After the storm- Global Financial Crisis 27 aug 2010


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Global Financial Order - Reasons for Crisis, Current Status, The BIG Shifts- Public Debt, Global De-leverage, Wealth Concetration & Creation.
Talk Delivered at Fore School Of Management, new Delhi

Published in: Economy & Finance
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After the storm- Global Financial Crisis 27 aug 2010

  1. 1. Time for storytelling… After the storm Gaurav Sharma Email: 27 August 2010 FORE School of Management, New Delhi 1
  2. 2. Global Financial Crisis Consumer Credit Markets Capital Markets Alternate Assets (Private Equity etc Big Shifts Approach 2 1 2 3
  3. 3. Lets get Started 3
  4. 4. Global Financial Crisis -Timeline of Crisis 2007/08…. The recent financial crisis is categorized as the worst since the Great Depression. Some of the major events related to the crisis are mapped to the Dow Jones Industrial Average 4
  5. 5. The turmoil was not merely another turn of the business cycle but a restructuring of the economic order. 5
  6. 6. Causes: US Housing Market Collapse Many experts believe that the global crisis was triggered by the US housing market collapse Easy access to credit: Falling interest rates and rising availability of mortgages, combined with rising housing prices encouraged consumers to buy homes Relaxed lending standards: To cater to the growing number of mortgage seekers, lenders relaxed standards and issued a large number of sub-prime loans Inadequate regulations: Regulations did not keep pace with innovations in US financial products, leading to much higher complexity, poor transparency and greater risk Complex credit derivatives: The invention and use of complex debt derivatives such as CDOs1 made it difficult to identify and contain the sub-prime lending problem, once default rates began to Rise Market collapse: The property boom led an over-supply of housing and prices could no longer be supported. Just like the self-perpetuating behaviour that led to the rise, the crash was also self- perpetuating. As prices fell, more foreclosures started taking place, increasing the supply of homes on the market. Lenders started to tighten their standards and fewer consumers could qualify for mortgages and help reduce the supply 6
  7. 7. Growing global financial assets provided increasing liquidity and credit availability at a global level Sources: McKinsey Global Institute; Global Financial Stock database 9 10 7 8 19 10 4 3 19 25 26 29 34 38 38 40 13 14 14 17 20 23 23 25 2 3 5 12 18 15 23 65 32 22 93 28 91 23 94 32 30 25 38 34 133 44 35 140 54 2 116 160 Equity securities Private debt securities Govt debt securities Bank deposits +8% +10% 41 3.333. 1980 95 2000 01 02 03 04 05 2006 CAGR % 95-04 06-08 Global financial assets $, trillions 4 4 Global Fin. assets/GDP, % U.S. Fin. assets/GDP, % 7
  8. 8. Historically low global interest rates after the bursting of the dot- com bubble sparked greater global liquidity… Sources: Federal Reserve System; ECB statistics 0 5 10 15 20 Japan FF ECB 1977 9787 07 Global interest rates % Global rates hit historic lows in aftermath of dot-com bubble burst 0300 Fed and ECB monetary easing created greater liquidity and helped global rebound after the tech-bubble burst 8
  9. 9. A vicious cycle completed to drive further illiquidity Risk aversion of investors Falling asset prices Announce- ment of losses Banks reduce funding to other banks Banks pay inflated price for liquidity Investors avoid lending to banks Banks/ hedge funds need to liquidate positions Rising losses in subprime market 9
  10. 10. Genesis of a Crisis Scant Regulatory Oversight Originate-and- Distribute Model Deterioration of Underwriting Standards Mortgage Securitization Mispricing of Risk Credit Default Swaps Excess Global Liquidity CrisisExcessive Financial Leverage Low Interest Rates Drive to Increase Investment Returns Rising Real Estate Prices 10
  11. 11. Regulatory Balkanization – Failure of Oversight Office of Thrift Supervision Federal Deposit Insurance Corporation Individual States Department of Labor Office of the Comptroller of the Currency Federal Reserve National Credit Union Administration Securities and Exchange Commission Commodity Futures Trading Commission Commercial Banks Thrifts Insurance Companies Securities and Exchanges Futures Credit Unions Industrial Loan Companies Bank Holding Companies 11
  12. 12. Global Financial Crisis  Proximate causes  Sub-prime lending  Originate and distribute model  Financial engineering, derivatives  Credit rating agencies  Lax regulation  Large global imbalances  Fundamental cause  Excessively accommodative monetary policy in the US and other advanced economies (2002- 04) 0 2 4 6 8 10 Jan-90 Dec-90 Nov-91 Oct-92 Sep-93 Aug-94 Jul-95 Jun-96 May-97 Apr-98 Mar-99 Feb-00 Jan-01 Dec-01 Nov-02 Oct-03 Sep-04 Aug-05 Jul-06 Jun-07 May-08 Percent Effective Federal Fund Rate in the US US Monetary policy too loose during 2002-04; aggregate demand exceeded output; large current a/c deficit; mirrored in large surpluses in China and elsewhere. 12
  13. 13. • Low interest rates • Excessive financial leverage • Complexity of financial products • Lack of effective risk management at large institutions • Inadequate appreciation/regulation of derivatives risk • Conflicts of interest at rating agencies • Mark-to-market accounting • Lack of access to liquidity • Poor corporate governance practices How Did We Get in the crisis? 13
