Banking Sector: g Easy Money, Hard Landing

Banking
g Sector:
Easy Money, Hard Landing
The Financial Meltdown
Meltdown::
Origins,, Consequences and Future
Origins
1
Financial Crisis – XXI Century
y
- 2000-2002 Technology Crisis
- 2007-2009 Real Estate Crisis/ Banking Crisis
- 2010-2012 Sovereign Crisis (USA / Europe /
Japan)
- 2012- (?) Currency/ Confidence Crisis
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19981998
998-2000
000 Technology
ec o ogy Bubble
ubb e
Economic Environment:
• Low Interest rates;
• Inflation under control;
• GDP growth,
th with
ith end
d off millennium
ill
i
exuberance;
b
• Adoption of the Euro;
• Beginning
B i i off assett bubble;
b bbl
• Irrational stock market rise;
• Debate:
D b t new and
d old
ld E
Economy;
• Virtual Wealth.
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Technology
ec o ogy bubble
bubb e
• Excess of liquidity
q
y in the market;;
• Direct access to the markets by investors, due to internet;
• Bug of the year 2000 – increased the perspectives of growth
(Tech Investment);
• Oil and commodities at decade lows;
• P/E above 400;
• Asset Pricing Models: Perpetuities – assume endless growth
growth.
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Hang Over of the year 2000
Th New
The
N
Millennium
Mill
i
• No big problems with the year 2000;
• Decrease in the earnings expectations of the technology
sector;
• Confidence Crisis in the .com;
• Devaluation of assets in the market;
• Bank had huge losses - Market Exposure;
• 9/11
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Politics Adopted and Consequences
• Interest Rate Reductions (US–1%, and EU–2%);
• Agressive Fiscal Policies;
• Debt Supercicle – Violation of Stability Pact (2003);
• Growth of Global Liquidity (World Imbalances).
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Banking Growth – Easy Money
(2003--2006)
(2003
• Cheap credit and excess liquidity;
• Incentives to ownership;
p
• Real Estate historical return of 5%/year;
• Underprice of Real Estate Risk;
• Economic Growth lead by China;
• Construction sector becomes the major motor of the US
economy.
y
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2003-2006
2003Real Estate Bubble
Worlwide
• Builders financed by banks;
• Easy credit to Homeowners ;
• Ajusted Rate Mortagages(ARM);
• Housing pricing boom;
• Stock market boomed – artificial wealth;
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Real Estate Data
• Home Prices (1998-2006):
• France: +100%
• Ireland : +130%
• US: +80%
• 5 milion houses build in Spain (1998-2007).
• Subprime lending (% of total):
• 2% in 2002
• 14% in 2008
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Origins of Financial Crisis
• After the Tech Bubble crisis that got worse with the 9/11 attacks, everyone feared the economic
colapse.
l
Th interest
The
i t
t rates
t were lowered,
l
d and
d so did the
th costt off mortgage.
t
H it was affortable
Has
ff t bl
to buy home, prices increased at a higher pace than income, providing homeowners extra equity
to spend, namely by refinancing houses – Real Estate Bubble.
• Before the year 2001, people needed to have a job, savings and their future obligations had to be
known in order to get a loan. It used to take up to 90 days for a loan to be approved, and the
bank used to g
go to the p
people’s
p
jjob.
• With new incentives, new companies were born (Countrywide, New Century Financial) and
buying house was never so easy. Mortgages caught fire, with fresh money from China and Oil
Producers, that bought every financial product that could give a better and secure return.
• LIER LOANS: At “Quick Loan Funding” you could get a loan in 30 minutes, you could have said
that your weekly earnings were four
f
times than real, that no one would check. These companies
gave employment to delivery pizza boys, car sales persons with no training.
market
• There was no State Regulatory Entity that regulated the mortgage market.
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The Beginning of the Hard Landing
(2006)
 Increase
in inflation and interest rates: rise in foreclosures;
• Banking sector agreed to finance the biggest ever LBOs and M&A.
