lessons learned from the recent turmoil in the credit markets mckinsey... · lessons learned from...

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Lessons Learned from the Recent Turmoil in the Credit Markets

Anthony M Santomero Senior Advisor McKinsey & Company

This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproduced for distribution outside the client organization without prior written approval from McKinsey & Company. This material was used by McKinsey & Company during an oral presentation; it is not a complete record of the discussion.

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TODA V'S DISCUSSION

1. An environment of credit and liquidity growth

2. The US mortgage market as the epicenter of the crisis

3. The concern over contagion

4. Implications and outlook • Winners and losers • Implications for select financial areas

5. Lessons for Professional Risk Managers

NYO-AAA 123-20080330-

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TODA V'S DISCUSSION





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GROWING GLOBAL FINANCIAL ASSETS FOSTERED INCREASED LIQUIDITY AND CREDIT AVAILABILITY

Global financial assets $ Trillions

167

1980 1995 2000 2001 2002 2003 2004 2005 2006

Source: McKinsey Global Institute; Global Financial Stock database

Equity securities

Private debt securities

Government debt securities

Bank deposits

3

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CROSS-BORDER CAPITAL FLOWS INCREASED SUBSTANTIALLY, WITH THE U.S. AS THE PREFERRED DESTINATION

".,.,.,.,.,.,.,.,.,.,.,., ,.,.,.,., .. ,.,.,.,., ,.,.,.,. , .. ,.,.,.,.".,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.,.,.,.,.,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.".,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.".,.,.,.,.,.,.,.,.,.,.,.".,.,.,., .. ,.,.,·'1 .,.,.,.,.".,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.,.,.,.,.,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.".,.,.,., .. ,.,.,.,.".,.,.,., .. ,.,.,.,.".,.,.,.,.,.,.,.,.,.,.,.".,.,.,., .. ,.,.,.,·,::::::::::)):::::::::::::))::11

8

7

6

5

4

3 ""CAGR 1980-90: 8.3%

2 •

c;:)ro· " 9J9J\Y

G~G«-..

~olo ,,~.

o I I I I I I

'80 '85 '90 '95 '00 '05

Percent 4.4 3.5 4.8 5.4 13.6 15.4 of global GOP

Source: McKinsey Global Institute; World Bank

674

-1 -9

o ~

I!IIIIII!I Net capital importers 1;-[2J Net capital exporters ~

8.

-140 -153

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US UK Aus India E. Lat. Mid Japan China Eur. Am. East

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PRIVATE CAPITAL, SEEKING ATTRACTIVE RISK .. ADJUSTED RETURNS, FURTHER FUELED LIQUIDITY

..... Cumulative commitment overhang

~ ;<-~.

o ~

Global buyouts ~mMl Commitments I ~

368 375 456 257

96 97 98 99 00 01 02 03 04 05 06 07

Source: PE Intelligence; Hedge Fund Research (HFR.com), McKinsey analysis

II Investments

400 348

300

200 233 238 233 22

200

100

o I::::::"'''' "

96 97 98 99 00 01 02 03 04 05 06

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GROWTH IN CDOs AND CLOs, HELPED ESTABLISH THE "COO BID" FOR LEVERAGED LOANS AND ABS

Percent

CAGR $480 billion Percent 1,200

1,100 Non U.S. Banks 1,000

Global 21 900

U.S. banks 800

" I 'U.S. 700 25

Securities firms* 600 I 500

,/ 400 ;'

300 /' COOs and Others** 200 ........ -.....,..,.

100

0

2000 2001 2002 2003 2004 2005 2006 2007 I I 2000 2006

* Also includes finance companies and insurance companies ** Also includes hedge funds, prime-rate funds and high-yield funds

Source: LSTA, BBA, Fitch, S&P PMD; Standard and Poor's Leveraged Buyout Review 6

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SINCE JULY '07, WE HAVE SEEN A REVERSAL OF CREDIT AND LIQUIDITY GROWTH WHICH PREVAILED FOR MOST OF THE LAST DECADE

Global COO Issuance Jan 1997 -Dec 2007 $ Billions

60

50

40

30

20

10

o

Credit and liquidity growth

Crisis onset July 2007

1 ,--------, ---------' Credit and liquidity crisis and contagion

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Main drivers of liquidity growth • Growth in financial assets (e.g.,

equity, private and government debt, bank deposits)

