Credit Crunch 2008: everything explained --- Twain

Some pioneers went in search of……..

........to make and print money..…… Stock markets Companies Central banks Property

........”I want to be richer than Mephistopheles!”..……

......raced to keep apace of their Pied Piper…… © Rick Turner

It all looks fairly complicated........

........ with some highly negative predictions:

Oct 2008: Total global losses could be US$3 trillion ( Roubini, Stern )

May 2008: Subprime losses could be US$500 billion ( Fitch Ratings )

April 2008: Total US loss estimated at US$945 billion ( IMF )

Source: Citigroup

Sources: Bloomberg, Reuters and Bank of England calculations. (a) Solid lines are historical official rates. Dotted lines for the United Kingdom, the United States and the euro area are derived from OIS contracts. Dotted lines for Japan show one-week forward rates.

INSTITUTION WRITEDOWN (US$ BLN) CAPITAL; RAISED (US$ BLN) MKT CAP (US$ BLN) YTD % CHG WRITEDOWN / MKT CAP 42.9 44.1 93.0 - 41.8 0.46 38.2 29.3 64.2 -46.5 0.60 37.1 17.9 32.5 -38.5 1.14 19.5 3.5 186.4 -7.2 0.10 15.5 24.5 71.1 -50.8 0.22 15.1 20.7 109.0 -40.7 0.14 14.4 5.6 41.3 -29.8 0.35 9.8 1.5 53.3 -23.7 0.18 9.3 9.3 5.2 -63.9 1.79 9.2 7.8 124.1 -18.2 0.07 8.2 13.9 15.6 -65.8 0.53 7.7 3.2 45.4 -32.4 0.17 3.8 0.6 75.4 -18.0 0.05 3.3 1.8 1.6 -11.2 2.01 3.0 4.1 79.8 -19.9 0.04

US$637 billion in subprime-related losses by global financial institutions (Bloomberg, 14 October 2008)

Meanwhile, 923 million around the world are going hungry and waiting for US$12.3 billion aid promised by industrialized nations at G8 meeting in Rome, June 2007 (Spiegel Online, 16 October 2008)

Movements causing borrowers and banks alike to go further into the red.

Homeowners in this segment typically don’t qualify for prime market rates in mortgage loans because they either have blemished or inadequate credit records (FICO credit score below 620, the FICO range is from 300 to 850).

It’s estimated that 25% of the US population falls into this category.

40% of new mortgages in 2006 were sub- or near-sub- prime, compared with 9% in 2001. This was fostered by the economic environment.

Relaxed US monetary policy until 2004 (July 2003 --- July 2004: Fed rate at 1%; Jan 2007 --- July 2007: 5.25%).

Plentiful international liquidity due to large net savings from Far East (including China) and from oil-exporter countries. International investors sought higher returns and safety in US Treasury and agency securities.

Yields on long-term US bonds were depressed by heavy international demand

American banks sought better revenue streams with high-yielding, risky and complex securities (i.e. derivatives backed by pools of mortgages: CDOs).

Default risk increased, not helped by mortgage brokers promoting subprime and Alt-A lending. Brokers and bankers alike earn via commission structures.

Aug 2007: US housing bubble bursts…

CDOs are Collateralized Debt Obligations , a type of structured credit product.

The purpose of these products is to create tiered cash flows from residential mortgages and other debt obligations (corporate rentals, etc.) that are supposed to make the entire cost of lending cheaper for the economy as the sum of its parts.

Collateralization is oriented towards helping diversify and lower the overall risk of mortgage defaults.

REMIC = Real Estate Mortgage Investment Conduit Lender/ Issuer Bank CDO (black box) Junior tranches Mortgage pool Mortgage loan US$ US$ US$ Borrower (you+me) REMIC Tranches

There are 3 tranche levels: senior (typically rated AAA); mezzanine (AA to BB) and equity (unrated).

A higher rating indicates more financial stability and less risk.

Interest Scheduled Principal & Prepayments ‘ AAA’ L + % or Net WAC Accounts ‘ AA’ L + % or Net WAC ‘ A’ L + % or Net WAC ‘ BBB’ L + % or Net WAC ‘ BBB-’ L + % or Net WAC Residual Excess Interest Servicer REMIC Trust Monthly Mortgage Payments $ $ $ P $ I Interest Payments Principal Payments ‘ AAA’ ‘ AA’ ‘ A’ ‘ BBB’ ‘ BBB-’ Residual $ I $ P Scheduled Principal & Prepayments Source: Fitch M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 M31 M32 M33 M34 M35 M36 M37 M38 M39 M40 M41 M42 M43 M44 M45 M46 M47 M48 M49 M50 M51 M52 M53 M54 M55 M56 M57 M58 M59 M60 M61 M62 M63 M64 M65 M66 M67 M68 M69 M70 M71 M72 M73 M74 M75 M76 M77 M78 . . . M 2000 M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 M31 M32 M33 M34 M35 M36 M37 M38 . . . M 1000