• Dry up in liquidity;
• No ways
y of getting
g
g easy
y and q
quick money;
y;
• Solution: Pack the loans and sell them - Securitization. Was used to obtain funds from the
investors at a lower rate by using special purpose vehicle (SPV), in order to reduce the risk of
bankruptcy. A credit derivative was also generally used to insure the credit quality of the
underlying portfolio so that it will be acceptable to the final investors.
• Artificially diversifies portfolios;
• Underestimate the risk of positive correlation.
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Securitization – Notion of Danger
g
• NSBE Bank loans 10 students $100,000/each,
$100 000/each which they will use to buy homes.
homes UNL
has invested in the success and/or failure of those 10 students, now home buyers. If
the students make their payments and pay off the loans, NSBE makes a profit.
Looking at it another way,
way NSBE has taken the risk that some borrowers (students)
won't repay the loan. In exchange for taking that risk, and lending, the borrowers pay
NSBE, interest on the money they borrowed.
• From the perspective of NSBE, those loans represent 10 different assets. If the loan
fails, NSBE takes ownership of the house. If the loan succeeds, NSBE gets his money
back along with the interest they charge.
charge NSBE can do two things with those loans: It
can hold them for 20/30 or 40 years and it would hope make a profit on the investment,
or it could sell them to some other investor, and walk away. In doing this, it would
make less profit than if it held onto them long term,
term but it would benefit,
benefit in the sense
that NSBE make some profit while also getting the original investment back. NSBE
gives up some of the reward (profit) in exchange for not having the risk. And because
people would never fail it was a win
win-win
win situation.
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Securitization – Notion of Danger
g
• So NSBE Bank decides that it’s better to cash now (We can have other investment
opportunities, and make more commissions). We could sell those 10 loans to 10
investors. Each investor would be taking a risk in buying those loans, because if any
loan defaults, the investor would lose. Naturally, investors would not be willing to
pay very much for those loans, knowing the risk involved, specially students! NSBE
wants to sell those loans for the best price it can get, so they decide to securitize those
loans by combining the 10 loans into one entity, an SPV in the Cayman Islands, and
split that one entity into 10 equal shares. Each investor still pays the same $100,000,
but instead of owning one loan, they will own 10% of all 10 loans. If one loan fails,
every investor loses 10%. The result is that NSBE bank is able to sell the assets for
more money, and investors are protected from the volatility of directly owning
individual mortgages, and thus gain from holding an artificially diversified asset.
H
However,
if a majority
j it off the
th mortgages
t
i the
in
th assett pooll actt in
i the
th same way
(correlated) then the risk is similar to owning one mortgage.
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Derivatives
The Weapon of Mass Destruction
• The extremmely quick growth of the derivatives markets, uncompreension, inovation and its use
nott only
l to
t cover risk,
i k but
b t instead,
i t d to
t increase
i
it namely
it,
l by
b giving
i i more leverage
l
t the
to
th portfolios,
tf li
had a catastrofic result over the time:
•
•
•
•
•
•
•
•
Barings Bank in 1995,
1995 losses of 1
1.4
4 bl USD;
OrangeCounty in 1995, losses of 1.64 bl USD;
LTCM em 1999, losses of 2 bl USD;
UBS em 2008/9
2008/9, 65 bl USD;
USD
Bear Stearns em 2008, ? bl USD;
AIG in 2008 and 2009: 160 bl USD;
H
HypoVereinsbank
V i b k (Real
(R l E
Estate):
t t ) 85 bl EUR;
EUR
Total losses exceed 1 Trillion dollars by end March 2009, and were projected to exceed 2
Trillion.
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The Danger of the Derivatives
• Derivatives represent more than 601 Trilion dolares(BIS – Bank of Internacional Settlements,
Dec. 2010) – 9,2x the World GDP;
• 6,5% unnallocated (29,8 Trilion USD/45% GDP);
• World dependant on Debt;
• OTC Products: No Clearing House – uncertainty about outstanding volumes
• Greece – no one knows how many derivatives there are on Greek debt.
debt
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Derivatives - Examples
• Futures, options, strutured capital garanteed products;
• Mortgage Backed Securities: Financial derivatives, that give the
owner the right to the cash flows from the mortgages;
• Emission of CDO’s (Collateralized Debt Obligations), with carry
trade financing and growing exposure, as a way of financing;
• VIE – Variable Interest Entity.
