PRBS Short Executive Program - Crisis: causes, consequences and cures; led by dr John Heptonstall

1. Short Executive Program
Satul Prunilor, 26-27 November, 2010
www.prbs.eu

2. The Crisis
Dr John Heptonstall, dean PRBS

3. Background
After a brief recession in 2000-2001, the period from 2002 to
2007 was one of vigorous growth.
International trade also grew rapidly, but in the countries
with the largest trade surpluses there here was no
commensurate increase in spending or consumption. In
Germany, consumer confidence had not yet recovered from
the ‘dot.com’ recession of 2001. Japan was still stuck in the
economic stagnation that has continued for almost two
decades. In
China, with a huge surplus engineered in part by keeping the
currency undervalued, the proceeds were used to accumulate
the world’s biggest foreign exchange reserves, but not to
increase domestic consumption.
The result was a massive increase in international liquidity.

4. In the past, such internationally-available liquid funds would
have been borrowed by the corporate sector and used to
finance capital investments. This time it did not happen. The
corporate sector had been making massive investments in
information technology prior to the ‘dot.com’ collapse, and
were now ‘licking their wounds’.
In the US the Federal Reserve became concened about the
low level of investment, and tried to stimulate investment
activity by engineering a sharp fall in US interest rates.
The system was now overflowing with liquid funds available at
very low cost. Banks, finding corporate demand still sluggish,
increasingly made the funds available to the public. The result
was a spending boom and a massive rise in household debt.

5. Total Debt in 2008 (Government,
Financial Institutions, Non-Financial
Companies and Households) as % of
GDP
Iceland 1,200
Ireland 700
Japan 460 -massive government debt
Britain 380
Spain 340
South Korea 320
Switzerland 310 - very high household debt
France 305 - very high non-financial business
Italy 295
United States 290 - high household debt
Germany 280

6. The Property Bubble
Changes in house prices, 1997 – 2010 - %
Australia 197
Britain 180
Spain 166
Sweden 159
Belgium 149
Ireland 142
France 133
Italy 96
United States 63
Switzerland 31
Japan (36)

7. Securitisation
Borrowers
(auto or house
buyers) Loan Originator (Bank)
SPV
issues the securities
Investors
Cash Flow before securitisation
Sale priceSale of assets
Sale priceInterest and
amortization
Cash flow after
securitisation

8. ‘NINJA’ Mortgages
“No income. No job. No assets”
Increasingly, mortgages were given to anybody who asked
for them. No ‘multiple of salary’ test. No cash down-payment.
Borrowers were offered further temptation in the form of
‘interest only’ loans, with (initially) no repayment of principal
and a very low interest rate, which jumped to a much higher
level after a couple of years. But who reads the small print?
Such borrowers were inevitably going to default as soon as
the borrowing rate ‘kicked-up’
These were the ‘sub-prime’ or ‘toxic’ mortgages that were
then used as security for a flood of bond issues.

9. «Structured Finance»
the securitisation-based bonds were issued in three ‘tranches’
The Senior tranche - rated AAA or A
very low risk - and carrying a very low coupon rate
The ‘Mezzanine» tranche - rated A or BBB
moderate risk - and medium-level interest rate
The ‘Junior’ or ‘Equity’ tranche - rated BB or below
Very high risk – but a very high interest rate

10. The Defaults Begin
Banks were attracted to the high-coupon ‘equity tranch’
mortgage-backed securities – and seem not to have asked
any questions about the quality of the underlying assets.
The defaults started. Banks were unwilling to disclose the size
of their holdings of ‘toxic’ paper. Banks became unwilling to
lend to other banks, and the interbank money market dried up.
Non-financial companies realised what was happening, and
concluded that if working capital funds were unlikely to be
available from the banks, they would hang on to whatever cash
they had. The commercial paper market dried up.
There was now a general credit crunch. The crisis had passed
from the financial markets to the real world.