• Increasing importance of private capital

• Entry of new investors into the market through innovative financial products (e.g., CDOs)

Source: Oealogic

Triggers of liquidity crisis • Complexity and

opacity of subprime/CDO risk

• Risk mispricing • Aggressive chase for

yield

Areas of contagion • Mortgage backed

securities • Wholesale funding

market

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TODA V'S DISCUSSION

1. An Environment of credit and liquidity growth


4. Implications and outlook • • •

Winners and losers Implications for select financial areas Impact on interest in risk management

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Working Draft - Last Modified 4f712008 12:15:01 PM Printed

Confidential

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CITI-FCIC-LEH 00151949

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RISKIER MORTGAGES CONTINUED TO GROW SIGNIFICANTLY, REACHING -50% OF MORTGAGE ORIGINATIONS IN 2006

Nonconforming* products as percentage of total mortgage originations

Sub-prime

Home Equity

Alt-A

49 49

01 01 02 02 03 03 04 04 05 05 06 06 07 07 01 03 01 03 01 03 01 03 01 03 01 03 01 03

* Excludes Jumbo Source: Mortgage Bankers Association, Census Bureau, Goldman Sachs Research Estimates

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Between 2003 and 2006 share of non-

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conforming <J

products grew i disproportionately

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SUB-PRIME MORTGAGES BECAME THE DOMINANT UNDERLYING ASSET FOR MANY COOs BY THE END OF 2006 Percent

Representative ABS COO ~

2002* ABS structured

ABS settlement franchise I ABS aircraft

ABS \~ COO equipment lease ABS auto

ABS credit card

prime

A29N)~I •••••••••• ~r20'$~c~~~~O~~~it

)))) )!41 CMBS large

RMBS RMBS Subprime MH

Representative ASS COO ~

2006*

RMBS subprime CDS

RMBS

ABS COO CDS

Note: ABS - asset-backed securities, COO - collateralized debt obligation, CMBS - commercial mortgage-backed securities, CTL - credit tenant lease, RMBS - residential mortgage-backed securities, HE - home equity, MH - Manufactured housing, RMBS - residential mortgage-backed securities, COS - credit default swap

* 2002 closed COO issue by SFE CABS III COO, Ltd, 2006 closed COO issue by GSC ABS COO 2005-1

Source: Fitch Ratings presale report 11

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RISING US MORTGAGE AND HOME EQUITY LOSSES BECAME EVIDENT AS EARLY AS 2004

Static cumulative loss rates by vintage Percent

19 18 17 16 15

I 14 13 I 12 .. 11 I

#

Q405

Q305

10 '" Q205

9 ff of'

8 '" 7 /Q105

.., '"

#

6 #'

#'

5 '"

NYO-AAA 123-20080330-

DISGUISED EXAMPLE

Q404

'" .... .. Q304 '"

4 #

3

,,/

~/ ",&.':#'

... ~ .. ;;;-. -.::: :...: .::.... _ _ ::::.. _ .-:-:::.. -=-- Q 1 04 Q204

...

2 1 0

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42

Age (months)

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COOs ACROSS RATING TRANCHES DECLINED SHARPLY IN VALUE, STARTING WITH THE RISKIER TRANCHES

Current value of COOs of subprime mortgages Tranches of ABX.HE.2007 -2 index

, " "./ .,J

~

r

...

\ \ .. ...

" ~

"Safer" tranches sustained their value for longer

~ ;<-~.

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\ \ AM (53¢) ~

30

20

10

o

"Riskier" tranches declined much sooner

, .. ..

July

2007

August September October

, ~

.,....,,-,..... ,/ ' ..... ,.... ...... -\/ , .. ... ... <to

..

November

'" .. ....... .. ~ -.. 'IiIICI ..

