The Credit Crisis Explained

Credit Crunch ExplainedBreakfast Club 2009

Credit Crunch ExplainedBreakfast Club 2009

1. What is it and who does it affect

2. The financial markets before the crisis

3. What caused the crisis: Collateral Debt Obligations (CDO’s)

4. What caused the crisis: Credit Default Swaps (CDS)

5. What caused the crisis: Frozen Credit Markets

6. What is the impact on Ireland

7. Where do we go from here

Credit Crunch Explained1. What is it and who does it affect

• The credit crisis is a reduction in the general availability of loans or a sudden tightening of requirement for a loan from a bank

• It is the first truly global financial crisis and affects the world economy

• It was triggered by the bursting of the sub-prime housing bubble in the US

• The offending products which amplified the effects of the property bubble burst originated in the US but were subsequently bought and sold by institutions world wide

• The crisis has exposed weaknesses in the financial industry regulation and the financial system

Credit Crunch Explained2. The financial markets before the crisis

• Financial globalisation improved countless lives around the world e.g. German savers funded the housing boom in Ireland

• For a quarter of a century finance basked in a golden age - laissez faire

• Trust is miraculous – you give money to complete strangers when you wouldn’t give it to your next door neighbour

• It is this trust that leads to a very liquid and strong financial markets - raises billions from investors to fund modern industry & technology

• Confidence is the most important element in the financial system

• Capitalism is prone to financial crisis and asset bubbles throughout the recent past

Credit Crunch Explained2. The financial market before the crisis

• Traditionally financial investors purchased debt instruments such as safe government bonds

• After the 2001 dot com bust and the 9/11 events the US Fed reduced the interest rates to as low as 1% in order to stimulate the economy

• Oil exporters, China, Japan and other Asian countries had large current account surpluses and choose to invest in government debt mainly safe AAA dollar US treasury bonds

• As the interest rates worldwide were very low this initiated an explosion of cheap credit

Credit Crunch Explained2. The financial market before the crisis

• Investors like pension funds, insurance companies and other financial institutions like to invested in safe secure AAA government debt

• The low interest rates drove the search for yield by investors

Credit Crunch Explained2. Financial markets before the crisis

• The abundance of cheap credit was great for the banks and they used this to grow and make a lot of money

• Investors see that the banks are making great returns and want to a better yields than government bonds

Credit Crunch Explained3. What caused the crisis: Collateral Debt Obligations

• The investment banks see opportunity to make commissions by satisfying the demand for higher yield by the investor community

• This search was the driving force behind the creation of the financial products which primarily caused the crisis

Credit Crunch ExplainedFinancial markets before the crisis

• The demand for yield let to financial innovation and this took the form of securitised credit instruments e.g. CDO’s

• Securitisation is simply taking a pool of illiquid assets and through financial engineering transforming them into a liquid security

• Securitisation was lauded in finance circles as it was used to reduce the credit risk and pass this on to end investors. This also reduced the need for bank capital requirements – originate to distribute model

• This helped regional institutions to diversify risk – this therefore would protect the whole financial system.

• Market participants did not appreciate or understand the associated risks

2. What caused the crisis: Collateral Debt Obligations3. What caused the crisis: Collateral Debt Obligations


• The Wall Street bankers connect the investors to home owners through Collateral Debt Obligations

• The bankers borrows heavily using cheap credit, then calls the mortgage lender and buys thousands of mortgages off them – house prices always rise after all!



• The banks pool these mortgages into a portfolio “box”

• The banker then gets a steady flow of cash from each mortgage every month



• Next the box of mortgages was financially engineered into a Collateralised Debt Obligation by dividing the box into three tranches or slices so that a rating agency will rate them

• If some mortgage payments default then the bottom tray may not be filled



• The CDO tranche are then rated by the rating agencies – this is a requirement in order to sell the CDO’s to investors

• The banks then sell the slices to investors with different risk profiles



• Everyone is making money and all parties want more home owners

• There are no more prime mortgages – but risk is added to mortgage qualifications as house prices always rise. What can go wrong!