11. Credit Derivatives
In the meantime, a new class of derivatives had been
rapidly growing. Like all derivatives, they were intended
as a tool for risk management, but were promptly used by
risk-seekers instead.
Some of the banks, already loaded up with toxic mortgage
paper, now attempted to generate further additional
income by taking on other peoples’ risks in the Credit
Default Swap market.
Total market size of the instruments assured was
estimated by the ISDA in Apri200 to be approximately
$35 trillion, but by mid-2008 had reached $82 trillion.

12. The Credit Default Swap
Fee payment
Contingent payment
if ‘event’ occurs
- either cash or an
equivalent security
Protection
Buyer
(Credit Risk
Seller)
Protection
Seller
(Credit Risk
Buyer)
John Heptonstall
(Swap
premium)
« Reference
entity »
(Bond Issuer)

13. Credit derivatives -continued
As the financial crisis deepened, many bond issuers
defaulted, and many more had their ratings reduced. Where
the bond holders had bought insurance through by a credit
default swap, the ‘risk buyers’ (ie protection sellers) had to
pay out. Most of the risk buyers were banks.
One of the most active and most heavily committed in this
market was Lehman Brothers. At the time of its bankruptcy,
Lehman had total assets of $600 bn., which was more than 24
times its own capital. A high proportion of these assets were
low-grade mortgage securities. Lehman had also tried to
become a market leader in credit default swaps.

14. The Banking Crisis
In the past, banks failed because retail customers lost faith
in the bank and lined up to take out their savings.
This time it was different. Bear Stearns and Lehman
desperately needed funds to allow them to roll over their
debts – and the other financial institutions refused to lend
them anything.
From this point onwards, no bank trusted the solvency of
any other bank.

15. Saving the Banks (I)
Some large problem banks were bought by even larger
banks
- Wells Fargo bought Wachovia
- Bank of America bought Countrywide and Merrill Lynch
- Lloyds TSB bought Bank of Scotland
- JP Morgan Chase bought Bear Stearns
but nobody saved Lehmann – and the impact was horrific
A few weeks later, both Bank of America and Lloyds TSB
had to be rescued themselves!

16. Saving the Banks (II)
The total cost of the ‘bank bailouts’ has been enormous.
In the USA:
$209 bn. of emergency funding
$700 bn. For TARP («Toxic Asset Repurchase Program»)
$150 bn. extension to the TARP provision
$600 bn. To rescue ‘Fannie’ and ‘Freddie’
plus the cost of nationalising AIG, Chrysler
and General Motors
In Britain, the Bank of England reports a total of £850 billion
In the EuroZone, the Commission puts the total at about
€1.86 trillion – plus the current injection for Ireland

17. The cost of the Rescues
The banks are not – for the moment, at least, and leaving
aside Ireland and Spain – the major problem.
Rescuing the banks, however, was a horrendously expensive
business. Goverments used up a huge part of their reserves
– and then had to go to the markets for more.
The main danger now is not bank default but country default.
Greece came very close to default. Ireland , one week ago,
was even closer. The danger will remain for a considerable
time.

18. Government Spending
as % of GDP
2000 2009 increase
Australia 34.6 34.9 0.9%
Canada 40.6 43.5 7.1%
France 51.6 55.6 7.8%
Germany 45.1 47.6 5.5%
Ireland 30.6 45.4 48.4% !
Italy 46.2 51.9 12.3%
Japan 37.3 39.7 6.5%
Spain 39.1 46.1 17.9%
United Kingdom 36.6 47.3 29.2%
United States 30.2 42.4 40.4%

19. Budget Balances as % of GDP
2000 2009
Australia -1.9 -4.1
Canada 2.9 -5.1
France -1.5 -7.9
Germany 1.3 -3.3
Ireland 4.8 -11.4 !!!
Italy -0.9 - 5.4
Japan -7.6 -10.3
Spain -1.0 -11.4
United Kingdom 1.3 -10.9
United States 1.6 -12.5

20. If the ‘Maastricht Criteria’ were to be rigorously
applied today, only two major countries would
qualify for admission to the Euro zone – and
those countries are not in Europe!