.... ' ......... /M (22¢) ,r~ .;-= *--... .. _ .. /A (16¢)

.. ~ ~

December January February

2008

\ BBB (13¢)

BBB- (13¢)

March

Source: ABX index values and home equity CDS spreads from Markit and JPMorgan 13

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COO RATINGS ARE BEING DOWNGRADED, SOMETIMES SEVERELY

2006 subprime transition table Percentage of outstanding classes

Original rating level

AAA

AA

A

BBB

BB

Current rating level (after downgrades, if any)

I AAA AA A BBB BB B eee ee ew* ) k.:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.} ········································1 ................................................................................ [ ....................................... [ ....................................... [ .. ·······································1·· ...................................... ]. ········································1

u.s. cash flow and hybrid COO of ABS-migration table Vintage 102005-302007

Original rating level

AAA

AA

A

BBB

BB

* Credit rating withdrawn

Current rating level (after downgrades, if any)

I AAA AA A BBB BB B eee ee) F.·.·.·.·.· ..... ••·••••••.•••.••• ......... ·.·A ........................................ , .·.·.·.· .. · ... · ... ··.·.·.·.· .. · ... · ... ·1. ·.· .. ·.·.· ... · ... ·.·.·.·.·.· .. · ... · ... ·t ·.· .. · ... · ... ··.·.·.·.· .. · ... · ... · ... ·.t ·.· ... · ... · ... ··.·.·.·.· .. · ... · ... ··.·.t .· ... · ... ··.·.·.·.·.·.· ... · ... · ... ··.·.·1 .· ... · ... ··.·.·.·.· .. · ... · ... ··.·.·.·.·1

Source: S&P, January 31, 2008; team analysis

lmilllli Percentage of tranches not downgraded

14

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THE FINAL LEVEL OF LOSSES IS STILL UNKNOWN.

Percent of loans entering foreclosure by quarter (1 Q 1998-3Q 2007) Annualized rate

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

NYO-AAA 123-20080330-

Subprime ARMs

All mortgages #'

0.5 ~~ ~ ~~ ~~~ ~ -- ~- - -~

-.,..".,..-"'"

o 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: Mortgage Bankers Association, Goldman Sachs Research estimates 15

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TODA V'S DISCUSSION





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ILLIQUIDITY SPREAD RAPIDLY TO OTHER ASSET CLASSES

::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::: ..................................................................................................................... ".

p~~~pp~~r~iG~B! •••••••• theCDObidi>··· ........................................

Post crisis onset events (July, 2007 onward)

• Moody's has changed its rating system for subprime-like loans, low/no equity loans, and low/no documentation ("liar's") loans as loss estimates for these loans have increased substantially

• Difference in interest rate between conforming mortgages (under $417,000) and prime nonconforming mortgages (>$417,000) grows to -100 basis points

• Moody's has downgraded 19% of the securities created from 2006 subprime mortgages they rated and put 30% on a watch list

• Fitch warned that numerous classes of COOs are on watch for a downgrade because the subprime debt resold into COOs had been downgraded or put on watch for a downgrade

• Banks negotiating for better terms on leveraged deals to clear $250-300 bn in high yield bond backlog

• Over 40 pending buyouts valued at $1 billion or more currently awaiting close and potentially in jeopardy (e.g., Sallie Mae transaction aborted)

• Over $200 billion in assets financed through the ABCP conduits moved back on banks' balance sheet

• Coventree, leading third party Canadian ABCP conduit, forced to restructure following inability to roll over commercial paper and unavailability of liquidity backstop lines

• Goldman Sachs (along with Perry Capital and other investors) injected $3 billion into the firm's Global Equity Opportunities Fund; Goldman's Global Alpha lost 27% of its value; AQR and Renaissance report similar declines

• Sudden declines in other currencies on the opposite side of the carry trade (e.g., New Zealand dollar and Australian dollar) accompanied by rise in the yen

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THE CRISIS CAUSED AN INCREASE IN THE "PRICE OF RISK" WITH CREDIT SPREADS MOVING FROM TOO lOW TO QUITE HIGH

Leveraged loan BB spreads* Percent

600

550

500

450

400

350

300

250

200

150

100

50

0 1999 2000 2001

Spreads peaked following the Enronl telecom defaults of 2002 and lasted for a

2002 2003 2004 2005 2006 2007 2008

* 3 months BB - US Composite over 3M LlBOR ** 9 year average (since 1/99), 5 year average (since 1/03), 3 year average (since 1/05)

Source: LCD; Moody's; Reuters; McKinsey analysis

--- BB

, ........... Average spreads

9 yr avg**: 2.09%

5 yr avg: 1.35%

3 yr avg: 0.84%

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TODA V'S DISCUSSION




• Winners and losers • Implications for select financial areas


NYO-AAA 123-20080330-

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GLOBAL WRITEDOWNS REACHED -$195 BILLION IN MARCH 2008

~

E2d us

a Non-US

$ Billions

a ~

q" frY ~ ·s 0 .~ Qi Cf ~ 0 c: ·s ~ ~

~ 63 S S .frY

~ ,...

