovery…

3.Stage 3: 2010 political crisis?

politically charged debates over tightening fiscal policy and regulation

recovery faces structural headwinds

3

Origins of the credit crisis1. 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.

2. Financial excess echoed previous crises…

expansionary monetary policy, lax lending standards and regulation, excessive borrowing and financial innovation all played a part

3. …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

4. 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 CDS – cheap ‘insurance’ against default ↔ heavily

leveraged investment in ‘tail risk’

SECURITISED CREDIT

ABS

RE-PACKAGED SECURITISED

CREDIT

CDO, CLO

CREDIT DEFAULT SWAPS (CDS)

UNDERLYING CREDIT

MORTGAGES, LOANS, BONDS

Pyramid in the Fog

The modern structure of the credit markets

4

’The Great Moderation’ in world GDP growth and inflation

0.0

0.5

1.0

1.5

2.0

2.5

3.0

65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07

0.0

1.0

2.0

3.0

4.0

5.0

6.0

World GDP growth, 4-year trailing standard deviation, lhs

World inflation (GDP deflator), 4-year trailing standard deviation, rhs

% %

Source: World Bank

5

US stock market and interest rates

600

700

800

900

1000

1100

1200

1300

1400

1500

1600

97 98 99 00 01 02 03 04 05 06 07 08

0

1

2

3

4

5

6

7

S&P 500, index, lhs US 10 year yield, rhs US Fed Funds target rate, rhs

%

Source: EcoWin

6

House prices rose as loan quality plunged

Sub-prime mortgage origination & issuance

0

100

200

300

400

500

600

700

800

900

2001 2002 2003 2004 2005 2006

Sub-prime origination

Issuance of residential MBS (subprime+Alt-A)

($bn)

7

The (housing) bubble that burst

House prices bubble

100

150

200

250

300

350

400

87 89 91 93 95 97 99 01 03 05 07 09 11

primary rents - CPIsource

House prices, S&PCase Schiller

index, Jan 1987 = 100

House price deviation massively exceeds previous cycles

Still some room to fall…?

8

Unprecedented delinquency…

Mortgage delinquencies

2

3

4

5

6

7

8

Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10

8

10

12

14

16

18

20

22

24

26

28

P rime mortgages, lhs

Sub-prime mortgages, rhs

% of total % of total

9

Residential construction activity “ceases”

New Home sales and housing starts

200

400

600

800

1000

1200

1400

1600

1800

2000

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

200

400

600

800

1000

1200

1400

1600

1800

2000

Housing starts - single unit New Home sales

000s 000s

10

Mortgage-related assets crash

Mortgage related securities crash

0

20

40

60

80

100

120

01/07 05/07 09/07 01/08 05/08 09/08 01/09 05/09 09/09 01/10

AAA series 7-1

AAA series 7-2

BBB series 7-1

BBB series 7-2

bp

11

Global issuance of asset-backed securities (ABS)

0

100

200

300

400

500

600

700

800

00 01 02 03 04 05 06 07

Sub-prime Residential MBS Prime Residential MBS Commercial MBS Other*

US$ billion

*Other includes auto, credit card and student loan ABS

Source: Bank of England’s 2008 Financial Stability Report

12

Global Credit Default Swaps (CDS), gross outstanding: 2001-2007

-

10

20

30

40

50

60

70

1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07

US$ trillion

Source: ISDA

13

Global issuance of collateralised debt obligations (CDO)

0

20

40

60

80

100

120

140

160

180

200

2004 2005 2006 2007

US$ bn

Source: SIFMA

14

Slicing and dicing or mortgage risk

Super-senior (55%)

AAA (25%)AA (5%)A (4%)BBB (3%)

BB (3%)Equity (5%)

0%

20%

40%

60%

80%

100%

The pool is packaged into sub-prime residential mortgage backed securities (RMBS)

The RMBS are tranched into different levels of credit risk

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

Pool of U.S. sub-prime residential

mortgages

AAA (73%)

