Successfully reported this slideshow.
We use your LinkedIn profile and activity data to personalize ads and to show you more relevant ads. You can change your ad preferences anytime.



Published on


Published in: Economy & Finance, Business
  • Be the first to comment


  1. 1. DEEP FINANCE the role played by financial markets in the current crisis and its resolution Enrico S. Cruz 19 March 2009 The views expressed in this summary reflect the perusal views of the undersigned. Opinions as stated are unsubstantiated by detailed empirical study.
  2. 2. Enrico S. Cruz – 19 March 2009 page “ Values have shrunken to fantastic levels; […] government of all kinds is faced by serious curtailment of income; […] the withered leaves of industrial enterprise lie on every side; […] the savings of many years in thousands of families are gone. More important, a host of unemployed citizens face the grim problem of existence and an equally great number toil with little return.” - Excerpts from Franklin D. Roosevelt’s inaugural speech in 1933
  3. 3. Enrico S. Cruz – 19 March 2009 page Outline of the Presentation <ul><li>History of the Crisis </li></ul><ul><li>Probable Causes of the Mortgage Crisis </li></ul><ul><li>Probable Causes of the Credit Crisis </li></ul><ul><li>Crisis Cycle Summary </li></ul><ul><li>Products in the News </li></ul><ul><li>What to Expect </li></ul>
  4. 4. Enrico S. Cruz – 19 March 2009 page History of the Crisis <ul><li>Prelude to the Crisis </li></ul><ul><li>A few ominous signs of approaching trouble surfaced during 1H 2007 (e.g. announcement of severe losses from bad bets on mortgages by some Bear Stearns hedge funds in June) </li></ul><ul><li>In July, a little known German bank, IKB, got into trouble because of its exposure to the US mortgage market but was bailed out by the German public authorities </li></ul><ul><li>Curtain Opens for the Banking Crisis </li></ul><ul><li>Move by BNP Paribas to suspend redemption of shares in a few of its euro money market funds shocks investors </li></ul><ul><li>Funding for bank-sponsored off-balance sheet vehicles dried up, forcing banks to bring these investment vehicles on balance sheet </li></ul><ul><li>Inter-bank lending seized up as suspicion about banks’ exposure to toxic US mortgage assets mushroomed </li></ul>2 <ul><li>Central Banks Come to the Rescue </li></ul><ul><li>As liquidity in money markets dried up as banks began to hoard funds, the ECB stepped in to provide short-term refinancing against a broad range of collateral </li></ul><ul><li>Both the Fed and the BoE also stepped up their liquidity support operations to the banking system and cut interest rates </li></ul>3 1 Feb 2007 Jun 2007 Aug 2007 Oct 2007 Dec 2007 HSBC announces that it will boost loan losses provisions on bad mortgages Bear Stearns hedge funds announce significant losses on mortgage bets Fed and ECB start responding to liquidity problems BNP Paribas freezes money market fund Banks move SIVs onto balance sheet and start announcing significant losses Fed introduces TAF to deal with fears about year-end funding pressures
  5. 5. Enrico S. Cruz – 19 March 2009 page History of the Crisis <ul><li>Crisis Spreads to Other Markets </li></ul><ul><li>As the huge exposure of banks to securitized mortgages and loans became gradually known, the crisis spread to credit markets </li></ul><ul><li>CDS spreads, especially on bank paper, surged and tensions came to a head in March with the Fed-backed rescue of Bear Stearns. Concerns about Fannie Mae and Freddie Mae brought another round of jitters in July </li></ul>4 <ul><li>Freddie/Fannie takeover, ML bought over, Lehman files for Bankruptcy </li></ul><ul><li>As GSE’s struggled to raise capital, US Government seized control, firing the CEO and management team and placing them in ‘conservatism’ </li></ul><ul><li>Lehman Brothers posted its biggest loss in history and filed for bankruptcy protection as it failed to find a buyer </li></ul><ul><li>Bank of America takes over Merrill Lynch </li></ul>5 <ul><li>The Crisis Deepens </li></ul><ul><li>Washington Mutual is seized by the government regulators and its branches and assets sold to JPMorgan Chase in the biggest