-:!!! 0 'V

$ a .p " .jj ~

;QCfj

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U ~ i? -QCfj RJ $ Q ~ ~ ~ ~ rf

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a ~ 0- 0Cfj 0 § ·~~~qa~

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Q;)frY 0Cfj <S Q;)0 <)0 .:p 4..0

'0 ~ ~ .;if § $ Q;)Cfj

00 ~ ?J q" " ~ Q;)~ t:J?~

~ ~?c ~ ! ~ '" ~ Qj (j ..::,.- (j ..::,.- U

................ \ i.· ... ·.···· ' .............. , ............. , ~

24.5 1 IKB parent company KNV Group absorbed -$7 billion of the writedowns resulting from an off-balance-sheet fund IKB controlled as part of its bailout of

the German bank. 2 Includes Mizuho, Nomura, Bank of China, Mitsubishi, Sumitomo Mitsui, Shinsei, Sumitomo Trust, Aozora Bank, DBS Group, Australia & New Zealand

Banking Group, Abu Dhabi Commercial and Arab Banking Corp 3 ABN Amro Holding NV was acquired by Royal Bank of Scotland Group Pic, Fortis and Banco Santander SA. The assets written down were parceled

out to acquiring banks. RBS reduced the value of ABN Amro assets it was incorporating into its balance sheet by 978 million pounds ($1.9 billion). This figure isn't included in the RBS writedown number on the table. The other buyers didn't specify their share of the ABN writedown.

4 Includes Wells Fargo, Lehman Brothers, DZ Bank, National City, BNP Paribas, and other North American and European banking institutions. Source: Standard and Poors; WSJ, Market Watch, various financial news, McKinsey analysis

24.5

20

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TO DATE, THERE ARE LIKELY SOME WINNERS AND MANY LOSERS

• Well-capitalized, prudently funded, highlyrated institutions that will weather the crisis and be able to make intelligent strategic investments at attractive prices

• Nimble proprietary investors that can take advantage of mispriced assets

• Distressed debt investors with substantial 'dry powder' available for investment at once again attractive spreads

• Emerging markets, which appear to have been somewhat insulated from the turmoil (at least until Jan' 08)

• Owners of credit assets purchased at improbably narrow spreads. The subprime mortgage market is filled with examples, some of which are well-known

• Residential real estate owners in badlyaffected markets, including Florida, Nevada, Arizona and California

~ "" ~.

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• Institutions with imprudent levels of I :l' leverage and overly reliant on the availability [ of the securitization markets

• Investment banks with a heavy dependence on the mortgage markets

• Rating agencies (particularly their structured credit groups)

• Mortgage guarantors, credit guarantors and GSEs

21

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NYO-AAA 123-20080330-

FUTURE IMPLICATIONS FOR SELECT FINANCIAL AREAS

Description

1~9ir1~liP!~Mt;lr~ I· Likely downgrades of insurers with high exposure to subprime or inability to adhere to new liquidity requirements absent additional capital injections

L;!]!]!]!]!]!]!1I • Likely shifts in governance and ownership as banks originate bail-out packages to offset potential mark-to-market downgrades of their assets ~