AA (12%)

A (7%)

BBB (5%)

Equity (3%)

CDMortgages Securitisation RMB

Source: Oliver Wyman

15

Banking sector goes into meltdown

Financial distress indicators

0

50

100

150

200

250

300

350

400

06/07 12/07 06/08 12/08 06/09 12/09 06/10

Countrywide

Citigroup, SIVs

Bear Stearns

Lehman's, Merrills

bp

3m interbank over 3m overnight index swap spread

16

Credit availability evaporates during crisis

Lending standards and lending growth

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

99 01 03 05 07 09

-40

-20

0

20

40

60

80

100

Commerical & Industrial loangrowth (lhs)

SLOS - banks tighteninglending standards on C&Iloans (rhs inverted 12M lead)

(YoY%) (YoY%)

17

Debt deleveraging exacerbates recession

The US debt burden*

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

52 56 60 64 68 72 76 80 84 88 92 96 00 04 08

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

Federal & localgovernment debt

Household

Average salary

* debt per person of working age

($) ($)

Household debt accumulation accelerates

18

0

2.000

4.000

6.000

8.000

10.000

12.000

14.000

16.000

1980 1982 1985 1987 1990 1992 1995 1997 2000 2002 2005 2007 July2010

The historical perspective

Dow Jones Industrial Index

1995Mexican ‘Tequila’ crisis

2007/09Subprime and related

solvency/funding crisis in the global financial sector

1987‘Black Monday’

2001/2002Stock markets bubble burst

1989/90US S&L and collapse of Japanese stock market

Citibank downgraded to BBB+

1982Latin loans

1997/98Emerging Markets crisis

Asia/Russia/Brazil

The historical perspective of the present crisis

19

0

50

100

150

200

250

300

350

400

450

Jan-90 Feb-94 Mar-98 Apr-02 Jun-06 Jul-10

European stock market

The historical perspectiveThe Euro stoxx 600 Index (1990-2010)

Recent developmentsThe Euro stoxx 600 Index (Aug 08-Jul 10)

The historical perspective of the present crisis: Stock markets

150

170

190

210

230

250

270

290

310

Aug-08 Feb-09 Aug-09 Feb-10 Aug-10

20

Dollar interest rates

The Fed funds rate and the US 3M interbank rate

The historical perspective of the present crisis: Interest rates

0

2

4

6

8

10

12

14

16

18

20

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

0

2

4

6

8

10

12

14

16

18

20

Fed funds target rate

US 3M interbank rate

(%)

21

Euro interest ratesThe ECB refinance rate and the German 3M interbank rate

The historical perspective of the present crisis: Interest rates

0

1

2

3

4

5

6

7

8

9

10

89 91 93 95 97 99 01 03 05 07 09

0

1

2

3

4

5

6

7

8

9

10

German 3M interbank rate

ECB refi rate

(%)

22

Interest ratesThe 3M interbank rate minus the yield on Treasury Bills – TED Spread

The historical perspective of the present crisis: Interest rates

-50

0

50

100

150

200

250

300

350

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

-50

0

50

100

150

200

250

300

350

3M Euribor less 3M Bubil

US 3M interbank rate less 3M T-bill

(bp)

23

(100)

0

100

200

300

400

500

600

700

800

aug-99 okt-01 dec-03 feb-06 apr-08 jun-10

(bp)

Germany Greece IrelandItaly Portugal

Sovereign spreads over swapsThe present situation: Credit markets

The historical perspective10 year government bond spreads over swaps (1999-2010)

Recent developments10 year government bond spreads over swaps (Jul 08-Jun 2010)

(200)

0

200

400

600

800

1,000

Jan-08 Jul-08 Dec-08 Jun-09 Dec-09 Jun-10

(bp

)

Germany Greece IrelandItaly Portugal

24

Investment Grade credit marketsThe historical perspectiveMerrill Lynch EUR investment grade Bank and Corporate 5 yr Spread Index

