The Current Turmoil Cause And Effect

The Current Turmoil Cause and Effect

Dr. B. Yerram Raju, Regional Director, PRMIA, Hyderabad Chapter

At the Seminar on Financial Risk Management, Gitam University, Visakhapatnam (November 14, 2008) Picture: Courtesy-Economist [email protected]

1

Feet in the frying pan – no where else to jump except fire. Economist, London. [email protected]

2

Current Risk Environment Foreign Capital fled  Confidence evaporated  Stock Markets plunged  Global Market meltdown  Currencies tumbled  Asset flight to safety  FIs blowing cold on credit  Government Interventions  Political environment Severe drought of credit and confidence lead recession. 

[email protected]

3

Hey days  Large inflow of assets  M&As drive business growth  Opportunities even in volatile markets

seized without winking the eye  Basel II compliance targets moved forward

[email protected]

4

Before the downturn: The Housing Boom 





The introduction of exotic loans, adjustable rate mortgages, and relaxed standards allowed for an increase in sub-prime mortgage lending. Low interest rates encouraged Wall Street investors to back sub-prime loans in greater quantities. Hedge funds worldwide borrowed money to invest heavily in subprime mortgages. [email protected]

5

D-days  Unprecedented outflow of funds  De-leveraging  Government investment/increased

scrutiny  Extreme volatile share prices  Recession fears  Nervous investors  Business uncertainty [email protected]

6

Features of Housing Finance Crisis  No-recourse Home

Loans: if a borrower defaults, bank can claim back the property used as collateral, but nothing more. Borrower in order to escape negative equity in the event of property value becoming less than mortgage value defaults on credit  Abandoned houses fall into disrepair and loose further value in the hands of lender. [email protected]

7

Securitization  



Loans are bundled into packages sold to outside investor Monthly payments of home owners collected by service agents and passed through to investors as interest payments on their bonds. Eventually gave rise to Collateralized debt obligations (CDS) – sophisticated instruments that bundled together packages of different bonds and then sliced them into tranches according to investor’s appetite for risk. (Economist 18.10.08 p.73) [email protected]

8

BANKS HAVE ALWAYS BEEN A WEAK LINK IN THE FINANCIAL SYSTEM BECAUSE OF A MISMATCH BETWEEN THEIR ASSETS AND LIABILITIES.

[email protected]

9

Characteristics of Subprime Mortgages 

Typical Subprime Loan Types  Hybrid Adjustable-Rate Mortgages (ARMs) • 2/28 Mortgage is fixed for the first two years and then switches to adjustable rate for the remaining 28 years • Other common Hybrid ARMs 3/27 and 5/25 terms  Hybrid Interest Only (IO) ARMs  40-Year Hybrid ARMs  Piggyback Second Liens  Limited Documentation Loan Programs

[email protected]

10

Characteristics of Structured Investment Vehicles 

Cash Structured Finance (SF) collateralized debt obligations (CDO) Asset Portfolio Highlights  Portfolios contain between 60 and 140 bonds  Assets may be diversified by market sector, however recent vintage SF CDOs have been concentrated in subprime RMBS  Assets may be diversified by risk profile (initial ratings)  Assets may be diversified by vintage  Asset acquisition and selection • Asset manager warehouses bonds prior to issuing CDO notes • CDO notes typically issued when asset manager has accumulated approximately 60-80% of the target portfolio • Initial portfolio is typically fully ramped within 6 months of CDO note issuance

[email protected]

11

Characteristics of Structured Finance CDOs 

Cash SF CDO Note Highlights  Credit enhancement comes from subordination and excess spread  Interest is paid sequentially to note holders  Over-collateralization (OC) and Interest Coverage (IC) performance tests are checked prior to distributions to subordinate notes  Excess interest may be used to: • If tests are passing then distributed to Preferred Shares or Equity • A portion may be used to repay mezzanine notes • If tests are failing then distributions may be used to cure the tests  Purchase new assets  Pay down senior notes

[email protected]

12

Originator Crisis Caused By Repurchase Wave         

The sudden performance deterioration caused a spike in first payment defaults (FPDs) and early payment defaults (EPDs) Loan buyers exercised their rights to put first payment defaults back to originators Large outlays for repurchase put substantial strain on smaller, poorly capitalized companies Early payment defaults in warehouse lines caused lenders to tighten The need to change product mix further constrained lenders as they saw volume/profitability fall High repurchase obligations and lack of financing drives marginal players into bankruptcy (Ownit, ResMae, MLN, People’s Choice) Larger players also under severe stress (Fremont, New Century, Accredited) Discount loan pricing continues to weigh on originators Well-capitalized entities can weather the storm, and opportunistic buyers are active [email protected] 13

The downturn begins: 



Interest rates rise and housing prices fall. Monthly mortgage rates for subprime borrowers skyrocket, but the post-2005 housing slump means they do not have enough equity to refinance or sell. Lenders, rating agencies, and investors underestimated the number of loans that would default. Relaxed standards lured borrowers into taking out loans they couldn’t afford once initial interest rates expired. 