o ;<-

• Tighter credit environment will impact consumer spending • Increased credit card defaults (e.g. 10% rise since Jan 2007) will add further strain

~~~~~~~~ on banks' capital and reserve requirements

• Return to stricter underwriting standards

li9IRlri~~~~~~i~1 · ~~~s~t~~~~::~ ~:eC~:d~aO:~g~~~~::d~~~g~t ::~;f~e~~~sb:~~:~eu:i~i~~'eP~r~~i~n squeeze

• Tighter credit will reduce potential for new deals • A slowdown in the real economy will further put pressure on commercial real

estate

"""'.::,·"··:··,··:···"·····"···"·"····"'1"'", ..... "' ...... ,, ...... ,~,' ..... , ...... ,', • Reduced economic activity combined with difficult credit and liquidity environments rlnanCla"seC,Lor,. .. . .............. .......... ....................... .......... II h ff t d t ddt .,.,.,.,.,.,.,., .. ,.,.,.,., ,.,.,.,., .. ,.,.,.,., ,.,.,., ., .. ,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.,.".,.,.,., .. ,.,.,.,., WI ave a major e ec on In us ry revenues an pro uc mix .................................................................................................................

tevern..les«» ,,',',',.,',', .... ,',',.,', , ... ,.,',. ".,', .... ,.", ... , .. , ... ,.,',',','"',',',,.,.,.,......... • Europe should be more resilient; emerging markets will gain prominence

=-Eil1l1 •. j:IC··.'.·t:·,t?1 • Re~uced econo.mic activity and difficult credit an~ liquidity environments have a :.3C3SeCQ major effect on Industry revenues and product mix

I • Europe should be more resilient; emerging markets will gain prominence 22

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1 .................................................. ··········1 1. Bond insurers............................................................................................................... NYO-AAA 123-20080330-

LIQUIDITY CRISIS WILL LIKELY LEAD TO EXITS, CONSOLIDATION AND SHIFTS IN GOVERNANCE STRUCTURE IN THE BOND INSURER SPACE

Significant downturn in the bond insurer space . ..

Stock price July 2007 - Jan 2008

11.1 """""""""'"''''''''''

62.1 ~c.:--&"'"

14.9 I ----------------- --------

RADV\N 54.5 ~------------.-

8.8

Source: Bloomberg, team analysis

. .. will give rise to 4 likely scenarios

Scenario Rationale

Exit • Insurers with significant market subprime exposure or

inability to raise capital requirements will be unable to maintain rating (e.g., ACA)

Run-off • Insurers with sufficient book existing business/high residual

earnings may be downgraded but continue to manage previously originated business

Raise • Different options depending on money - Level of distress

- Governance structure (e.g., PE owned vs. public)

Bail-out • Banks with significant economic interest can invest to offset potential mark-tomarket exposures that would result from downgrades

Implication

• Likely concentration across insurers with little exposure and exit of high subprime exposure insurers

• Potential changes in ownership and governance, as banks could acquire significant shares in insurance business to mitigate expected balance sheet losses from asset downgrades

23

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12~R;t~ll(;r;ajt •••••••••• •••••••••• •••••••••• •••••••••• ••••••••••••••••••••••••• •••••••••• •••••••••• •••••••••• ..........1 NYO-AAA 123-20080330-

RECENT UNEMPLOYMENT TRENDS AND DELINQUENCY RATES SHOW THAT HIGHER CHARGE~OFFS ARE STILL TO COME

Credit card charge off rate and unemployment rate Percent

8.0

7.5

7.0 6.5

6.0 5.5

5.0

4.5

4.0

3.5

3.0

1996 1998 2000 2002 2004 2006 2008F

Average US credit card delinquencies - 2007 Percent

5.2

5.0

4.8

4.6

4.4

4.2

4.0

AMEX rate increased by 25% from 04, 2006 to its highest level since 2002

Capital One's 04 rate = 5.4%, its highest level since 2003

2010

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Source: Card Data; Bureau of Labor Statistics; Team analysis

= Unemployment rate

Industry charge off rate

III Recession

• Increasing unemployment and delinquency rates will lead to increasing losses for commercial banks

• Collection function will become increasingly important to prevent future losses

24

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YIELD SPREAD ON HIGH YIELD BONDS INCREASED MORE THAN 3x OVER THE LAST YEAR

BB - us Composite 3 Months spread* bps

450

400

350

300

250

200

150

100

50

o Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan

2007

* Over 3 Month T -bill Source: DataStream

2008

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IN 2007 ALL LENDING EXPERIENCED STRICTER STANDARDS AS A RESULT OF THE IMMINENT CRISIS Net percentage of U.S. banks tightening lending standards Percent