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Derivatives - Examples
• SPV – Special Purpose vehicle
• SIV - Special Investment Vehicle
• CRE – Commercial Real Estate
• ARM – Ajustable Rate Mortgage
• CSOs - Collateralized Synthetic Obligations (CDOs backed primarily by credit
derivatives)
• SFCDOs - Structured Finance CDOs (CDOs backed primarily by structured
products )
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Derivatives - Examples
New progams were created in order to provide that every american could
have a house of their own:
PAY OPTION NEGATIVE AMORTIZATION ADJUSTABLE RATE
MORTGAGE (PONAARM)
This new program would help first time buyers, that did not have income to
pay
p
y the interest. For the first couple
p of y
years y
you could p
pay
y only
yap
part of the
interest, and the difference gets added to the principal. So if in the future the
income does not increase substancially these people cannot pay the house.
However as long as the prices of the houses continue to rise,
rise these defaults
just are not possible.
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CDO -Collateralized Debt Obligations
• The underwriter is typically an investment bank;
• Before September 2008 these underwriters were Bear Stearn,
Merrill Lynch, Citigroup, Deutsche Bank and Bank of America;
• In 2008, only 12 companies worldwide had a AAA rating.
However 6400 CDO’s had the most wanted top rating…the
AAA!
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CDO-- Collateralized Debt Obligations
CDO
• The CDO’s and ABS spread risk and uncertainty about the value of the
underlying assets more widely, rather than reduce risk through diversification.
• Credit rating agencies failed to adequately account for large risks (like a
nationwide collapse of housing values) when rating CDOs and other
derivatives.
• Over exposure to a financial instrument considered safe.
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CDS-- Credit Default Swap
CDS
• Derivative contract between two counterparties, where the buyer makes
periodic payments to the seller, and in return receives a payoff if an
underlying financial instrument defaults.
defaults A company
company's
s credit default swap
spread, is the cost per annum for protection against a default by the company;
• Compared to insurance, because of the premiums paid, there are several
diferences:
dif
• The seller does not need to be a regulated entity:
• The seller is not required to maintain reserves to pay off buyers;
• The risk is offsetted with other dealers and transactions in the bond
markets;
• The buyer of a CDS does not need to own the underlying security, or a
credit exposure, in fact the buyer does not have to suffer a loss from the
default event;
• No clearing house: no data for outstanding CDS.
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Bank exposure
• Shareholders got too greedy;
• Banks got over exposed to Real Estate;
• Huge potencial losses as defaults rise;
• Losses related to securitization – off balance records;
• Solvability ratios in danger;
26
2007-2008 Financial
2007Crisis
•World
World imbalances: 2 Economic Models
• China / Japan – Buy US / Europe bonds – expand monetary base to finance their exports
– buy foreign bonds - Asset Model;
• Europe
p / US – Financial model – expand
p
monetary
y base to finance consumers - Debt
Model;
•Cheap credit / Excess liquidity:
oil-exporting
exporting countries;
• surplus of savings - East Asian and oil
• new players, new products, new transactions and markets;
• the impact of the “carry trade” fuelled investment flows into a range of markets.
•Underprice of risk of housing;
•Outsource
O t
off risk
i k managmentt (Investment
(I
t
t Banking
B ki and
d Rating
R ti Agencies);
A
i )
•Misscalculation – “Size Matters” – of having 5 ou 500 bilion. The risk models assumed
that the positions could be fully hedged;
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Financial Crisis - Origin
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Financial Crisis - Imbalances
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2007-2008
2007Fi
Financial
i lC
Crisis
i i
•
NINJA LOANS: Easy credit to people that had no means to pay, no
warranties, except the house that they would buy;
•
Bankrupcy of the second biggest financial credit firm: New Century Financial
Corporation;
•
More than de 393 banks and thrifts have close from 2008 to 2011 in the US
(Source FDIC).
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Short selling
Good or Bad for Markets
Markets?
