Products

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Liquidity Market Crisis 2007 what has happened
to liquidity in the market?February 2008
Trevor Williams, Chief Economist, Economic
Research, Lloyds TSB Corporate Markets
February 2008
Products Markets
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Liquidity has drained out of financial markets
Financial market liquidity
07
Source Bank of England
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Securitisation slows less liquidity, more
repricing deleveraging
US CMBS indices widen sharply
US CMBS Monthly Issuance Falls Sharply
Global CDO issuance has fallen rapidly (USD bn)
CLO Market Freezes in Q3
Source BoE
Source SP LCD. Figures in EUR bn
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How did the credit crisis evolve?
Initially low inflation and low interest rates
led to a search for yield and more risk taking
in mistaken belief that risk would remain low in
future
Source Bank of England
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Co-movement of volatility caused markets to shut
down, should we be surprised?
(a) Proportion of variation in changes in
three-month option-implied volatility of UK, US
and euro-area equities, interest rates and
exchange rates explained by the first
principal component over a six-month rolling
window. (b) April 2007 Report.
Sources British Bankers Association, Chicago
Mercantile Exchange, Citi, Eurex,
Euronext.liffe, Royal Bank of Scotland and Bank
calculations.
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Effects of low volatility on financial stability

• Low volatility today does not necessarily mean
  the system is permanently more stable
• If low volatility reflects conjunctural factors
  (strong growth, low inflation), decline may be
  temporary. And even if decline were permanent,
  spikes are always possible
• Some of the factors that increased liquidity and
  helped reduce volatility may at times undermine
  financial stability
• Hedge funds HERDING? Derivatives EXCESSIVE
  LEVERAGE? Financial integration CONTAGION?
• Low volatility may stimulate excessive risk taking

Source, Richard Portes, London, 2007
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Risk was mispriced

• Financial innovation may have increased
  resilience to small shocks (diffusion of risk)
  and raised vulnerability to large shocks that hit
  across markets (multivariate tail risk)
• Markets may ignore tail risk (e.g., because of
  marking to market) as in carry trade?
• Incentives to take on tail risk may have risen,
  this interacts with herd behaviour
• Financial integration may amplify shocks

Volatility has been low

• and spikes have subsided quickly
• But markets have been buying low volatility
  (with unhedged exposures) bets that could go
  bad
• Rise in volatility could lower Sharpe ratios
  (e.g., in carry trade), force liquidation
• And some markets might freeze

And global liquidity has been high

• Measured by interest rates, supply of central
  bank liquidity, difference between broad money
  growth and estimates of money demand,
  international reserves
• Benign conditions despite global imbalances
• This was not and is not a sustainable long-run
  equilibrium

Source, Richard Portes, London, 2007
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Global corporate debt defaults rates are expected
to be higher, but have been lower than expected
in every year since 2004
Speculative-grade global corporate bond default
rate forecasts
The losses on the credit market we estimate at
between 15 to 250bn. Only 100bn has been
announced so far
Source Bank of England
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Global growth to be highly differentiated in
2008, but still strong
Real GDP North America 2006 2007 2008 2009 2010 U
nited States 2.9 2.2 2.0 2.8 2.8 Canada
2.8 2.6 2.4 2.6 2.6 Europe Eurozone 2.9
2.6 2.0 2.1 2.0 Germany 3.1 2.6 2.0 1.8
1.5 France 2.2 1.8 2.0 2.2 2.1 Italy
1.9 1.8 1.4 1.3 1.3 UK 2.8 3.2 2.1
2.7 2.8 EU27 3.1 3.1 2.1 2.4 2.3
Asia Japan 2.2 1.9 1.5 2.0 2.1 Emerging
Asia 8.3 8.4 8.3 7.2 7.1 China 11.1 11.5
11.0 9.3 8.6 India 9.6 9.1 7.8 7.7 7.6
World 2000 PPPs 4.8 4.7 4.3 4.4 4.4
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Concerns about liquidity has widened borrowing
spreads
UK corporate spreads over benchmark bond yields
Source Lloyds TSB Corporate Markets
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and asset prices hit as corporate default risk
rises
Chart 1
Chart 1
Chart 2
Chart 2
Source LTSB Data stream
Source Bloomberg
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Financial volatility is still intense
Source Lloyds TSB Corporate Markets
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even though interbank rates have been normalised
Source Lloyds TSB Corporate Markets
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However, credit risk is greater than when the
crisis first broke
average
Source Lloyds TSB Corporate Markets
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Size of global equity and bond markets is huge,
but
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notional amounts outstanding of OTC derivatives
is much larger
Source Lloyds TSB Corporate Markets
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What caused the problem global derivatives
Source Lloyds TSB Corporate Markets
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Growth in interest rate swaps and credit
derivatives
These are the main areas of derivative growth
where bank default risk could come from
Source Lloyds TSB Corporate Markets
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But global liquidity plentiful growth is still
strong - and is not the problem, so what is?
Source Lloyds TSB Corporate Markets
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Subprime what does a AAA rating mean?
Problems remain and are still intense how much
losses, who has them?

• Under a 14 loss estimate
• 20 of AAA tranches will default
• 85 of mezzanine CDOs will be wiped out
• Under a 20 loss estimate
• 60 of AAA tranches will default
• 95 of mezzanine CDOs will be wiped out
• Fitch losses well over 20 4th Dec, 2007
• Moodys testing monoline insurers for 19 losses
  17th Dec, 2007

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Lessons from the recent financial turmoil
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What are the implications?

• Global economic growth is likely to slow to
  around 4.3, but should still remain relatively
  robust, led by continuing solid economic
  performance from emerging markets
• Financial strains are likely to remain until the
  fundamental questions of valuation and exposure
  are addressed how much liabilities have to be
  brought on to balance sheets?
• Corporate and individual insolvencies forecast to
  rise, reflecting weaker economic growth, tighter
  credit conditions and high leverage
• Risk of recession in those countries most
  affected by the ongoing turmoil in credit
  markets, notably the US

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What are the likely results?

• Change in legislation as regulators try and catch
  up with the markets
• Greater transparency, for issuers, insurers,
  ratings, credit scoring methodologies, disclosure
  of who has debt, implications for balance sheets
  of exposure (confidential to regulator)
• Understanding and reporting of total leverage and
  so exposure of whole of firm risk is required in
  future, not just on balance sheet, but all
  products. Only then can proper analysis be taken
  of risk of defaults
• Models have only be taking account of risk on
  balance sheet (i.e. regulated capital), totally
  missing overall risk. This is gross failure on an
  epic scale.
• Scenarios / stress testing must be more varied
  and blue sky.

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