Mortgage lending

60

40

20

o

-20

Commercial lending

60

40

20

o -20

03 03 04 05 06 06 07 01 04 03 02 01 04 03

Note: Y-Axis shows percent of respondents who tightened lending standards Source: Federal Reserve

Credit cards & other retail loans

60

40

20 Other loans ,f

o \I.e ....... '''=_' ... ""'l: ..... ' =",," ~ ,;Credit card

-20

Commercial real estate

60

40

20

o -20

03 03 04 05 06 06 07 01 04 03 02 01 04 03

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PREVIOUS MARKET DOWNTURNS EFFECT ON REVENUES OF THE U.S. SECURITIES INDUSTRY

u.s. securities industry financial results* End Q1 1980 value indexed to 100 (quarterly figures)

2,800

2,600

2,400

2,200

2,000

1,800

1,600 ""m

1,400

1,200 ,':':': .:::::.

............... -

1,000

800

600 ',:.:.

400

200

o

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Securities firms revenue

Absolute revenues below corresponding quarter in previous year

Q1 19801981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

* Extracted from aggregated income statement, selected balance sheet, and employment data on the U.S. domestic broker-dealer operations of all NASD and NYSE member firms doing a public business derived from their Financial and Operational Combined Uniform Single (FOCUS) Report filings

Source: SIFMA; McKinsey analysis 27

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MCKINSEY'S SCENARIOS SUGGEST CAPITAL MARKETS ARE LIKELY TO REMAIN SOFT THROUGH 2010 Global capital markets and IB (eMIB) revenues* € Billions

I--diifo ____ ..

374**

? ,------1 1 1 1 1 1 1

2004 2005 2006 Post-write- Pre-write-downs downs

2007

* Sales and trading, ECM, DCM, loan origination and syndication, and M&A revenues.

-316

'Long chill' 'Late tackle'

2010 Scenarios

** Estimates based on results of ten Global players, which may over-state total industry growth given relative out-performance by leading firms, plus third quarter results from November year end firms leading firms, plus third quarter results from November year end firms

Source: Company reports; McKinsey Global Capital Markets Revenue Pool 28

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WIDE VARIATIONS IN PERFORMANCE ACROSS PRODUCTS DURING 2001

CD 2006 Global revenue

Global securities revenues growth Percent

High 80

40

o

Picking up market share

ECM I I I I I I I I I I

Cash Equities Commodities

Full ~ throttle I ~ e--Sec_ Lending

o ~ ~ !!L s;

& Financing ~

-~~------------r--------------~------------Average ~

'OJ -12% ~

Growth* 2006-07 (post writedowns)

-40

-80

-120

-160

Low-200 Laggards

Prop trading

D C M - -----------i

Bonds

10 15 20

Low

Note: 2007 results include estimated write-downs

DCMLoans

25

Source: McKinsey Global Capital Markets Revenue Pool; team estimate

: Equity I Derivatives

Slowing down

I 30! 35 40 45 50

Average 31% High

Growth, 2005-06

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Several institutions around the globe have been threatened by major liquidity problems

• Third-largest U. K. lender, assets of -£1 OObn • 1/08: Asked the Bank of England for a £26bn

liquidity support facility 2/08: Nationalized, adding -£25bn of loans, -£30bn of guarantees, and -£55bn mortgage book to the U.K. gov't

• Collapse was attributed to heavy reliance on

ii1J;;~; Coventrce

(Aug 2007)

• 8/13/07 - Coventree, a non-bank issuer of commercial paper, fails to roll several of its issues; citing contract technicalities, its backup liquidity providers don't step in 8/14 - 17 other ABCP issuers request emergency liquidity; -$100bn market disrupted Effects felt as far away as Asian CDS market

(Sep 2007) wholesale funding 8/16 - key players market agree on stabilization plan, 23 short-term fixed issues become long-term floaters In aftermath, role of rating agency DBRS comes under scrutiny

Centro P'r{\.p1H""tl.e$ \tn~vp

(Dec 2007)

- Sudden moves in short-term rates

• 17% market share prior to difficulties ~ Countrywide~ . Relied heavi.lyon securitization to fund new 1m! HOME LOANS mortgage origination

• 8/07: When securitization became difficult, announced plan to draw on the entire $12bn credit

(Aug 2007) line and obtained $2bn of new capital from BoA

• 12/16/07 - Centro, an international commercial real estate developer, failed to refinance $3.4bn of maturing debt raised to fund an acquisition

• Centro originally planned to access the CMBS market to refinance, but market was locked up when needed

• Lenders quickly granted a 2 month extension; Centro begins attempts to sell itself; situation still unresolved as of early March

• 1/08: BoA announced the agreement of an allstock deal valued at $4bn for Countrywide.