  14. 14. Differences Between Financial Crisis in US/Europe and India What has not happened here  No subprime  No toxic derivatives  No bank losses threatening capital  No bank credit crunch  No mistrust between banks Our Problems  Reduction in capital flows • Pressure on BoP • Stock markets • Monetary and liquidity impact • Temporary impact on MFs/NBFCs (Sept-Oct) • Reduction in flow from non-banks • Perceptions of credit crunch 14
  15. 15. But do we really understand the real reason for crisis ? The conventional wisdom used to be that the basic cause of the crisis was bad incentives in the mortgage industry , while it’s tempting to blame what happened on just a few greedy bankers who took irrational risks But is that the real reason.... The large global impact of the crisis suggests that the problems with subprime mortgages were a symptom rather than the cause The main causes are : -Flawed global financial order in which the incentives to take on risk are incredibly out of step with the dangers those risks pose. -System where growing inequality and thin social safety net creates tremendous political pressure to encourage easy credit and keep job creation robust, no matter what the consequences to the economy’s long-term health -Unequal access to education and health care in the united states and other countries (including India) puts everyone in deeper financial peril. 15
  16. 16. So far…. 16
  17. 17. Global banking trends after the crisis The near-term prospects for US and European banks are decidedly grim. The global financial crisis will bring about the most significant changes to their operating framework banks have seen in decades. There will be fundamental re-regulation of the industry, ownership structures are shifting towards heavier state involvement and investor scrutiny is rising strongly. Equity ratios will be substantially higher. As a result, growth and profitability of the banking sector as a whole are likely to decline. Lean years lie ahead for US banks. Performance improvements during the last 15 years have often been due to strong lending growth and low credit losses. As private households reduce their indebtedness, revenue growth in some European countries but especially the US may remain depressed for several years. With weak loan growth and a return of higher loan losses as well as a fundamentally diminished importance of trading income and modern capital market activities such as securitisation, banks may be lacking major growth drivers. Consolidation to continue but with a different focus. While there will still be a considerable number of deals, transaction volumes are likely to decline and restructuring stories rather than strategic M&A may dominate. The probability of domestic deals has increased, while that of cross-border mergers has declined. Internationalisation of banks likely to slow. Uncertainty about the future prospects especially of foreign markets and strictly national banking sector stabilisation programmes are triggering a re-orientation towards domestic markets. This is more relevant for European banks that have greatly expanded into other European countries recently, while American banks overall may continue to target the national market rather than going abroad. 17
  18. 18. Private Equity is a cyclical business Global Private Equity Since it emerged as a major asset class in the 1980s, PE has experienced three major booms. In the 1980s, the PE industry capitalised on the sale of many poorly run public companies and corporate divestitures available at low cost and largely financed with junk bonds. From private equity’s heyday a few years ago when deal makers were riding high, to the gut- wrenching drop in deal making through last year’s recession, this industry knows what it’s like to ride the roller coaster. Private equity has always been a cyclical industry, and signs of a nascent rebound in 2010 underscore that fact. During the 1990s, debt financing played a less prominent role. PE industry returns were driven mainly by gross domestic product growth and expanding price-to-earnings multiples during the long economic expansion. Over the past decade, PE rode a credit bubble inflated by low interest rates to record deal values. That boom, of course, came to an abrupt end with the mortgage-led debt crisis that froze credit markets in 2008 and triggered a global recession affecting nearly every industry. 18
  19. 19. India’s economy has experienced a robust and broad- based recovery from last year’s financial slowdown Fund-raising has been on the rise again, particularly, from the domestic fund houses. While the core infrastructure sector and the telecommunications sector continued to attract PE investment, we are experiencing the revival of the real estate sector. Other sectors like consumer products and retail, financial services and technology are also showing signs of improved deal activity. There were 11 PE-backed IPOs thus far in 2010 — compared to seven total in 2009 — as the companies leveraged the rising stock market to raise capital. More PE-backed IPOs in the coming months if the stock market remains favourable. Looking ahead, valuations are an expected concern, accentuated by the fact that stock markets continue to soar. Top deals see global funds participate; emerging consumer-driven sectors Private Equity - India 19