?
Shorting is the practice of selling a financial instrument that the seller does not own at
the time of the sale. Short selling is done with the intent of later purchasing the
financial instrument at a lower price. Short-sellers attempt to profit from an expected
decline in the price of a financial instrument.
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Short Selling – Good or Bad
Bad?
?
• In September 2008 short selling was seen as a contributing factor to undesirable market
volatility and subsequently was prohibited by the SEC for 799 financial companies during
three weeks and then extended in an effort to stabilize the stock price of those companies;
• In August 2011,
2011 some European countries banned Short Selling;
• Since the ban, the stocks are lower, showing that the short selling ban did not solve the
problem;
• It
It’ss a part of asset managment,
managment and it contributes to the fair value between companies in
the same sector;
• Makes possible the hedge between markets;
• Bigger
Bi
return
t
f pension
for
i funds,
f d as they
th receive
i a fee
f for
f the
th loan
l
off financial
fi
i l instruments;
i t
t
• Increases liquidity in the market;
• Today’s sellers, will be tomorrows buyers;
• Naked Short Selling is another practise that cannot be mistaken with legal short selling.
Naked short selling implies that i can sell more stocks of a company than they really exist.
Example: Volkswagen shares rose due to Naked Short Selling Covering.
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August of 20072007-2008
• The financial crisis had implications in the commodities markets,
markets
with the run of money to these markets. As consequence the
prices rose and so did inflation;
• Increase in interest rates (until August 2008) in order to stop this
other
th bubble,
b bbl but
b t the
th homeowners
h
were the
th mostt affected;
ff t d
• Banks have now on their balance,
balance assets that are valued based
in theorical models and cannot sell them in the market. Huge
potencial losses;;
p
• The Centrals Banks inject funds in the money market in a
desperate way to restore confidance, with no sucess.
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Some measures…….
measures
• ECB lent 350 bilion euros, in December 2007, trying to stabilize
markets;
• Intervention
I t
ti
i the
in
th money markets
k t off around
d 300 bilion
bili
USD
(ECB, FED, BoE e BoJ) in August 2008;
• German Banks asked for 46% of this facility!
• Decreases in interest rates of 275bps for ECB, 450bps for the
BoE and 500bps for the FED, during 2008 and 2009;
• The Central Banks, except ECB, were printing money to finance
public spending.
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2008:
2008
008: Paulson,
au so , Ge
Geithner
t e Plan
a
• All plans were based in a mass spending cycle,
cycle in order to restore confidence;
• Paulson’s Plan - buy $700 bilion in Toxic assets of the Banking sector;
• Central Banks extend theirs credit facilities do Investment Banks and consider to buy
private debt;
• Geithner’s Plan, pleadges more than $1 trilion just in Public-Private Investment
Programs, in which the governement through it’s agencies finance the private investor
i order
in
d for
f him
hi to
t buy
b distressed
di t
d assets
t from
f
th banks.
the
b k
• These rescues of $12,8t were equivalent to $42.105 for each american, or 14 times
the currency in circulation.
• TARP – Term Auction Facility Program;
• TALF – Term Asset-Backed Lending Facility;
• FDIC – Federal Deposit Insurance Corporation;
• TAF – Term Auction Facility
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G20, IFM - Conclusions
• Avoiding protectionism;
• Stimulate the economies through fiscal and monetary policies;
• Enpowerment of the IMF;
• Increase to $1 Trilion the IMF funds; (In 2011 these funds were stilll not available)
• The systemic importance of financial institutions, markets and instruments depend on wide range
of factors, including their size, leverage and interconnection, as well as founding mismatches;
• Effective enforcement of regulation of the financial system, including, funds, insurance and rating
agencies;
• The G20 National Authorities commit to assist each other in enhancing their capacities to
strengthen regulatory framework;
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Public Spending:
p
g Explosive
p
situation
• Governments increased spending;
• Economic slowdown;
• Lower taxes revenues;
• Higher Deficits;
• Interventions
e e o s in the
e financial
a c a sys
system;
e ;
• Private debt became a Public problem.