21. yrs. Yield %
Unemployment C/A Budget Total Age of 10 yr.
balance balance debt debt bonds.
Germany 7.5 +5.2 -3.7 52.7 5.6 2.59
USA 9.6 -3.3 -9.0 98.1 4.8 2.75
Britain 7.7 - 1.8 - 10.1 53.5 13.7 3.25
Italy 8.3 -3.1 -5.0 116.0 7.2 4.14
Spain 20.8 -4.4 -9.6 44.3 6.4 4.59
Portugal 10.7 -8.1 -7.3 75.2 6.6 6.86
The Problem Countries
compared with Germany
as % of 2010 GDP

22. Part two: Looking for Solutions

23. The situation today - four issues
a) Repairing the financial condition of a number of key states
and their central banks, controling their budget deficits
The problem countries are still Greece, Ireland - and
the United States.
b) Ensuring that financial institutions will, in future, be
adequately financed and managed responsibly.
c) Avoiding a ‘trade war’, and finding a way of stabilising the
world currency system
d) Restoring the economies of the ‘old’ developed countries
to a path of stable growth, at a rate high enough to reduce
unemployment to an acceptable level.

24. Bailing Out the Sovereign States
The need to save the banks led to a further deterioration in
the condition of already over-borrowed states. By 2009 there
were growing fears that some might default.
Interest now started to focus on the ability of the IMF to
‘rescue the rescuers’. The IMF, however, had already made
a $250 bn. rescue loan to Greece. Its remaining loan capacity
for the year was just $272 bn. It was clear that its resources
were inadequate in comparison with the potential problems.
Regional and/or bilateral lending has had to carry the major
part of the load.

25. During the early stages of the crisis the ECB bailed out the
problem countries by purchasing their sovereign bonds – but
was rapidly depleting its own resources.
The Euro-zone member countries, plus Britain, Sweden and
Poland, have agreed (in June 2010) to set up a ‘stabilisation
fund’, with total resources of €500 billion. (Half of this is already
earmarked for aid to Greece).
The fund is being set up as a ‘special purpose vehicle’, owned by
the sponsoring countries, with shares in proportion to their
economic strength. The ECB is providing €60 billion. The balance
will be raised through bond issues. Each member will provide a
guarantee of 120% of its position, and this is expected to give the
bonds a AAA rating.
The EU «Stabilisation Fund»

26. The Financial Stability Board (I)
A predescessor of the Board, the Financial Stability Forum, was
created in 1999, its members being the Finance Ministers and Central
Bank Governors of the G7 countries. A principal objective was to try
to prevent financial shocks from moving from country to country,
and thus destabilising the whole system.
In the wake of the crisis (in April 2009) the Financial Stability Board
was set up at the initiative of the G20 as a broader-based successor to
the Forum. The members are the G20 countries plus Spain, and plus
the European Commission.
The Board will also work closely with the IMF and the BIS (Bank of
International Settlement) and has offices at the BIS HQ in Basle,
Switzerland..

27. Bank Regulation at International Level
‘Basel III’
As a result of the banking crisis that arose from the LDC defaults of
1982-1983, the Basle Committee on Banking Supervision of the BIS –
made up of central bank staff members from 27 countries – introduced
two sets of regulations designed to ensure that international banks were
adequately capitalised to survive future crises.
The capital required was 8% of the bank’s ‘risk assets’ divided into ‘tier
one’ (4%) and ‘tier two’ (4%). Only one half of the tier one was required
to be straightforward shareholder equity, the rest being permanent debt
and preferred shares.
.The outline of a new international standard, ‘Basel III’, was presented at
the G20 meeting in July 2010. Tier one capital will be increased to 6%,
of which 4.5% must be true equity. In addition, banks will be required to
maintain a ‘capital conservation buffer’ of 2.5% of risk assets, also in the
form of equity. In short, the equity capital provision is to be increased from
2% to 7%.

