Financial Markets


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My class presentation at IIMA which contains an overview of the credit crisis till Dec 2008.

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Financial Markets

  1. 1. By Raghu Subramanian
  2. 2. Treasury Yield Curve 8 7 6 5 Yield 4 3M T-Bill 3 10 Yr T-Bill Eff. Fed funds rate 2 1 0
  3. 3. For more information go to 070826_HOUSING_GRAPHIC.html
  4. 4. Fixed rate loans  Floating rate loans  3/1, 5/1, 7/1 Adjustable rate mortgages  (ARM) Interest only loans  Ninja loans (No income, no job and no assets) 
  5. 5. ◦ In 2006, 22% of homes purchased (1.65 million units) were for investment purposes. ◦ Additional 14% (1.07 million units) purchased as vacation homes ◦ During 2005, these figures were 28% and 12% ◦ An estimated one-third of ARM originated between 2004 and 2006 had quot;teaserquot; rates below 4%, which after expiry would significantly increase the mortgage payment ◦ The share of subprime mortgages to total originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006.
  6. 6. Prime loans  ◦ Loans given to people with credit scores of > 680 Alt-A loans  ◦ Loans given to people with credit scores of <= 680 Subprime loans  ◦ Loans given to people with credit scores of <= 620
  7. 7. Declining home prices  Foreclosures  Rising commodity prices 
  8. 8. Feb 2007  ◦ HSBC's first-ever profits warning came in February this year when a $10.6bn (£5bn) hole in the company's US sub-prime business was revealed. Aug 10 2007  ◦ The next jolt came from French bank BNP Paribas, which said early in the day that it was freezing three investment funds once worth a combined $2.17 billion because of losses related to U.S. housing loans.
  9. 9. Market size is $2 trillion  This market is used to fund short term  financing based on asset backed commercial paper such as homes and autos Banks used asset backed commercial paper to  fund long term investments
  10. 10. 13th Sept 2007  ◦ General maturity times are 30-40 days but have shortened to a week ◦ Banks are increasingly finding it difficult to raise short term funds for their asset backed commercial paper and fund their long term investments ◦ This means that their cost of capital has risen with yields demanded having gone higher ◦ Also exacerbated by the fact that many buyers moved to buying treasuries instead of commercial paper
  11. 11. 18th Sept 2007  ◦ Fed cuts both federal fund and discount rates by 50 basis points and signals more rate cuts. ◦ Markets all around the world stage a huge rally. ◦ Dow Jones goes up 330 points or 2.5%, Nasdaq up 2.7%, S&P up 3% The dollar falls against a basket of currencies  Commodity prices hit the roof  Treasuries stage a substantial rally 
  12. 12. Nov 2007  ◦ Ambac, guarantees $546 billion of securities. ◦ MBIA guarantees about $652 billion of municipal and structured finance bonds ◦ FGIC has insured $314 billion of debt ◦ Concerns in credit quality of securities prompts S&P and Moody to nearly downgrade AMBAC and MBIA.
  13. 13. Proposes to buy the muni bond insurance  business. Declines to purchase their CDO bond  insurance businesses. Markets jump higher signaling the entry of  Warren Buffet as a sign of confidence. AMBAC & MBIA decides to raise additional  capital through equity dilution to keep its AAA rating.
  14. 14. Jan 21 2008  ◦ Many worldwide markets took a beating as indices crashed lower. ◦ In response the Fed cut rates by 75 basis points to calm markets ◦ However, it was later found that the volatility was due to Societe Generale unloading a Euro 50 billion of equity derivatives during this time from Jerome Kerviel’s portfolio.
  15. 15. Auction rate security refers to a debt  instrument with a long-term nominal maturity for which the interest rate is regularly reset through a dutch auction Attractive market as it is cheaper to raise  funds through this market. Size of the market in 2008 was $200 billion 
  16. 16. Feb 7 2008  ◦ First instances of failed auctions occurred ◦ Citigroup, UBS, Merrill Lynch, Morgan Stanley and others refused to act as buyers of last resort since they wanted to protect their own capital ◦ These banks had marketed ARS as safe securities. ◦ Class action lawsuits were filed against these banks ◦ ML agrees to buyback $10 billion of ARS ◦ Citibank agrees to buyback $7.5 billion of ARS ◦ BOFA agrees to buyback $4.5 billion of ARS ◦ Wachovia agrees to buyback $9 billion of ARS ◦ UBS agrees to buyback $9 billion of ARS
  17. 17. July 2007  ◦ Two Bear Stearns hedge funds collapse.. Why did this happen.  These funds purchased CDO’s that pay an interest above the cost of borrowing  They leveraged themselves about 25 times to purchase more CDO’s  The subprime market came under stress and creditors demanded higher collateral against these assets putting a strain on Bear Stearns’ balance sheet  Other funds started to sell bonds to preempt Bear from selling before them.  Prices went down further and Bear Stearns had to offload debt from its books leading to significant losses.
  18. 18. 13th Mar 2008  ◦ Bear Stearns' available liquid funds fell from $12.4 billion to $2 billion, as customers pulled out money ◦ Other financial institutions refused to provide short-term loans as counterparty risk reached a high. ◦ Bear Stearns experienced what is called “a run on the bank” due to which it could not arrange for enough money to sustain its operations