  20. 20. • Private equity’s ―golden age‖ of low interest rates, abundant leverage, mega-deal making and effortless returns is over, and will not soon return. Global PE investments sank to a level not seen since the last downturn. All regions and industry sectors suffered. • The dynamics underlying the decline differed by region. In North America and Europe, economic uncertainty and frosty debt conditions constrained deal making. In emerging markets, the massive dislocation of value brought about by declining economic growth and tumbling equity markets led to a mismatch of buyer and seller expectations. In both regions, the rapid rebound of equity markets did not give valuation and deal multiples a chance to reset. • PE firms readjusted their investment focus to the opportunities 2009 presented, favoring carve- outs, growth equity, acquisition finance, balance-sheet restructurings and distressed debt investments. • Fund-raising declined across all major PE asset classes and was weak in every region. Despite their continued commitment to PE, the ―denominator effect‖ and the paucity of PE distributions squeezed LPs’ liquidity and impaired their ability to commit to new funds. • The downturn forced significant markdowns in portfolio valuations, causing short-term PE returns to decline by double digits; recent vintages were hit hardest. • Leading PE firms that laid the groundwork during the downturn should be positioned well for market conditions in 2010 and beyond. Key takeaways from Private Equity Industry 20
  21. 21. Countries in the fire zone are likely to face severe economic pressures as they increase public debt to greater than 90% over the next few years, which will in turn stall growth Imagine earning $100 to pay $90-110 rupees as interest on debt…. BIG SHIFTS: Increase in Public debt might trigger another crisis 21
  22. 22. BIG SHIFTS: World Wealth Status- Gradual Shift happening to Asia 22
  23. 23. The spectre of deleveraging has been haunting the global economy since the credit crunch reached crisis proportions in 2008. BIG SHIFTS: Debt and Deleveraging (1/3) The deleveraging process may just be getting under way and is likely to exert a significant drag on GDP What’s more, analysis of deleveraging episodes since 1930 shows that virtually every major financial crisis after World War II was followed by a prolonged period in which the ratio of total debt to GDP declined significantly. The one exception was Japan, whose bursting asset bubbles in the early 1990s touched off a financial crisis followed by many years... The fear: an unwinding of unsustainable debt burdens will drag down growth rates for years to come. So far, reality has been more benign, with economic growth recovering sooner than expected in some countries, even though the financial sector is still cleaning up its balance sheets and consumer demand remains weak. 23
  24. 24. BIG SHIFTS: Debt and Deleveraging (2/3) 24
  25. 25. BIG SHIFTS: Debt and Deleveraging (3/3) 25
  26. 26. China Hong Kong India Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand 0 11,000 13,000 19,0002,000 22,0004,000 * Assessment including key product penetration (credit card, life insurance), openness to foreign banks, market consolidation, financial stock per capita ** Financial stock includes bank deposits, government and corporate debt and equity Sources: MGI; WMM; Size of 2009 financial stock** Degree of market maturity* GDP per capita, 2009 € High Medium Low Vietnam Mature market with high penetration of banking and insurance products Emerging fast-growing markets with under-developed banking sectors; growth driven by product penetration and increase of bankable population Transition markets with fast maturing market structure and fast growth Asia is not a homogeneous region; it consists of markets at different stages of development Consumer Credit Markets- ASIA 26
  27. 27. 27 Asia’s population(Some countries) is aging rapidly … 200 1 202 1 205 1 10 working adults* support 1 retiree** 6 working adults* support 1 retiree** 3 working adults* support 1 retiree** * Working adults are adults from 15 to 64 years old ** Retirees are adults 65 years old and above Sources: Data up to 2021 from Asian Demographics; data for 2051 from Firm estimates Population over 65 years old % 20 16 7 20 15 7 14 5 9 10 14 20 2021E2001 Singapore Need for retirement investment increases with time Hong Kong India Taiwan Korea China which will create pension-related wealth management opportunities
  28. 28. Important banking trends for Asia (1/2) 1. Asia is fragmented, and markets have distinct characteristics: Asia is not one homogeneous market, but rather a fragmented region of independent markets at different stages of development. 2. The bulk of Asia’s growth will come from a few large markets, though selected smaller markets have high growth rates: China, India, Korea, and Taiwan account for 80% of the financial assets in Asia (excluding Japan) and will be key growth drivers. However, smaller markets such as Vietnam and Indonesia are expected to grow rapidly. 3. Consolidation is happening at varying paces across the region: Malaysia, Korea, and Thailand have made good progress in banking consolidation, while countries like Taiwan are still highly fragmented. 4. Persistent boom-bust cycles have been observed in the capital markets: Historically, the growth of Asia’s capital markets has not been linear; the region is likely to face boom-bust cycles in the future. 5. Large and profitable pan-Asian foreign franchises have emerged: Citibank, HSBC, Standard Chartered, and GE Capital have created material Asian franchises with a median share of 1.7% in active Asian markets and 40%-50% PBT margins in 2009. 6. New local “empowered” players are seeking regional and global growth: Many local market leaders are going beyond their home markets (e.g., DBS, ICBC, CCB, Chinatrust, Kookmin, CIMB, OCBC). 7. Rapid influx of new bankable customers in large markets (China, Indonesia, and India): Approximately 600mn new ―bankable‖ customers will enter the market in the next 5-10 years. 28