U.S. bank failure in history </li></ul><ul><li>Unprecedented market volatility despite the improvement in the availability of credit </li></ul><ul><li>Withdrawals from hedge funds </li></ul>6 Mar 2008 Jul 2008 Bear Stearns collapses GSEs plunge on capital concerns; IndyMac seized by regulators Sep 2008 GSEs taken over by US Govt. ML taken over by BoA Lehman files for Bankruptcy. GS and MS became CBs regulated by Fed; AIG bailed out by Fed HBOS taken over by Lloyds <ul><li>January – February 2009 </li></ul><ul><li>UK government pledged to increase its stake in Royal Bank of Scotland to 70% from 58% as the bank posted a huge loss of GBP 28 billion for 2008 </li></ul><ul><li>US government extended financial aid to Bank of America injecting additional $20 billion and providing guarantees against losses on $118 billion bad assets </li></ul><ul><li>UK launched its second rescue package which includes the Asset Protection Scheme to guarantee UK banks ‘ risky assets </li></ul><ul><li>Eastern European financial crisis arises </li></ul>7 Oct 2008 Washington Mutual, inc. seized by FDIC and assets sold to JPM The House passes the $US 700bn revised rescue plan Fed floods the financial market with dollars to reduce MM rates Royal Bank of Scotland Group Plc, HBOS Plc, and Lloyds TSB Group Plc get a 37 billion-pound bailout from UK Gov’t Nov 2008 Citibank bailed out by US Gov’t Dec 2008 The Fed announced a 75bp rate cut to 0.25%with a target rate of 0% to 0.25% Pres. Bush unveils rescue plan for GM and Chrysler; S&P downgraded 12 major U.S. and European Banks Icelandic banking system collapsed; IMF approved a $2.1 billion financial support Feb 2009 UK Gov’t increased its stake in RBS to 70% Eastern European financial crisis arises Canadian Parliament approved $50billion economic stimulus plan
  6. 6. Enrico S. Cruz – 19 March 2009 page The Traditional Mortgage Model Qualified Borrower Bank Depositors USD Title USD Certificates of Deposit USD PN / Title Developer Probable Causes: Mortgage Crisis
  7. 7. Enrico S. Cruz – 19 March 2009 page The New Mortgage Model Qualified Borrower Bank Depositors USD Title USD Certificates of Deposit SPV / CDO Investors Assets USD USD USD PN / Title USD PN / Title Wall Street Developer Probable Causes: Mortgage Crisis Subprime
  8. 8. Enrico S. Cruz – 19 March 2009 page Probable Causes: Mortgage Crisis <ul><li>Low interest rates </li></ul><ul><li>Continuous rise in house prices </li></ul><ul><li>Growth in developing countries leading to excess global savings </li></ul><ul><li>relative to capital investments </li></ul><ul><li>Loose credit policies / NINJA loans </li></ul><ul><li>Originators of subprime mortgages originate to sell (no “skin in the game”) </li></ul><ul><li>Investors looking for yields; with buyers of MBJ over rely on rating </li></ul><ul><li>Excessive leverage / Risk management failure </li></ul>GREED ?
  9. 9. Enrico S. Cruz – 19 March 2009 page Probable Causes: Credit Crisis Prepared by: Jeffrey Frankel, James W. Harpel Professor of Capital Information and Growth at Harvard Kennedy School Housing crash Financial crisis 2007 -08 Recession 2008 -09 Eventual loss of US Global hegemony Stock market crash Oil Price Spike 2007-08 Failures of Corporate governance Underestimated risk in financial markets Excessive leverage in Financial institutions Stock market bubble
  10. 10. Enrico S. Cruz – 19 March 2009 page Crisis Cycle Summary Subprime Crisis <ul><li>Rate resets </li></ul><ul><li>Loose credit policies </li></ul>Mortgage Crisis Credit Crisis Financial System Crisis <ul><li>Falling prices </li></ul><ul><li>Use of securitizations </li></ul><ul><li>to free up balance </li></ul><ul><li>sheets </li></ul><ul><li>Low trust levels </li></ul><ul><li>Liquidity </li></ul><ul><li>Capital concerns </li></ul><ul><li>Increased volatility </li></ul><ul><li>Risk aversion </li></ul><ul><li>Risk management </li></ul><ul><li>- unrecognized risks </li></ul><ul><li>- Excessive leverage </li></ul><ul><li>- Valuations </li></ul><ul><li>Real Sector </li></ul><ul><li>Credit availability </li></ul><ul><li>Corporate governance </li></ul><ul><li>Valuations </li></ul><ul><li>Excessive leverage </li></ul>job cuts?
