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The Liquidity Crunch Causes and Consequences
10 June 2008
Martyn Hoccom
Lloyds TSB
2
How did we get here?
“They were impelled to it by the seminal lunacy which has always seized people
with the notion they can become very rich. There were many Wall Street
insiders who fostered this insanity…”
The Great Crash 1929 – JK Galbraith
3
The Liquidity storm of 2007
“When the music stops in terms of liquidity things will be complicated. But as long as the music is playing , you’ve got to get up and dance. We’re still dancing”
Chuck Prince Citigroup, July 9th 2007
“This was obviously a very disappointing quarter for us”
Chuck Prince Citigroup, October 1st 2007
4 November 2007 - Chuck Prince resigns
4
Size of the global securities marketSource :Bank of England Stability review
Government/banks$70.7 trillion
Corporate$67.7 trillion
Money Markets$6.4 trillion
Corporate bonds$11.0 trillion
Residential mortgage-backed securities$6.5 trillion
Government debt$25.8 trillion
Investment-grade$10.2 trillion
High-yield$0.8 trillion
Corporate Loans$6.1 trillion
Bank deposits$38.5 trillion
Asset-backed securities$10.7 trillion
Leveraged$0.5 trillion
Commercial mortgage-backed securities$0.7 trillion
Corporate Equities$50.6 trillion
Investment-grade$5.6 trillion
United States$5.8 trillion
Non mortgage asset-backed securities$3.5 trillion
Europe$0.7 trillion
Non-Agency$1.8 trillion
Jumbo$0.5 trillion
Agency$4.0 trillion
Sub-prime$0.7 trillion
Alt-A$0.6 trillion
5
Markit iTraxx Index
Markit iTraxx Europe Crossover Index (series 8)
Source : Bloomberg
200
250
300
350
400
450
500
550
600
650
700
bps
6
Credit Pricing
1 Year Bond Spread over UK Gilts by Rating: 2003 to 2008
0
50
100
150
200
250
May
03
Aug 0
3
Nov 0
3
Feb 0
4
May
04
Aug 0
4
Nov 0
4
Feb 0
5
May
05
Aug 0
5
Nov 0
5
Feb 0
6
May
06
Aug 0
6
Nov 0
6
Feb 0
7
May
07
Aug 0
7
Nov 0
7
Feb 0
8
May
08
Bas
is P
oin
ts
AAA
AA
A+
A
A-
BBB
7
UK Macro – Market Background
UK – Sterling Liquid Assets relative to total asset holdings of UK banking sector
Source : Bank of England
8
UK Macro – Market Background
UK-resident banks' and building societies' net sterling lending to UK households and non-financial companies
Source : Bank of England
Notes:It is the difference between household's and PNFCs' M4 lending and M4M4 Lending is the lending made by banks and building societies to the personal sector
-50
0
50
100
150
200
250
300
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
£ billions
9
Days of August 2007
Sub prime mortgages were the trigger – amongst the underlying causes were:
– Take away the modern terminology and you have something very old fashioned - Banks lost money on fuelling a speculative asset boom -
– In a period of remarkable stability and low credit spreads a “search for yield” – this is why mortgages originated in Paris Texas ended up on the balance sheet of banks in Paris France
– Weakened Credit Standards as a result of dislocation between originators and investors
– Increasing Sophistication of products whose “ model to market” became very misaligned from “mark to market” under stress
– The herd mentality and extreme difficulty to stand against the crowd
10
The Market Story
USD - OIS, 1m Libor, 3m Libor - since 2/10/06
1.90
2.40
2.90
3.40
3.90
4.40
4.90
5.40
5.90
6.40
03/1
0/06
03/1
1/06
03/1
2/06
03/0
1/07
03/0
2/07
03/0
3/07
03/0
4/07
03/0
5/07
03/0
6/07
03/0
7/07
03/0
8/07
03/0
9/07
03/1
0/07
03/1
1/07
03/1
2/07
03/0
1/08
03/0
2/08
03/0
3/08
03/0
4/08
03/0
5/08
USD LIBOR 1 MONTH USD LIBOR 3 MONTHS USD 1 MONTH Overnight Index Swap
11
ABCP Market
DROUGHT
US asset-backed commercial paper outstanding - $ Trillions
0.70
0.80
0.90
1.00
1.10
1.20
1.30
Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08 Feb 08 Mar 08 Apr 08
$ Trillions
12
ABCP Market
Asset Backed commercial paper spreads
One-month top-tier ABCP versus one-month Libor (basis points)
-20
0
20
40
60
80
100
120
140
Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08 Feb 08 Mar 08 Apr 08
13
CDS Spreads
5 Year SENIOR CDS Spread Curves
0
50
100
150
200
250
300
24 A
pr 08
04 A
pr 08
17 M
ar 0
8
26 F
eb 0
8
06 F
eb 0
8
17 J
an 0
8
28 D
ec 0
7
10 D
ec 0
7
20 N
ov 07
31 O
ct 0
7
11 O
ct 0
7
21 S
ep 0
7
03 S
ep 0
7
14 A
ug 07
25 J
ul 07
05 J
ul 07
15 J
un 07
Bas
is P
oin
ts
BarclaysHBOSHSBCLloyds TSBRBS
14
What has the Liquidity Crisis Changed ?