Monthly Mortgage Payments (regular + subprime) buys US$ US$ REMIC

The CDOs pooled the riskier tranches in the hope of profiting from their higher expected yields. Banks accounted for them on their trading books, loan books and off-balance sheet (for tax reasons). The result was an increase in their credit risks, so they tried to repackage this and sell it onto other institutions.

prepaid principal DEFAULT LOSSES TOXIC Unrated tranches Tranche CC Tranche BBB AA AAA M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 M31 M32 M33 M34 M35 M36 M37 M38 M39 M40 M41 M42 M43 M44 M45 M46 M47 M48 M49 M50 M51 M52 M53 M54 M55 M56 M57 M58 M59 M60 M61 M62 M63 M64 M65 M66 M67 M68 M69 M70 M71 M72 M73 M74 M75 M76 M77 M78 . . . M 2000 M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 M31 M32 M33 M34 M35 M36 M37 M38 . . . M 1000 R I S K I N C R E A S E S Y I E L D I N C R E A S E S Bank CDO (black box)

The US government intervened with financial support for Money Market mutual funds, Freddie Mac and Fannie Mae and to prevent short selling (notable amongst hedge funds) because they are the key to the current liquidity triangle .

The illiquidity of the CDOs has been further complicated by credit wrappers which have earned them “synthetic” investment-grade AAA to AA ratings when their underlying assets are actually higher risk than previously assumed.

Lender/ Issuer Junior tranches Mortgage pool Mortgage loan US$ US$ US$ Borrower (you+me) REMIC Tranches Money Market Mutual Funds Hedge funds Foreign Investors Mortgage REIT Bank CDO (black box)

The banks have been subject to changes in the Basel accord which is oriented towards improving credit risk management and increasing transparency for investors. The banks created CDOs as a means of complying and still generating profits.

Initial impact of Indirect Monetary Policy Instruments Source: IMF INTERBANK MARKET Funds held immediately prior to final settlement to enable banks to meet obligations to each other and to the central bank. Only institutions with accounts at the Central Bank (CB) and the Central Bank participate. CALL LOAN or REPO MARKET Market for funds with overnight maturity. Transactions take place during the day. Banks and large organizations participate. TERM MONEY MARKET Market for funds with 1 day< maturities <1 year. Includes secondary market in T-bills and other paper. Banks and large financial organizations participate. Initial impact of Indirect Monetary Policy Instruments BOND MARKET Market for paper of over 1 year remaining to maturity. Banks and other financial and institutional investors participate. PRIMARY MARKET Initial sale of T-bills by the Government’s agent, usually the CB. Sold by auction or tap issue. PRIMARY GOVERNMENT BOND MARKET Initial sale of government bonds by Government’s agent, usually the CB. Sold by auction or tap issue. FOREIGN EXCHANGE MARKET Liquidity of the Money Market affects the functioning of the Foreign Exchange Market. Money Market liquidity and stability affects the liquidity of the Bond Market.

companies Governments US$ investments US$ return + bond yields US$ Short term debt US$ T-Bill US$ Certificate Deposit Money Market Mutual Funds

Companies Governments US$ investments US$ return + bond yields US$ Short term debt US$ T-Bill US$ Certificate Deposit Money Market Mutual Funds

NO SHORT SELLING CENTRA:L BANKS’ INJECTION: US$ 300+ BILLION Capitol Hill US$ 55 billion US$ 200 billion US$ 85 billion US$ 700 billion Bank CDO (black box) Potential mortgage liabilities: approx US$ 5,500 billion

up to US$ 700 billion to acquire CURRENT IMPLICATIONS STRATEGIC ALTERNATIVES

NO WHOLESALE BAILOUT OF TOXIC ASSETS

Banks are encouraged to cancel all dividend payments and to raise capital by issuing equity in themselves

=> not favored because it dilutes existing sh/holders

Governments acquire holdings in troubled banks for 3-5 years and have board representation as sanity checks

HIGHER TAXES

Statutory national debt will rise from US$ 10.6 trillion to account for the purchase

Counter to free market

reverse sell in the future conditions + time unknown TWAIN: US$500 bln to buy toxics, US$200 bln sector restructuring PROBLEM ASSETS

… need to ask for “MORE SIR, PLEASE,” from G8 leaders...

GERMANY * € 500 bln (US$672 bln) UK * GBP500 bln (US$850 bln)

US

US$700 bln (TARP)

US$100 bln (tax credits)

US$250 bln (to acquire

equity in banks)

ASIA + WORLD BANK * US$10 bln US$3.2 TRILLION PLEDGED BY GOVERNMENTS Source: Reuters, various Internet news sources FRANCE * €360 bln (US$491 bln) RUSSIA * US$50 bln