28. The Financial Stability Board (II)
The function of the Board is to monitor developments in the
international economy, to identify any emerging problems or trouble
spots, and to provide the G20 with ‘early warnings’.
The Board is also intended to work closely with the IMF in ‘addressing
financial sector vulnerabilities and developing and strong regulatory,
supervisory and other policies in the interests of financial stability’. Its
particular role will be to closely monitor the biggest international
financial services firms.
The Financial Times (5 October 2010) reports, however, that
«The Group is split over proposals to require extra capital
requirements (ie beyond Basel III) on the biggest banks, and on the
‘bail-in’ proposals that would require creditors to share the cost of
propping up the banks».

29. Stress Testing (I)
Some progressive companies have recently developed
financial stress tests, to evaluate their ability to survive the
stresses of an economic downturn.
In May 2010, Similar stress tests were applied to 19 of the
largest US banks. Of these, 10 failed the test on the grounds
that they were under-capitalised, and were given one
month to acquire the additional funds needed.
The largest shortfalls to be made up were:
Bank of America $33.9 billion
Wells Fargo $13.7
GMAC $11.5
Citibank $5.5
Morgan Stanley $1.3

30. Stress Testing (II)
The 10 US banks raised the additional funds needed
largely through asset sales, not from further ‘bail-outs’.
In July 2010 a similar testing process was applied to 91 of
the largest banks in Europe. Here the situation was more
complicated because of fears that the multiplicity of
regulatory regimes would produce skewed results.
The testing was therefore not performed by the ECB or by
any central authority.
In some of the Eurozone countries the testing was done by
the national regulator. In others the banks themselves have
been asked to stress test their own balance sheets.

31. Stress Testing (III)
Of the 91European banks, analysts had predicted that
between 10 and 20 banks would fail, mostly because of
inadequate tier one capital ratios.
In fact. just 7 failed the test:
1 in Germany
1 in Greece
5 regional banks in Spain
Yet four of the Greek banks tested had tier one capital ratios
of less than 6%!
One senior German banker has publicly described the whole
exercise as a joke.

32. The USA, the Dollar, and the
World Currency Markets
The USA has a large and growing budget deficit, and very
large accumulatred national debt, and a massive Current
Account deficit. It has been able to continue to run such a
deficit because the rest of the world were willing to hold
dollar-denominated securities.
The US government has apparently not chosen to address its
deficits by reducing its expenditures, as most other countries
are trying to do. Instead, the strategy seems to be to stimulate
the economy by pumping more money into it
– and obtaining the required funds by printing money (the
$600 billion ‘Quantitative Easing’ program, or ‘QE2’) .

33. The USA – continued
The ‘QE2’ program is clearly inflationary, and in August
2010 the dollar turned sharply down.
The remarkable economic success of China and its massive
export surplus has come in part from having an
undervalued currency. The Chinese renmimbi (or yuan) is
nominally pegged to a currency basket, but in reality to the
US dollar. So as the dollar fell, so did the renmimbi. As the
dollar became more competitive, the renmimbi became
even more competitive.
Other countries have already responded, through currency
market intervention (Japan) or through protectionist
measures (Brazil). The danger now is a trade war.

34. Politicians have promised a new era, in which the power of
the finanial markets and institutions would be curtailed, the
obscene profits and bonuses would be eliminated, and in
which it would be impossible for such a crisis ever to happen
again.
The only real change is that the toxic debt has been largely
transferred from the balance sheets of the banks and added
to the national debts of states, some of which are now
themselve in difficulties – and the international currency
system is looking unstable.
«International markets have moved far ahead of the capacity
of political leaders to understand, let alone properly oversee
them.»
Philip Stevens, Financial Times, 30 July 2010
The Situation
Today