This leads to a 113% increase in foreclosures from July 2006 to July 2007.

[email protected]

14

The downturn continues: 

Delinquencies and foreclosures on subprime mortgages force dozens of mortgage lenders to go out of business, contract, or declare bankruptcy. Many have stopped issuing subprime loans altogether. Even borrowers with good credit history are forced to pay higher interest rates. 





By the end of July/early August 2007, both National City and Wells Fargo have stopped approving home-equity loans through brokers, as well as subprime mortgage loans. Thursday, August 16th, 2007 Countrywide Financial, the nation’s largest mortgage lender, borrows $11.5 billion so that it can continue making loans. By August 21st, 2007, Countrywide Financial has laid off nearly 500 employees in the subprime mortgage lending unit.

[email protected]

15

Hedge funds are hit hard:  Global Hedge funds that borrowed

money to invest in subprime mortgages are forced to sell their mortgages at extremely low prices to pay off lenders and investors who want out.  To raise cash quickly, many hedge funds dumped stock, causing stock market prices to plunge worldwide. [email protected]

16

Banks pull back: 



Banks re-evaluate highrisk loans in the face of potential losses on loans to hedge funds. As a result, credit is tightened for borrowers across the board, affecting commercial real estate, leveraged buyouts, venture capital lending, mergers and acquisitions, etc. [email protected]

17

Who is to Blame?  

   



Lenders: for their predatory lending practices focused on subprime mortgage candidates Rating Agencies: Overrate the MBS and other derivatives with underlying securities of little value with full knowledge. Mortgage brokers: for steering borrowers to unaffordable loans Appraisers: for inflating housing values Wall Street investors: for backing subprime mortgage loans without first verifying the security of the portfolio Borrowers: for overstating income levels on loan applications and entering into loan agreements they could not afford Government: for lack of oversight [email protected]

18

Ongoing Effects:

   



Subprime mortgage industry collapses, thousands of jobs are lost Surge of foreclosure activity Housing prices and sales are both down Interest rates rise across the board as the effects of the collapse of the subprime mortgage industry seep into the near-prime and prime mortgage markets Investors lost billions of dollars in securities tied to the subprime mortgage industry, resulting in upheavals throughout the global financial market [email protected]

19

Deterioration not by day but by hours  

  

Fed Reserve allowed certain firms to liquidate and certain others bail-outs Treasury Secretary proposed a bail-out package of $700bn whereas the loss involved crosses trillion dollars The fire engulfed Great Britain and Europe Japanese markets also tumbled All Central Banks came out with bail-out packages and nationalization of banks in the troubled zone. [email protected]

20

Government Action: 





To avoid complete market failure and to allow banks to borrow money cheaply, the Federal Reserve, European Central Bank, and their counterparts flood the market with billions of dollars, euros, and yen in August 2007. The injected government funds were designed to encourage banks to continue making loans rather than conserving cash and making the credit crunch worse. Government action led to inflation and an international credit crunch that slowed economic growth worldwide. BAIL OUT ENCOURAGES RISKY BEHAVIOUR

[email protected]

21

Lessons in the process being learnt   



     

Development of speculative real estate markets and lax standards of credit appraisal are the surest routes to economic disaster Rating instrumentality is no substitute to independent due diligence Higher capital allocation with or without Basel II or prospective Basel III is no insurance for bank failures triggered by systemic, people and process failures Sophisticated mathematical models, notwithstanding back testing, stress testing and the like hardly forebode collapses. Better that the model-driven soothsayers exit the market. GAAP is not enough Macro prudential analysis (MPA) requires revisit High degree of flexibility is required in the choice of benchmarks Appetite for mergers and acquisitions move in a new direction Injecting liquidity through equity is a better route than a bail-out package Regulators to keep watch on leverage ratios more than the capital.