  29. 29. Important banking trends for Asia (1/2) 8. Extremely high wealth concentration: Less than 1.5% of Asian households control about 50% of personal financial assets (PFA); this privileged segment is growing rapidly, and its wealth could match that of the segment’s Continental European counterparts by 2010. 9. “Flipped” risk-return perception of financial investments: 40%-60% of Asian PFA is still held in low-interest-earning deposits due to ―flipped‖ risk-return perception; this perception is driven by a fear of investment risk, perpetuated by poor historical performance of the underlying capital markets. As a result, consumers are stuck at the awareness stage of the sales funnel for most investment products. 10. Many billion-dollar product markets have emerged: Significant revenue and profit pools across many markets have created an opportunity for selective players to create large and profitable niche businesses. 11. Demand has increased for borrowing among consumers; consumer finance is still highly underpenetrated in Asian markets (except for Taiwan and Korea): The younger generation is more open to borrowing and believes that borrowing can improve lifestyle. This belief, coupled with existing low penetration of credit products, suggests that consumer credit will experience exponential growth in the Asian banking sector. 12. Rapidly aging populations have increasing retirement needs: Asia’s populations are aging rapidly. Concerns about meeting retirement needs will drive the development of innovative pension products, subject to conducive regulatory environments. 29
  30. 30. Technology reshaping the landscape – Mobile and Internet Adoption rates 30
  31. 31. Key take away from this session The Global Financial System is still not out of the woods (European crisis, consumer credit, public debt etc ): the hidden fractures still threaten the world economy… the FAULT LINES are to be fixed. Global Debt and leverage reduction will result in slow growth. The Economic Wealth shift happening to East Private equity’s “golden age” of low interest rates, abundant leverage, mega-deal making and effortless returns is over, and will not soon return.  Technology (Internet and Mobile) is reshaping the world of financial services. The Asian financial markets are projected to grow very fast. 31
  32. 32. ANNEXURE 32
  33. 33. Federal Reserve under Alan Greenspan (Easy Money) Fannie Mae, Freddie Mac & Congress: GSEs supporting affordable housing – increased demand for subprime and Alt-A loans Borrowers at best were uninformed; at worse, lied about their financial condition Mortgage Brokers, Appraisers, Realtors: Overvalued properties and pushed borrowers into gimmick or complex mortgages Rating Agencies misrepresented security/asset values Large Commercial and Investment Banks demonstrated poor risk management practices Regulators (Banking & SEC) allowed excessive leverage and failed to criticize the large institutions’ business models; no regulation of derivatives Separation of Ownership from Origination: Securitization allowed loan originators to care less about the quality of the loans they originated  Mark-to-Market Accounting forced unreasonable valuations of securities when there was no liquidity How Did We Get Here? 33
  34. 34. How the story unraveled… •In the aftermath of the dot-com bubble burst, growth of liquidity and easy credit availabilities, combined with novel structuring of financial assets drove a dramatic expansion of structured credit; investors chased yield and bet on real asset performance in residential real estate and didn’t properly understand true credit risk •Even while the economy remained strong, housing prices ceased to rise, and many subprime borrowers began to struggle to service their debt •Default rates of RMBS and CDO began to rise dramatically, and financial asset valuations were strongly impacted by market reaction against in-transparency and complexity in the instruments, and a failure of trust in their credit ranges •Downgrades in financial asset values helped spur a reduction in market liquidity. A reinforcing cycle, based on loss of confidence and transparency, drove further deterioration in financial asset value as well as a crisis in funding liquidities •The devaluation of financial asset values, combined with a funding liquidity crisis, hit the capital market participants in various ways. Many players exited the markets •Central banks injected capital to secure the availability of funding liquidity, and held or reduced interest rates to support the capital market. The side effect was to expose the real economy loop to the risk of inflation •Regardless of the scenario, there will be some winners and many losers as the cycle continues to unravel. 34
  35. 35. What caused the bubble? The monetary policies of central banks particularly the US Federal Reserve and the ECB in some countries were too loose – they focused too much on consumer price inflation and ignored asset price inflation Global imbalances – the Asian crisis of 1997 and the policies of the IMF led to a desire among Asian governments to save funds 35
  36. 36. Growing Importance of Finance Note: Financial services and insurance accounted for 7.8% of U.S. GDP in 2009. 36
  37. 37. Housing Prices 37
  38. 38. Leverage 38
  39. 39. Growth of a complex market.. 39