43
1966-2011
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Rating Agencies
Conflict of Interest ?
• The best known are Moody’s, S&P and Fitch;
• Their stamp of approval would be like if these products could sell themselves;
• The best rating is AAA (pay less interest) and the worst BBB (pay more interest, bigger
risk).
) D is for Default;;
• Because the housing prices went up, even the BBB looked as good as the AAA;
• The credit rating agencies had the incentive to lower the requirements and award the
securities with the best rating,
rating because they were paid by the Investment Firms that
made these securities;
• No one was paying attention to the misspricing of risk;
• There was
as a big irresponsability
irresponsabilit from those who
ho evaluate
e al ate these complex
comple financial
products. Simply by being complex, they never should be attributed the highest
rating, comparing them with the sovereign debt of the countries;
• Ex.
E A town
t
i Norway,
in
N
N ik had
Norvik,
h d a problem…..aging
bl
i
population,
l ti
and
d needed
d d to
t
invest in order to get future cash flows to pay increase obligations. They took a loan
against the future earnings on a hydroelectric plant and borrowed money to buy AAA
CDO’s
CDO
s. They simply looked at the rating that implied a low risk of default of their
investment…. Bankrupted….
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Supervision
p
(Lack of
of))
• Lack of oversight - No questions asked;
• Market regulated itself;
• There were no rules or supervision regarding the mortgage sector;
• Lack
L k off knowledge
k
l d – financial
fi
i l inovation;
i
ti
• No control over Credit Default Swaps;
p
• Rating Agencies out of the supervision;
• The Hedge Funds were not in the scope of the Supervision;
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Moral Hazard vs Systemic Risk
• Why save the Banks / Countries?
• Question of moral hazard raised: if we bail someone out of a problem that they have
created, then what is the incentive they will have next time to avoid making the same
mistake?
sa e
• This is the question raised by the population in general, and can be the base for recent
social unrest, beside the rising of unemployment;
• The feeling of unpunishment can contribute for substancial social and political
challenges in the near future;
• Financial sector has contributed to the welfare in the last decades. The situation of not
saving
g the banks,, would cause the undermining
g of all our society
y - systemic
y
risk;;
• The systemic risk was the most undervalued risk. Valuing it, implicates that all the base
of the society can be in danger of falling, if the perception is high. Too big to fail: AIG,
Fannie Mae, Freddie Mac, Citigroup, Bank of America, etc, if failed would have created a
confidence crisis;
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2010-2012 Current
2010Economic Situation
• Low interest rates;
• Lack of confidence – investors, consumers, industrials;
• Intervention in the Markets;
• High
g unemployment
p y
rate;;
• Social unrest;
• Lower consumer spending;
• End Public Spending Cycle;
• Top of Debt Supercicle;
• Transfer of economic power to the developing nations.
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2010--2012 Financial Stress
2010
•Deposits at ECB rise – Eg. Siemens deposited over €6 bilion;
•Banks stop lending to each other;
•Volatility
Volatility Increase;
•US fiscal Imbalances;
•Stress Tests to Banks – two months after the Irish system colapsed - 2010;
• Basel III – New Rules
•Forex Interventions – BoJ, SNB, FED;
•Rating
Rating Agencies : Downgrade of Sovereign Debt – Portugal,
Portugal Ireland
Ireland, Greece
Greece, US
US…
•Lower Growth : Recession(?) – Austerity Measures;
•Inflation: +3,5% CPI in the US; 2,5% in Eurozone;
- Inflation
I fl ti bad
b d for
f Banks:
B k Assets
A
t depreciating
d
i ti – Bonds,
B d St
Stocks,
k R
Reall E
Estate,
t t b
bad
d lloans;
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2010--2012 Sovereign Crisis
2010
• Public
P bli D
Debt
bt >100% GDP (US,
(US Italy,
It l G
Greece, IIreland…);
l d )
• Deficits > Potencial Prowth;
• Violation of Stability Pact (Debt/GDP <60% and déficit <3%);
• Banking Crisis – ECB dependance for liquidity;
• Eg. Portuguese banks have 50b ECB loans – 29,5% GDP
• Risk Aversion (JPY, CHF,GOLD);
• Trade Imbalances (US / China);
• Uncertainty of Fiscal Policies – higher taxes, low visibility;
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2011 – Rating Agencies
• Downgrade of Sovereign Debt – Portugal, Greece, Ireland;
• US Debt downgraded by:
• Dagong Rating Agency ;
• Egan Jones – In July 2011 downgraded US Debt;
• Fear of being behind the curve,
curve like in 2008;
• Tolerance towards USA;;
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2010-2012
2010A problem
bl
called
ll d Greece
G
Greece?