\J )p

q

cw (Mar 2008)

• Downgraded by credit rating agencies

• Drew on its entire $7.3bn of emergency credit lines to repay debt maturing in May '08

• May lead to shrinking its lending operations or asset sales

Source: Bloomberg, literature search

(Mar 2008)

• Started with riskier liquidity position relative to competitors

• 3/12 - 3/14: Series of events rapidly reduced cash position from $17bn to $2bn

• 3/14/08: Emergency funding from JPMC and NY Fed

• 3/16/08: JPMC announced an agreement to buy Bear for $236M ($2 per share)

30

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A liquidity crisis can arise for an institution in several ways NYO-AAA 123-20080330-

31

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Liquidity evaporated in the interbank market in mid-2007 and has yet to fully return

UBOR overnight rates spread' bps, 2007-2008

500

450

400

350

300

250

200

150

100

50

o -50

-100 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar

2007

* Over Fed funds rate ** Over U.S. 3 month Treasuries

Source: Bloomberg

2008

UBOR 3-month rates spread** bps, 2007-2008

250

200

150

100

50

o Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar

2007 2008

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Access to short-term liquidity was severely reduced by disruptions in key markets

:::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::

!qY~~~9r~i~~~i~~~¥~ iij9r~~§iij9~§m~Qltii §pt~~g§§~~tp!yiii<

rI61~~~~!iffl'lt~1 ............................................................................................................ ···········1

bilhkbil'~h¢~$h¢¢t$ii

Source: Federal Reserve, literature search

u.s. commercial paper amount outstanding $ Billions 1,400

1,200

1,000

800

600

400

200

~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~

Discount rate spread Thirty day A2/P2 less AA nonfinancial commercial paper 160TI--~--~--~--~--~~--~---r--~--~--~-,

140

120

100

80

60

40

20

0 to to to to to "- "-0 0 0 0 0 0 0 ~ (D en a N N ~ ~ ~ ~ ~ § ~

• HSBC: Moves $45bn in SIV assets onto balance sheet (Nov 2007) • Citibank: Moves $58bn in SIV assets onto balance sheet (Dec 2007) • Credit Suisse: Moves $8bn in SIV and other off-balance sheet

securities on balance sheet (Mar 2008)

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The Fed has gone to great lengths to support the U.S. economy overall and the liquidity of its financial system

6.0

5.5

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

-

-Fed

ra (0 a

ra ;:::: a

-ECB

ra OJ a

II

ra 03 a

-BoE

ra 25

I

I

r-S2

I

ra N

<Xl a -. ~

a

I

\ -,

*Not on review for downgrade as collateral (reserving the right to demand other assets if pledged collateral turns bad)

<Xl <Xl

~ ~ a a

• The US Fed has taken a more aggressive approach than its British and European counterparts in dealing with the f credit and liquidity environment ~.

o

• Fed reduced its policy rate 225 ~ basis points since summer ~

!!i.

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Bear's rapid drop from $17bn to $2bn in liquidity holdings may have been driven by three groups of customers and counterparties

Q:

Guy Moszkowski- Merrill Lynch

A:

Sam Molinaro- Bear Stearns, CFO, COO

Source: WSJ 3/18/08 (reported drop from $17bn capital base to $2bn in cash); over same period SEC Chair Chris Cox cited a drop in liquidity from $18bn to $2bn (Bloomberg March 20) 35

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Bear was unable to repay its outstanding repo lines with available resources

Total liquidity as % of gross repo financing at FYE'07

106% 93%

72% 77%

MS MER LEH GS

Total liquidity as % of net repo financing at FYE'07

1289%

889%

328%

MS LEH MER

Source: Analyst reports

• A Repo borrowing is a form of short-term borrowing on a secured basis against a securities inventory

• Example - A lender has $99M to invest for 14 days from 1

Nov 2007 to 15 Nov 2007. Bear can provide the Fannie 11/15/17 as collateral and quotes a Repo rate of 4.5%; hence the lender will earn Repo interest of $0.2M.

- Flow

36

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CIT announced a $7.3 billion drawdown on its backup line of credit

$ Billions, FYE'07

Short term assets • Cash • Assets held for

sale

Long term assets • Net receivables • Op lease eq • Retained int ·GW • Other

Assets

90

Liabilities

90 Short term financing • CP • Deposits • Factoring credit

balances • Accrued liabilities

Long term financing • Secured • Unsecured

7 .....IW""l..:i"""""'l..:i"""""~"""""'~""""""J....'! .......... __ _

Equity

