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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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GOVERNMENT INTERVENTION 1
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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GOVERNMENT INTERVENTION 2
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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POLICY IMPLICATIONS OF THE
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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POLICY IMPLICATIONS OF THE
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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POLICY IMPLICATIONS OF THE
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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POLICY IMPLICATIONS OF THE
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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POLICY IMPLICATIONS OF THE
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.