?
• Default
D f lt (?);
(?)
• ECB Intervening in the Markets;
• IMF Intervention;
• Risk of Contagion (Italy, Spain…France?)
• Alert for Italy?
• Economic Slowdown – Recession;
• Social Unrest;
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Europe: Challenge
EFSF - European Financial Stability Fund /
Eurobonds
• Debt vehícle – up to two trilion euros ?
• Reestruture the banking sector – loan capital;
• Support banks capital struture, buy bonds;
• Leverage itself – endangers rating fo the countries;
• Lack of politic/economic support – fiscal union;
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2010-2012 Help of the ECB
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2010--2012 Lack of Resources
2010
• IMF – Resources of $400 bilion (Cristine Lagarde- Sept. 2011).
• Central Banks expanding Balance Sheet;
• Acting as lenders of last resort;
• Transfer of Risk – Supranacional Institutions;
• ECB -Buying
Buying Bonds
- Bank Financing (Unlimited Funding)
• FED- Buying Bonds – Quantitative Easing Programs;
• SNB – Peg EUR/CHF at min
min. 1
1,2
2 chf per euro;
• BoJ – Intervining to stop the Appreciation of Yen;
• Confidence in the currency ? – Gold,
Gold US German Bonds
• Currency crisis?
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Safe Heavens
• Gold
• CHF
• US Bonds
• German
G
Bonds
B d
• JPY
56
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2Y Greek – Bond Yield
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The Debt Supercicle
• Fiscal Policy is Out-of-control;
• Liquidity Trap – preference for liquidity;
• The population is aging faster in the developed countries, that are now the most in debt.
• The population aged 65 and older, as a percent of those aged 20 to 64, will rise from 20,7% to
36% over the next 25 years;
• With the cost of debt rising more than the GDP we can expect a specter of default or very low
interest rates.
• Investors
I
t
worry about
b t fiscal
fi
l sustainability
t i bilit (decrease
(d
off entitlements);
titl
t )
• Debt bought by Central Banks;
• Foreign Exchange imbalances continue, US deficit - the dollar under pressure;
• Countries asking for a future supranational currency in order to avoid this problem.
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Future
• Estagflation - High unemployment rate and inflation;
• Low Growth;
• Higher taxes;
• Prices of agriculture commodities may also increase,
increase due to this crisis.
crisis The financing of
agricultural chemical has dropped, and farmers are without financing – Agflation (?)
• Eurobonds (?) – Fiscal and Political Union
• New Stability Pact – Eurozone;
• Reestructure Banking Sector: Seggregation between comercial and investment banking;
• Glass –Steagall Act revival (?) - In 1999 we asssited to the repeal of the Glass–
Steagall
g Act of 1933 that made a clear division between investment banking
g which
issued/bought securities and commercial banks which accepted deposits.
• Dood Frank Bill: reform of the financial industry;
• Volcker Rule: Avoid over-exposure of banks;
• Use of more capital, less debt in the system; (convert subsidies into capital)
• Currency crisis ?
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One thing we can say of this debt supercycle,
supercycle is that each new
round of stimuluspolicy never corrects the underlying problem of
financial imbalances.
Designed to do exactly the opposit: prevent a painful washing of
the previous excesses. By doing this, we are setting the scene
for a greater problem down the road – Sovereign/Currency
Crisis.
“There is no doubt this will happen again. The flaws of the
h
human
nature
t
are such,
h that
th t we cannott change
h
th ”(Al
them”(Alan
Greenspan – 2009).
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