• CIT's financing had a significant duration mismatch: $6 billion of short term financing effectively supported long-term assets

• As this short-term financing grew significantly more expensive, CIT found it hard to replace

Source: SEC filing, literature search

• CIT is a non-bank commercial financing company; it relies on ongoing borrowings to finance its lending

• Due to credit market turmoil, it was forced to use more capital-intensive short term financing sources - e.g., its use of secured borrowing rose from 5% as of FYE '06 to 30% a year later

• Recognizing this "deteriorating funding profile", on 3/18 and 3/19 Moody's and S&P downgrade CIT's short term credit ratings (e.g. S&P to "A-/A-2" from "AlA-1 "); long-term ratings put on review by Moodys and Fitch and cut by S&P (to A- from A)

• On 3/20 CIT was forced to draw its entire $7.3bn of emergency credit lines

- CIT must have enough cash to cover $9.7bn of debt that matures in 2008, $4.1 bn of which comes due in May

- "We recognize that, given the current market environment, we need to run a smaller company. " - Jeffrey Peek, CfT's CEO

• CIT claims that credit line will cover all funding needs for 2008

37

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Previous international banking crises suggest how long the current environment may persist

• The first energy crisis affected Spain's banking system, leading to 52% of 110 banks into serious financial problems

• Commodity-shock driven recession led to loan losses and then insolvency in banks; three largest banks nationalized

• Recession preceded by financial market liberalization and the collapse of exports to the former Soviet Union led to a severe depression; the Finnish government spent over 10 billion Euros over the crisis period to support Finnish banks

• A restructuring of the tax system caused financial bubble that formed during 1980s to burst; the central bank was unsuccessful to defend the currency's fixed exchange rate even with the interest of 500%

• Non-disclosure and a lack of transparency resulted in lowering rating companies' evaluations of Japanese banks; thirteen Japanese financial institutions went effectively bankrupt during 1995

Indexed real home prices (annual avg.) 13-5 -f

I :::J

I 12,,' -l

11.5 J i I 110~

"(.,:,;;, 1(J03=lOO

, . .......... 'CO-.... -....-...

.. "

105 J

100 J 4 year decline

!I ____ ~--~----~----~--~----~----~~~ %+-lndex t· 4=--1 00 .~:-;~<:".s---: .:<~{ to.,,:, ~R~i$ 5"

l;·.):(..;(-x

t-.3 t-2 T t-4 t.l ,+1 r+2 t+3

Annual real GOP growth

f t s.

. " ,

us; <.-'X

~ -- ' - - A,,*,'3@ fud)'\f<l"'~C:lXeJ< al ••

, ~edei:croml~S".. ,,""

'>, --'-"'M!N'-,.,.;#~ ~

"'"0( 100 ..... Joe';':

t4 t·) t-1 t-l tH ",-., , .. Years

Years

Source: "Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison", C. Reinhart & K. Rogoff, Feb 2008

• The "Big 5" crises had an average peak-to-trough house price decline of over 20% -the declines lasted for 4 years on average

• US home price declines began -20 months ago and are

• Might be reasonable to expect continued price declines for at least 2 more years

• The "Big 5" crises produced recessions that were, on average, 2 to 3 years long

• US GOP performance has not (yet) shown signs of suffering to the same extent

38

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TODA V'S DISCUSSION





NYO-AAA 123-20080330-

39

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RISK MANAGEMENT LESSONS LEARNED FROM CURRENTI RECENT CRISIS (1/2)

NYO-AAA 123-20080330-

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RISK MANAGEMENT LESSONS LEARNED FROM CURRENTI RECENT CRISIS (2/2)

NYO-AAA 123-20080330-

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THE CRISIS IS PROMPTING BANKS TO REVISE AND IMPROVE RISK MANAGEMENT PRACTICES

Specific tactical response

Broad, comprehensive review and/or redesign

Activities .............................................................................................................................................................................................................................................................................................................................................................................................................................................................

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TODA V'S DISCUSSION

1. An environment of credit and liquidity growth





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43

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lessons learned from the recent turmoil in the credit markets mckinsey... · lessons learned from...

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