[email protected]

22

Indian Context  In India, the closeted financial system is

not heavily exposed to the financial crisis.  PM: None can be immune from a global melt down.  In politics, economic reason always does not prevail (e.g. Farm Loan Waivers)

[email protected]

23

India’s Position     



Government asserts that the impact of the sub-prime crisis is moderate (FM & RBI) Caught in the grip of inflation – touching the highest double digit in the post-reform era. But there was a free fall of the stock markets pushing down Sensex by 57 percent from its level 9months ago (24-X-08)-<9000 Markets continue to be volatile despite several blue chip companies and Banks reporting encouraging results for Q2. Reason: Several FIIs continue to pull back their investments sheerly for their own survival with credit and home loan markets, inter-bank lending choking up. Despite low agriculture growth (2%), Indian economy estimated to grow 7.7-8 percent as per the RBI Policy announcement. Hence markets have a chance to bounce back. But Indian investments are sluggish. Foreign investments distant.

[email protected]

24

Political Environment  Elections in six States round the corner:

December 2008  General Elections likely to take place in Feb2009  UPA Government is treading on wafer thin majority  Terrorism threatening security and life  Relations with the US and Far East as also Europe significantly improved. [email protected]

25

Knee-jerk Action  

 

 

Sep 16-08: RBI allows Banks to participate in Forex market; FCNR and NRE deposit rates increased Sept 22: Finance Ministry raised the overseas borrowing caps for infrastructure companies from $100mn to $500mn with average maturity of 7 years to boost capital flows. Oct 22; RBI also announced confirmatory statement. Oct 7:Infrastructure to include Mining, Exploration and Refining Companies, for ECB purposes. Borrowing cap raised ten times from $50mn to $500mn. SEBI said it would effectively monitor FIIs for preventing shortselling. Oct6: SEBI lifted restrictions on issue of Participatory Notes by FIIs to arrest outflow of FII funds; FIIs allowed to issue PNs against securities including derivatives as underlying assets. Limit of 40% of FIIS total assets to issue PNs done away with.

[email protected]

26

Credit Policy announcements by the RBI      

Cut in CRR by 50 basis points effective Oct 11.(9to 8.5%) Further cut announced on Oct 10 by 100basis points.(7.5%) Oct 15: Further cut in CRR by 100basis points (6.5%) Oct 14: Infused Rs.20000cr liquidity thru special lending route for MFs; Banks allowed to borrow for 14days at 9%p.a. Oct 20: 4days ahead of Credit Policy announcement, RBI cut REPO rate by 100basis points to 8%; the first REPO cut since 2004 November1: Further CRR cut in two tranches: retrospective October 25 fifty basis points; Nov 8-another 50 basis points. (Effective 5.5%)   

Repo Rate cut by 50 basis points.(Effective 8%) Buy back of Market Stabilisation Scheme (MSS) dated securities Special Refinance window – 1% of net of demand and time liabilities of Banks

Signaled Rate cut from commercial banks easing the credit flow.  Liquidity improves  Markets reacted favourably al bait temporarily.  This is in tune with the global trends. “All the perfumes of Arabia will not sweeten this little hand.” 

[email protected]

27

Source: Economist, London Oct 25-31, 2008 [email protected]

28

Measures taken by G-8 other than India Us: $700BN BAIL OUT PLAN; Fed cut key interest rate to 1% UK: Govt injected cash of £37bn into 3 major banks Bank of England cuts interest rate to 4.5% Germany: €500bn financial rescue Japan: Bank of Japan cuts interest rate to 0.3% 1.8trillion yen stimulus plan

Brazil: Abandons its tax on foreign investment. Plans to sell $50bn in dollar swap futures contracts to defend currency. Russia: 950bn Rouble long term funding to Banks 1.3trillion Rouble to State-run Vnesheconombank to service Russian Banks’ foreign loans China Abandons its tax on foreign investment Plans to sell $50bn in dollar swap futures contracts to defend currency

Source: Amrita Narlikar, University of Cambridge: Financial Express dated 01.11.2008 [email protected]

29

Regulators & Government all Alert  US Fed cut rates to 2% the lowest in 50

years – also indicated further rate cut  UK closing in for zero interest rate  All other countries in Europe and Pacific follow the same route.  Avoid am-Bush on November 15, 2008 at the G-20 Summit

[email protected]

30

Risk Management Process – Can it come to rescue? Establish the context

Identify the risks

Analyze the risks

Evaluate the risks

Treat the risks

Internal context

What can happen?

IDENTIFY EXISTING CONTROLS

Compare Against criteria

Identify options

External Context

When? And

Determine consequences & likelihood

Set priorities

Assess options

Risk Management Context

Where?

Determine level of risk

Development criteria

Prepare and implement plans

Collaborative Risk

Define the structure

Risk Analytics

Treat Risks

Analyze & evaluate residual risks

Scenario Analysis

Policy Management

Key Risk Indicators Monitor & Review

[email protected]

31

Thank You for the patience [email protected]; [email protected]

[email protected]

32