Investment Grade Spreads (1996-2010)

(200)

(100)

0

100

200

300

400

500

600

700

dec-96 mrt-98 jun-99 sep-00 dec-01 mrt-03 mei-04 aug-05 nov-06 feb-08 mei-09 jul-10

(bp

)

A rated EUR Bank Index A rated EUR Corporate Index BBB rated EUR Corproate Index

The present situation: Credit Markets

25

The present situation: The Financial Sector

The impact on banks – worldwide

Writedowns and credit losses

3Q 2007 – June 2010 (EURbn)

Capital raised 3Q 2007 – June 2010

(EURbn)

Worldwide 1,391 1,177

Americas 922 628

Europe 436 440

Asia 33 109

Source: Bloomberg as of 26 July 2010

Global Recovery and Policy Crisis (Europe)

27

Global Recovery – led by the East

• Emerging economies have led the

global recovery

• EurozoneEurozone to lag behind the US US

• ChinaChina resilient as policy is tightened

• AsiaAsia to outperform LatamLatam and EMEAEMEA

Global growth 1998-2010

-6

-4

-2

0

2

4

6

8

10

12

US Eurozone Japan Latam EMEA Asia exJapan,China

China

-6

-4

-2

0

2

4

6

8

10

12

2008 09 10F

28

Developed economies - a big step down

GDP profiles

91

92

93

94

95

96

97

98

99

100

101

102

103

104

Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10

91

92

93

94

95

96

97

98

99

100

101

102

103

1041Q08 = 100

Australia

US

Eurozone

UK

Japan

Canada

Eurozone GDP profiles

93

94

95

96

97

98

99

100

101

Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10

93

94

95

96

97

98

99

100

1011Q08 = 100

Italy

Germany

Eurozone

Greece

Belgium

France

NLSpain

29

Structural Headwinds to growth

Four medium term challenges:Four medium term challenges:

1. Credit creation is still dysfunctional

2. Household deleveraging to continue

3. Creditor nations are reluctant to spend

4. Fiscal and monetary consolidation

Bank lending to non-financial corporates

-20

-15

-10

-5

0

5

10

15

20

25

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

-20

-15

-10

-5

0

5

10

15

20

25

US commerical and industrial loans

Eurozone loans to non-financialcorporate sector

(YoY%) (YoY%)

30

‘Relief rally’ falters as policy debate rages

US equities & government bonds

6000

7000

8000

9000

10000

11000

12000

13000

14000

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

2.0

2.5

3.0

3.5

4.0

4.5

Dow Jones (lhs)

US 10Y Treasury (rhs)

(%)10 year peripheral spreads over Bunds

0

200

400

600

800

1000

Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10

0

50

100

150

200

250

300

350

400

450

Greece (LHS) Italy Ireland Spain Portugal

ECB bond purchases begin

31

Eurozone debt crisis weighed on the EUR

EUR/USD versus 10 year Greek-Bund spread

1.18

1.23

1.28

1.33

1.38

1.43

1.48

1.53

Oct-09 Dec-09 Feb-10 Apr-10 Jun-10

0

250

500

750

1000

EUR/USD

10 year Greek-Bund spread (RHS Inverted bp)

32

“Make the bankers’ pay…”

'If They Want a Fight, That's a Fight I'm Willing to Have' (Obama, Jan-10)

33

Monetary policy to relieve the squeeze?

Systemic InteractionSystemic Interaction The economy, asset prices, policy

and finance are interdependent

TIGHTERREGULATION

FINANCIAL SYSTEM

The POLICY The POLICY SQUEEZESQUEEZE

TIGHTER FISCAL POLICY

Monetary policy may be loosened to offset the Monetary policy may be loosened to offset the pressure from tighter regulation and fiscal policy pressure from tighter regulation and fiscal policy

TIGHTER REGULATION

REAL ECONOMY

ASSET PRICES LOOSER

MONETARY 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]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:

1. Improved primary budget balance = either lower expenditure or higher taxes

2. Lower interest rates = loose monetary policy or bullish bond market sentiment

3. Faster nominal GDP growth = either faster real growth or higher inflation

4. Reduce existing debt = either sell-off assets or restructure/default on existing debt

35

Eurozone debt – shades of black

0 20 40 60 80 100 120 140

Finland

Spain

Neth.

