subprime meltdown - prof_ ugut

8/4/2019 Subprime Meltdown - Prof_ Ugut

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The Subprime Meltdown

Professor Grace S. Ugut, PhDAssociate Dean, EXCELL


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GLOBAL IMBALANCES

Country receives a huge and

sustainable flow of foreign lending

Runs the risk of a subsequent financial

crisis because external & domesticfinancial fragility will grow

Lesson learned from past crisis


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GLOBAL IMBALANCES

After Asian Crisis 1997-1998

Savings glut

Chinas current account surplus in 2007

= 11% of its GDP = Japans surplus +

Germanys surplus

Emerging economies becomemassive capital exporters

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)

Was this caused by deliberate policies?

Yes, through accumulation of official

foreign exchange reserves,

expansion of the sovereign

wealth funds, and easy

monetary policy

Other countries with housing bubbles:Australia, Spain, and UK absorbed 19%

of the total surplus

US deficit absorbs 44% of these total

surpluses of the world economy

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.

Supporting the US currency

and financing US external

deficits


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THE BEGINNING9/11: 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 debitobligation sold to banks and various overseas funds

As a result: a housing boom

To feed the demand, lenders devise even riskiermortgages


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THE BEGINNING

The bubble bursts:

Subprime borrowers begin defaulting on theirmortgages, when the oil price started to increase

HOME PRICES FALL

First casualty: mortgage lenders, such as :

New Century & Argent


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THE BEGINNING

Credit crunch:

Lenders stop lending, afraid of losses

Borrowers with good credit start defaulting onmortgages

The casualty: big mortgage lender: Countrywide


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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


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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 withhigh leveraged IB

collapsing

This will have an impact to thecompanies debt refinancing


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GOVERNMENT INTERVENTION 1

AIG, the worlds largest insurance company & a bigissuer of credit default swaps gets USD 85B creditline 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


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The casualty: the last 2independent investment banks:Morgan Stanley and GoldmanSachs, share prices plunge becauseof short sellers

EARTHQUAKE CONTINUES

Money markets may be at risk after ReservePrimary fund failed to repay in full on Lehman debtsecurities

Is Universal bank

the better model?


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Ban on short seller

Has been seen as liquidity provider. A

classic problem of asymmetric

information.

US Treasury and FederalReserve unveil plans for thecreation of taxpayer-fundedentity that will buy US $700Bof trouble mortgages frombanks (distressed mortgaged

securities)

Limited compensation of executives

Treasury insures money-market funds

The bailout package is for

buying the distressed

securities (balance sheet)

OR to recapitalize the

institutions that are

burdened by distressed

securities (equity)

Something like preferred and

ordinary stocks with warrants

Bring private sector to

participate in

recapitalizing banking

stock

Securities are hard to value

Sellers know more about them thanthe buyer

In any auction process, the treasurywould end up with the dregs

What the tax payer gets in return?

-Change in the MTM rule, FAS 157

- Regulate credit derivatives market

There is a need

for centralized

clearing for CDS

and other OTC

products,

initiative by CME

SPILLOVER EFFECT


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TALKING ABOUT SPILLOVER EFFECT:HOW ABOUTTHE EUROPEAN BANKS?

Contagion effect:

AIGs last annual report reveals US $300B of credit insurance forEuropean banks for the purpose of providing the banks with theregulatory capital relief rather than risk mitigation in exchange fora minimum guaranteed fee

Devastating effects on European banks ratings andmarket confidence

High leverage (SHE/ TA) ratioof 35 (US banks leverage ratiois less than 20).

The channel of

transmissions is high

LDR of many bankswhich means high

dependency on funding

from money market


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TALKING ABOUT SPILLOVER EFFECT:HOW ABOUTTHE EUROPEAN BANKS?

GLOBAL LIQUIDITY COORDINATION

o

Shows risk aversion through the gap between 3 months-LIBOR and T-bill rate.

o Has been 20x higher than early 2007 level of less than 20bps to 400 bps in September 2008.

Ted Spread:


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IMPACTS OF THE CRISIS TO

EMERGING MARKETS

For some (e.g. Korea, Hong Kong, Taiwan), its all about the ability ofemerging markets to cut interest rates, boost demand with fiscal policyand intervene to bail out shaky financial systems and recapitalize thebank.

For others: high inflation, volatile commodity prices, shaky fiscalpositions and the need to attract foreign capital to finance currentaccount deficits constraints their responses.

Falling commodity prices (particularly oil) have improved the outlook oninflation in many emerging countries, but many frazzled investors still

want to get high interest rates, which sends the currencies down, makeit impossible for many emerging countries to cut the interest rates.


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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 6months until October 2008, Rupee has depreciated by 26% againstUSD)

Inflation is running about 12%, above the main policy interest rate of9%, which means that India real interest rates are -3%

The Reserve Bank of India in the first week of October has changedthe capital requirements to inject more liquidity into the bankingsystem but did not cut the interest rates.

The cost of running food and fuel subsidies at a time of highcommodity prices has pushed Indias effective fiscal deficit muchhigher (i.e. 10% of India GDP), increasing the risk of capital outflowand fall in asset prices if investors lose confidence.

If India fiscal position worsens, Indias sovereign rating could beunder threat.


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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 theExchequer


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SUBPRIME PROBLEM

Corporate governance

Compensation: High bonuses for irresponsiblerisk-taking action

Proposal 1: Imposing additional capital charges for bankswhere rewards are not sufficiently correlated with long-term results.

Proposal 2: Deferring compensation or forfeiting it ifperformance worsened.

Nomination

Internal audit

Risk management

Fairness, Accountability, and Transparency: Disclosure


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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 theworst possible time

National Deposit Insurance has to adopt risk-basedassessment and risk-based pricing

(FDICs fee in the US at the moment ranges from 10 cents perUSD 100 to 43 cents per USD 100)


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SUBPRIME PROBLEM

Does government have to abandon inflation targeting?

How can monetary policy respond to the negative shock tothe economy from the financial crisis, when inflation targetingrequires a commitment to reduce inflation back to its target?

What is needed at the moment: Inflation targeting withflexibility.

When shocks to the economy are sufficiently large, inflationmight have to approach the target gradually over time and this

could be longer than 2 years that is usually assumed as areasonable time horizon.

To get inflation down to the target quickly will weaken thecredibility of central bank and increase volatility.


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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 supportscapital formation, achieve the goal of economic growthand development, rather than trading for its own sake

Act as a re-insurer or discounter for certain obligationsheld by central banks

Monitor global risks and establish an effective earlywarning system

Act as bankruptcy court for financial restructuring ofglobal company above a certain size

Managing global imbalances of current account surplusesand deficits, turn excess savings into either high-returninvestment or consumption by Worlds poor, developmentof local currency finance


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SUBPRIME PROBLEM

What roles do rating agencies play in this crisisand post-crisis?

Credit rating agencies, whose lucrative work in

advising banks on how to structure complexproducts, like CDO, have endorsed proposals thatthey be banned from advisory on structuralproducts.

Credit rating agencies are consideringrecommendations to adopt a different ratings scalefor complex finance products than corporate orgovernment bonds.

subprime meltdown - prof_ ugut

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