  11. 11. Enrico S. Cruz – 19 March 2009 page Products in the News: Synthetic CDO BBB AAA Equity BBB AAA Equity BBB AAA Equity BBB AAA Equity Proceeds Proceeds Collateral SPV AAA / BBB Floating Rate Notes Initial Cash Flows Outstanding Collateral Amount Outstanding Collateral Amount Collateral SPV Final Cash Flows Libor Floating Rate Notes Coupon Protection Credit Spread Floating Rate Notes Coupon Libor & Credit Spread Collateral Default Swap Counterparty Asset Swap Counterparty Reference Portfolio AAA / BBB Ongoing Cash Flows
  12. 12. Enrico S. Cruz – 19 March 2009 page Products in the News: Leverage Notes Bank Investor <ul><li>Investor’s view: bullish on bond </li></ul><ul><li>Investor borrows 4x his funds to buy ROP 32. Gains (net of funding cost) / Losses (inclusive of funding cost) are magnified by 4x. (assuming price at par) </li></ul><ul><li>If ROP 32 is STABLE or APPRECIATING in value, client gains from interest earned and bond appreciation less cost of funds </li></ul><ul><li>If ROP 32 DROPS in value, client has to deposit mark to market (MTM) losses to bank </li></ul><ul><li>If the investor fails on top up, the bank sells at any price to recover US$300. Any remaining funds are returned to the investor. </li></ul><ul><li>It is likely that investor recovers < US$100 initial investment </li></ul>Principle of Leverage Notes from an Investor’s Perspective US$100 US$400 ROP 32 If MTM of the bond is NEGATIVE: Bank Investor US$300 cash to top up US$400 ROP 32
  13. 13. Enrico S. Cruz – 19 March 2009 page Products in the News: Minibond Singapore (19 September 2008) - “Should Minibond Series 3 have taken the retail route?” Up to $200Mio of these notes were sold to a gullible retail public who probably thought they were buying five year bond issued by 6 leading banks that paid a 5% coupon per year but where in reality, not only exposed to the US housing market but also to complex credit default swap arrangement where substantiative party was the now bankrupt Lehman Brothers”
  14. 14. Enrico S. Cruz – 19 March 2009 page Products in the News: Minibond The Probable Structure: First to default (FTD) Note Linked to 6 Banks Retail Investors USD Minibond Ltd (LB SPV) Market 5% USD Note Libor + Premium Sell protection on 6 Banks (FTD) USD (collateral) Bonds/CDO USD
  15. 15. Enrico S. Cruz – 19 March 2009 page Products in the News: Equity Accumulator Bank Investor Bank sells at discount Bank sells 2x at discount vs. spot If price > spot If price < spot <ul><li>Investor’s view: bullish on shares </li></ul><ul><li>Investor enters into a contract to buy shares every 2 weeks over next 6 months at: </li></ul><ul><li>- a Discount to today’s market if price is above today’s level </li></ul><ul><li>- 2x number of shares at spot rate if shares are below today’s spot rice </li></ul><ul><li>GAINS, if shares trade up as the investor buys at a discount </li></ul><ul><li>LOSSES, if shares trade down as the investor must buy at spot rate twice as many shares. </li></ul>Principle of Accumulator of Shares from an Investor’s Perspective USD USD Note or Shares
  16. 16. Enrico S. Cruz – 19 March 2009 page Products in the News: Leveraged Finance Banks Investors Private Equity Company Shareholders Target Company (TC) Loans USD USD Loans secured by TC shares USD Shares of TC Shares <ul><li>To repay loans: </li></ul><ul><li>Increase leverage at TC, increase </li></ul><ul><li>ROE </li></ul><ul><li>Declare dividends / upstream cash </li></ul><ul><li>Sell TC with higher valuations </li></ul>
  17. 17. Enrico S. Cruz – 19 March 2009 page Products in the News: Commodity Hedges Fuel Hedge 12 March 2009 “ Cathay Pacific Posts $1.1 billion Loss for ‘08” “ Common hedging methods lock in fuel prices, protecting airlines when prices rise . But when prices fall, the difference is often accounted for as a loss” “ Australia’s Quantas Airways Ltd. used a relatively expensive hedging technique that involved options , Chief Executive Alan Joyce has said. But Quantas could walk away from its options as fuel prices dropped, unlike the less expensive hedges, which lock in prices. It now largely benefits from falling prices , he said.”