  19. 19. The Fed steps in and takes $30 billion of  mortgages onto its books It provides J.P.Morgan with financing to take  over Bear Stearns It did this because the risk of not doing so  would endanger the entire financial system. How ?? Is the question asked by many.  Enter Credit Default swaps (CDS) 
  20. 20. Size of market is $62 Trillion  The swaps became one-way bets on the  demise of financial institutions as traders hedged the risk that their partners might implode. Traditionally, CDS are used as insurance to  protect bonds against default. However CDS have now become instruments  of speculation with CDS positions far exceeding those of the bonds they insure.
  21. 21. A company may have $1 billion worth of  bonds outstanding but $10 billion worth of CDS on those bonds. When a company defaults, the sellers of CDS  contracts have to pay the bondholders.
  22. 22. At the time of its collapse, it was estimated  that Bear Stearns had $60 billion worth of bonds. Not rescuing Bear would mean that bond  insurance would have to make huge payouts on CDS contracts outstanding against those bonds. This could have lead to downgrades of these  insurers which would have led to further write downs for the entire financial system.
  23. 23. Combined Mortgage book stands at $5 Trillion ◦ Mortgage defaults were increasing rapidly. ◦ Estimated losses were at $50 billion ◦ Issued $3 billion worth bonds at record high ◦ spreads to treasury bonds. ◦ Required to issue $233 billion more worth bonds which the government would probably have been forced to buy. ◦ Therefore, the government decided to take over the two institutions
  24. 24. ◦ Lehman did not come clean on its write downs. ◦ For a month before declaring bankruptcy, customers withdrew $400 billion ◦ Banks stopped lending to Lehman ◦ CEO Richard Fuld ignored warning signs assuming that the company cannot fail ◦ Firm was unable to raise capital by selling off its assets as Bank of America and Barclays backed out of the bidding process two days before bankruptcy. ◦ It was estimated that Lehman had $85 billion worth of toxic assets.
  25. 25. The fall of Lehman was gradual rather than  sudden so market participants had time to adjust. Lehman was a buyer and seller of CDS  contracts so the net effect was considered to be manageable. However, Lehman did cause massive  problems that almost led to AIG going bust.
  26. 26. In 2006, Merrill Lynch purchased First  Franklin, one of the largest issuers of subprime mortgages. This makes Merrill Lynch the largest player in the market. The tightening credit conditions force ML to  take massive write downs to the point where its own survival comes into question It sells mortgages worth $29 billion for $7  billion in a bid to raise capital Finally it sells itself out to Bank of America 
  27. 27. BOFA gains access to Merrill Lynch’s  investment banking business, one which it never able to achieve on its own It also gains access to Merrill’s huge  brokerage business. BOFA can now cross sell its brokerage  services to its deposit holders
  28. 28. AIG sells insurance for bonds by issuing CDS.  Just before and during Lehman’s  collapse, CDS spreads hit the roof. This prompted credit rating agencies to call  into question the quality of bonds insured by AIG which led to AIG being downgraded The downgrade led to AIG having to provide  an additional $13 billion in collateral which it could not raise since all markets were frozen
  29. 29. The Fed bails out AIG with an $85 billion package and  takes an 80% equity stake in the firm The failure of AIG would mean that the bonds insured by  AIG would hold little value since the insurance cover would no longer exist. This would to further write downs and further tightening  of credit conditions. CDS spreads would widen further which would take cost of  funding to untenable levels. Banks would hoard capital and stop lending to each other  which would lead to further tightening of credit conditions. The resulting impact of all this was considered to be so  large that the Fed had no choice but to bail out AIG.
  30. 30. Goldman Sachs and Morgan Stanley shares take a  beating Treasury bonds stage a huge rally  Morgan Stanley and Wachovia talk merger  Money market funds trade under $1 after  Lehman goes bankrupt Hank Paulson proposes a $700 Billion bailout  Goldman Sachs and Morgan Stanley get into  commercial banking. The pure play investment banking model is almost extinct. Buffett strikes a sweet deal with Goldman Sachs  WAMU goes under and J.P.Morgan laps up its  assets
  31. 31. ◦ In 2006, Wachovia purchased Golden West Financial ◦ Golden West had a huge portfolio of option adjustable rate mortgages (around $26 billion) that let borrowers make minimum payments less than what they owe. ◦ CDS swaps protecting $10 million of Wachovia 5 yr bonds traded for the equivalent of $3.5 million initially and $500,000 a year compared with $670,000 a year and no upfront payment the previous day. ◦ Citibank buys Wachovia for $1 a share.
  32. 32. The $700 billion bailout plan is rejected by  the U.S house of representatives Treasury yields sink 45%  Oil drops by $10 per barrel  Gold goes up 3%  The CBOE volatility index hits the highest ever  value The S&P 500 falls by 9%.  European governments bail out a bunch of  European banks
  33. 33. Q&A
  34. 34. It is the spread between the 3 month Eurolibor and the 3 month T-Bill  3 month Libor is the rate at which banks borrow from each other  Typical spread is 50 basis points  6 5 4 3 3 month T-Bill 2 3 month EuroLibor 1 0