• Sub-Prime mortgages are now introduced to CDO’s

• As long as house prices continue to go up everyone is happy

What caused the crisis: Collateral Debt Obligations2. What caused the crisis: Collateral Debt Obligations3. What caused the crisis: Collateral Debt Obligations


• As is evitable some home owners default – interest rates increased during 2005 - 2006 and variable rate mortgages were widely created

• Many houses are placed on the market - the CDO no longer has a flow of cash and house prices go down.



• The CDO’s are now worthless and the banks and investors are left with huge holes in their balance sheets

• This causes many institutions to be basically insolvent – and extra punishment for the home owners is that their investments are now almost worthless too


Credit Crunch ExplainedCredit Default Swaps (CDS)

• Meanwhile undetected, a huge credit derivative industry was also poised to reinforce the damage caused by CDO’s

• A CDS is very similar to insurance and were regarded as easy money


CDS Seller

e.g. AIG

CDS Payments

On a “Credit Event” loss will be paid to bank

Coupons

GM Bond Institution$1

bn

$1 bn

e.g. HBOS GM Bond


• The CDS seller e.g. AIG will need to place Collateral with the CDS buyer e.g. HBOS to ensure that HBOS gets paid if GM defaults on its debt or other credit event.

• As counterparty default was rare CDS sellers like AIG often sold many thousands of CDS contracts each requiring a piece of Collateral

• As Counterparties ratings declined during the Credit Crisis i.e. a credit event, the haircut on collateral increased and the seller had to place more collateral

• The “safe” tranches of CDO’s were “insured” with a CDS in order to ensure this received a AAA rating.

What caused the crisis: Credit Default Swaps (CDS)4. What caused the crisis: Credit Default Swaps (CDS)


• CDS contracts were initially created in order to provide insurance for institutions and to reduce Credit risk.

• This worked well until speculation began whereby investors with no underlying bond were purchasing a CDS on GM i.e. speculating that GM will default on its debt

• This would be the equivalent of all of the neighbours in your street taking out insurance on your house in the hope that it would be destroyed!

• The widespread speculation caused a huge distrust in the markets as no body knew who held toxic assets or who had sold a CDS based on a company in danger of defaulting

What caused the crisis: Credit Default Swaps (CDS)

BANK


Credit Crunch Explained5. What caused the crisis: Frozen Credit Markets

• The Credit Crunch is the story of the loss of confidence from the financial system – once this is lost the money markets are frozen and the wider economy is therefore affected

• The London Interbank Offered Rate (LIBOR) rate increased dramatically reflecting the lack of trust the banks had for each other. This made it very expensive for banks to short-term borrow from one another

• Governments guaranteed most bank deposits thereby preventing a mass run on all banks which are rumoured to be in trouble

• Central bank institutional bailouts, economic stimulation and IMF support to weaker nations prevented a long term depression as happened after the 1929 Wall Street crash.

Credit Crunch Explained6. What is the impact on Ireland

• Irish banks were not exposed to credit derivative securities but they are highly levered and exposed to the property sector and suffered as a result of the frozen credit markets

• The beginning of the credit crunch coincided with the property bubble bust in the Anglo-Saxon economies such as Ireland & Spain

• Ireland - €URO = Iceland

• The total freeze in the credit markets and the dramatic loss of demand for property caused many to default on loans and exposed the banks to very large write-downs

• The government has guaranteed all deposits and funded the four main banks to a great extent – exposing tax payers to a future high taxes and also to the detriment of the country credit rating

• Has opted for a cross your fingers & make-it-up-as-you-go-along solution to solving the financial crisis within Ireland - NAMA

Credit Crunch Explained7. Where do we go from here

• Sophisticated US financial services combined dangerously with relatively unsophisticated financial services else where

• Regulation in the past has failed to eliminate sudden crisis – clever financiers work around the rules – innovation is always ahead of regulation. If there was an easy way it would already be the foundation stone of modern finance

• The crisis has exposed securitization and VaR methodologies

• The shadow banking industry grew enormously during the period of cheap credit – this industry was unregulated unlike the banking sector (40% - 60% split of loans)

• Many of the root causes of the crisis have yet to be resolved

• Modern markets are flawed, unstable and prone to excess – but the alternative planned markets (Communism) were not exactly a success!

Economy & Finance

The Credit Crisis Explained