Ireland

Aus tria

Germ any

Portugal

France

EU16

Belgium

Greece

Italy

2009

2010F

2011F

Eurozone Debt-to-GDP% of GDP Who's in the naughty corner?

-16

-14

-12

-10

-8

-6

-4

-2

0

0 25 50 75 100 125 150

IRL

NLMAL

POR

GR

FRA

BEL

ITAEU16

SLK

SLO

LUX FIN

GER

SPA

AU

CY

Debt % GDP

deficit % GDP

increasing stress

decreasing stress

(2009 stats, EC)

36

EUR – emergency repairs

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

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

37

Eurozone positives

Eurozone exports & IP (YoY% )

-30

-20

-10

0

10

20

30

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

-30

-20

-10

0

10

20

30

Exports

Industrialproduction

(YoY%)Eurozone exports & IP (levels)

65

70

75

80

85

90

95

100

105

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

65

70

75

80

85

90

95

100

105

Industrial production

Exports

April 2008 =100

38

Eurozone negatives

Car registrations & construction

-30

-20

-10

0

10

20

30

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

-15

-10

-5

0

5

10

15

car registrations (lhs)

Construction output (rhs)

(YoY%) (YoY%) Car registrations & construction (levels)

750

800

850

900

950

1000

1050

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

75

80

85

90

95

100

car registrations (lhs)

Construction (rhs)

(000s)

Dec 2006 = 100

39

Fiscal tightening to drag from 2011

Change in balance 2010-2012 (% of GDP)

0% 1% 2% 3% 4% 5% 6%

GR

US

ES

PT

UK

FR

IE

Eurozone

GE

AT

BE

JP

NL

IT

FI

Policy change Cyclical change

2010 budget balance (% of GDP)

-12%-10%-8%-6%-4%-2%0%

IE

US

ES

JP

GR

UK

PT

FR

Eurozone

NL

GE

AT

BE

IT

FI

Structural Cyclical

40

European growth – a Northern bias

Europe GDP growth forecasts (YoY% )

-6 -5 -4 -3 -2 -1 0 1 2 3 4

Greece

Spain

Italy

UK

Eurozone

Belgium

Netherlands

France

Germany

Sweden

Poland

2009

2010

2011

41

Growth threat to Southern Europe’s solvency

90

100

110

120

130

140

150

2001 2002 2003 2004 2005 2006 2007 2008 2009

90

100

110

120

130

140

150

GR GER IT PT SP

Unit labour cost for total economy (2001=100)

42

Worst case scenario – EMU break-up

43

A Eurozone break up would be painful

-15 -10 -5 0

Germany

France

Netherlands

Belgium

P ortugal

Italy

Spain

Ireland

Greece

Greek exit Total break-up

Cumulative output loss 2010-2012 (in % relative to base)

88

90

92

94

96

98

100

102

104

106

108

2009 2010 2011 2012

Base Greek exit Total break-up

German GDP (level, 2009 = 100)

-10%

Output effects of Eurozone break up German output loss relative to base

44

Inflation for periphery, deflation for core

-5 0 5 10 15 20

Greece

P ortugal

Ireland

Spain

Belgium

France

Netherlands

Germany

2012 2011 2010

Inflation in total euro break-up scenario (CP I, % yoy)

Peripheral bond spreads under break up

0

2

4

6

8

10

12

07 08 09 10 11 12

Greece P ortugal Spain Ireland Italy

Spread 10-year government bond relative to Germany in EM U break-up scenario (in %-points)

end year forecasts

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)