Short answer – Everything !!
– Originate and Distribute Model
– Conduit Vehicles
– Liquid asset definition
– Cost of funding
– Basel 2 and ratings
– Transfer pricing
– Balance sheet structure
– Value of Retail Deposits
– SIVS
– CP Markets……etc etc
15
Risk Appetite Design
Clear Articulation and measurement system so Board can know under stress how institution is performing
Governance linkage from Board approved limits to operational activities
Resolution of potential conflicts of interest over treating liquidity management as a cost resource versus a profit centre
Measurement and allocation mechanism of costs of liquidity
Operational risk tolerance – problems very visible in “ real time” world of settlements
Consistency across measures and clear definition
16
What is Liquidity Management ?
A profit centre ?
Fully costed and allocated operation with cost recognised and allocated across business lines ?
Something treasury and the money markets desk do ?
Integrated part of financial plan ?
Driving strategy
17
What is a Liquid asset ?
Not an issue greatly discussed prior to August 2007 !!
AAA securities ??
Secured Repo- Issuer / Collateral / Haircuts/Relationship
Eligible at central Bank in normal operations-back to the 1980’s ?
New arrangements with Bank , Fed , ECB – how enduring-how act in a future market dislocation
18
Stress Testing
“ Liquidity Stresses are low-frequency , but extreme severity , events that are not well understood”
FSA Section 3.5 DP07
“ Stress tests and contingency funding plans funding plans have not generally assessed impact of simultaneous disruption to securitisation and interbank markets “
Bank of England - April 2008
19
Stress Testing
Well defined and granular stress testing against a range of events
A continual process not a one off piece of analysis as markets and business profile changes
Flexible and interactive so scenarios can be rapidly changed and updated
Comprehensive across the institutions on and off balance sheet exposures
Judgement ; business sense-not spitting out dozens of unchecked data sheets
20
Stress Testing
Liquidity Commitments
Conduits
Data Money Markets
Medium Term Market
Retail
Off Balance Sheet
Nature of Stress
Central bank actions
Assumptions Market Capacity
Behavioural Assumptions
Time & Speed
Rollover Vector
Stress Model
Negative Cash
time months0
Positive Cash
21
Secured Funding under Stress
Assesses the amount of secured funding that could be lost in a crisis
Partners Large and Stable Trading Counterparty
Government Bonds
T1 Equities
T3 Equities
EMG Debt
Structured Debt
Col
late
ral T
ype
Secured Funding Counterparties
Source : Lehman Brothers
22
Contingency Planning
Asset Inventory
Use/Availability of Central Bank Facilities
Depth of Repo/Funding Market
Assessment of Collateral
Reputational / Market signalling Impact
Backup Liquidity Lines
Funding Relationships
Negative Cash
time months
0
Positive Cash
Stress Impact
Contingency Action Impact
23
Pricing for Liquidity
“ Off balance sheet contingent liquidity exposures appear not to have been priced adequately into internal models at firms ”
Bank of England April 2008
Pricing of on balance sheet lending need to address impact on bank costs of the credit crunch
Credit Crunch has put more focus on ability to fund growth
Value of long term deposits
Market characterised by increased focus on aligning internal funds transfer pricing for Liquidity premia with external market conditions
24
Pricing for liquidity
The “nice decade “ is over
Asset led income targeted planning assuming an limitless supply of close to Libor wholesale funding is over
Not aligning the true market costs of funding to assets may lead to excessive non value generating activity
Words are easy-establishing the Governance, MI and culture to live the story of economic value is a challenge
25
Commitments/ Liquidity facilities
Effectively liquidity options written to clients
Charging often “bundled” into overall product offering
Credit crunch, Mono line rating issues etc have highlighted risks
Pricing needs to reflect risks of draw - a function of market spread movements ; drawn margins , collateralisation etc …
26
Valuation of Deposits
Deposit gathering the non-glamorous / non sexy
The value of strong deposits are now much more widely appreciated
More focus going forward on the value of the “Funding Franchise” too often neglected in the recent asset boom.
27
Closing thought
“ The squall became a hurricane…plain folk will ask. Why should we trust anyone?”
Philip Stephens FT - 21 September 2007