  18. 18. Enrico S. Cruz – 19 March 2009 page Products in the News: Commodity Hedges Probable Hedge: Jet Fuel Swaps <ul><li>Oil user purchases fuel oil from the market: </li></ul><ul><ul><li>Pays the floating market price to physical oil supplier </li></ul></ul><ul><ul><li>Receives physical oil </li></ul></ul><ul><li>Oil user enters into hedge with the bank: </li></ul><ul><ul><li>Pays fixed price to the bank </li></ul></ul><ul><ul><li>Receives floating market price from the bank </li></ul></ul><ul><li>Net result: Oil user pays fixed price for physical fuel oil: </li></ul><ul><ul><li>Floating price receipts from the bank offset those paid by oil users to physical suppliers </li></ul></ul>Bank Oil User Physical Oil Delivery Floating Oil Price Fixed Price Floating Fuel Price Principle of Hedging from a Consumer’s perspective Cashflow Diagram: Swap PHYSICAL CONTRACT HEDGE CONTRACT International Oil Market
  19. 19. Enrico S. Cruz – 19 March 2009 page What to Expect Greenspan (AWJ) Opinions 12 March 2009 “ It is now very clear that the level of complexity to which market practitioners at the height of their euphoria tend to push risk management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.” “ Adequate capital and collateral requirements.” “ A regulatory regime that will ensure responsible risk management on the part of financial institutions ,while encouraging them to continue taking the risks…” Bernanke FT 10 March 2009 “ Overhaul of financial structure infrastructure and new reforms would require global consideration.” “ Creation of an authority that would monitor systemic risks”
  20. 20. Enrico S. Cruz – 19 March 2009 page What to Expect Buffett 2008 Letter to Shareholders “ Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.” “ They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years” “ Though historical volatility is a useful ---but far from foolproof ---concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black Scholes formula now placed on our long term put options overstate our liability, though the overstatement will diminish as the contracts approach maturity.”
  21. 21. Enrico S. Cruz – 19 March 2009 page What to Expect Josef Ackerman Speech for the Centre on Capitalism and Society Columbia University 20 February 2009 “ A New Era: How the Crisis will reshape Politics, Societies and Finance” <ul><li>Transformative Impact on the role of the state in the Economy </li></ul><ul><li>- Swing back towards interventionist policies </li></ul><ul><li>- Change in values: equalitarian income distribution, personal trust. </li></ul><ul><li>Rebalancing of economic and political power, G20 vs. G7 </li></ul><ul><li>Financial Sector due for serious changes </li></ul><ul><li>- Increased capital and liquidity </li></ul><ul><li>- Changes in regulatory capital requirements for certain assets </li></ul><ul><li>effectively raising risk charges </li></ul><ul><li>- Modification to fair value accounting </li></ul>
  22. 22. Enrico S. Cruz – 19 March 2009 page What to Expect Josef Ackerman Speech for the Centre on Capitalism and Society Columbia University 20 February 2009 “ A New Era: How the Crisis will reshape Politics, Societies and Finance” <ul><li>Financial Sector due for serious changes </li></ul><ul><li>- Increased coordination of supervisory activities especially globally </li></ul><ul><li>active firms </li></ul><ul><li>Increased transparency on the distribution and extent of risk </li></ul><ul><li>Systemically important institutions (e.g. hedge funds) will come </li></ul><ul><li>under supervision </li></ul><ul><li>Substantial changes in the business models of the banks </li></ul><ul><li>- Independent investment bank </li></ul><ul><li>- Limits placed on quantitative risk models and will be complemented </li></ul><ul><li>by one comprehensive assessment </li></ul><ul><li>- Capital allocated to more stable business activities </li></ul><ul><li>- Pay structure geared for long run, sustainable profitability </li></ul><ul><li>- Regulation will aim at keeping banks “small and simple enough to fail” </li></ul><ul><li>- State investment in the sector </li></ul>
  23. 23. Enrico S. Cruz – 19 March 2009 page What to Expect The role of the academe?