Credit Crunch Where From, What Next

1

• Credit Crunch Where From, What Next?
• Professor Tyrone M Carlin

2
Agenda

• Quick Background Scan
• Estimating Cumulative Losses
• What Next?

3
Part 1 Background Scan
4
(No Transcript)
5
Mortgage Originations by Product (US Bn)
6
Origination By Product
7
Evidence on Underwriting Standards
8
Case-Schiller Home Price Indices
9
Subprime Deliquencies by Cohort
10
Sub Prime RMBS Index Prices
11
Some Known Cumulative Losses

• Citigroup - 40.7bn
• UBS - 38bn
• Merrill Lynch - 37.7bn
• HSBC - 15.6bn
• BOA - 14.9bn
• Morgan Stanley - 12.6bn
• RBOS - 12bn

• JP Morgan - 9.7bn
• Washington Mutual - 8.3bn
• Deutsche - 7.5bn
• Wachovia - 7.3bn
• Credit Agricole - 6.6bn
• Credit Suisse - 6.3bn
• Mizuho Financial - 5.5bn

12
Part 2 - Estimating the Losses
13
A Gaggle of Loss Estimates

• July 2007 Ben Bernanke, 100 Billion
• October 2007 The Economist, 200 Billion
• November 2007 Deutsche Bank, 300 Billion
• January 2008 Larry Summers, 400 Billion

• February 2008 Goldman Sachs, 500 Billion
• March 2008 UBS, 600 Billion
• April 2008 IMF, 1 Trillion
• July 2008 Nouriel Roubini, 2 Trillion

14
Key Loss Drivers
Macro Factors
House Prices
Rate Resets
Cashflow Shocks
Delinquency
Available For Sale Housing Stock
Foreclosure
Recovery Rates
15
Case-Schiller Home Price Indices
16
House Price Foreclosure Indices
17
Potential Negative Equity Distribution
18
Some Implications

• 52 Million US households have a mortgage.
• By y/e 2007 5 had negative equity.
• Indications suggest 20 fall in prices year on
  year very likely, more possible.
• This would create approximately a further 20 of
  negative equity households.
• That is 12.5 million households.

19
Who is Most Vulnerable?

• Those who purchased at the top of the asset price
  cycle are most vulnerable to negative equity.
• Housing prices topped out in late 2005.
• Subprime origination Q12005 Q32007 1.4
  Trillion.
• These loans had the poorest credit
  characteristics but are typically non recourse.

20
Monthly Mortgage Rate Resets
21
Fixed Rate Delinquencies Also Increasing
22
Prepayment Patterns
23
Some Observations

• Of 52 million households with mortgages, some 50
  relate to houses purchased from 2004 onwards.
• Total outstanding mortgages 10 Trillion
  (approx).
• This includes at least 1.5 trillion in
  outstanding subprime.

24
Implications

• On present estimates there are in excess of 2.5
  million vacant available for sale housing units
  in the U.S.
• Recent NAB disclosures suggest security
  realisations as low as 50 of mortgage balance.
• In these circumstances, estimates of 1 Trillion
  direct losses cannot be seen as a hard ceiling.

25
Part 3 - What Next?
26
Three Themes

• Continuing strains on bank capital and earnings
  positions.
• Stress in broader financial system
• Potential fallout in derivatives markets

27
Banking System Capital Under Strain

• Direct loan losses
• Lower value of credit protection
• Off balance sheet assets brought on balance sheet
• Higher specific and general provisioning
• Lack of securitisation mechanisms

28
Bank Profits Under Pressure
29
Bank Writedowns and Capital Raisings (US
Billion)
30
Securitisation Still in Coma
31
Australian ABCP Outstanding
32
Bank Long Term Funding Cost
33
Bank Short Term Funding Cost
34
Credit Growth Aggregates (Annualised)
35
Reporting Tighter Mortgage Lending Criteria
36
Tightening Business Lending
37
Beware False Dawns in Reported Earnings

• Increasing concerns being raised in relation to
  valuation assumptions for illiquid (Level 2
  Level 3) assets pursuant to FASB 157.
• Evidence of asset sale window dressing
  arrangements (e.g disposals of assets at gt market
  by provision of loan subsidies to asset buyers).
• Evidence of aggressive changes in provisioning
  policies (e.g 1 April 2008 Wells Fargo moves from
  120 to 180 day past due writeoff).

38
Financial Systems Architecture Under Severe Strain

• This is not a liquidity crisis.
• Rather, this is a crisis based on
• Solvency
• Transparency
• Trust
• Price is not the issue in the global financial
  system, availability is.

39
Bank Senior Claim CDS Cost
40
TED Spread
41
Exchange Settlement Balances (Aust)
42
Dont Forget the Monolines

• June 2008, AMBAC and MBIA downgraded from AAA to
  AA.
• AMBAC insures a portfolio of 524 billion.
• MBIA insures a portfolio of 673 billion.

43
Systemically Significant Institutions Suffering

• Fed sponsored bailout of Bear Stearns
• Monoline Insurers under stress
• Effective nationalisation of Freddie Mac Fannie
  Mae
• Effective nationalisation of AIG
• FDIC now has gt100 banks on distress watchlist
• JP Morgan still a sleeper with 50 of all
  global derivatives trades crossing its books.

44
The Rise Role of Derivatives

• OTC derivatives markets have ballooned in recent
  years.
• Much of the growth has occurred in tail risk
  products.
• Market dominated by a limited number of
  broker-dealers who act as common counterparties
  to a large number of market participants.
• Netting, Collateral and Closeout rules relating
  to derivatives are accorded different treatment
  in insolvency resolution.

45
Outstanding Notional Outstanding Derivative
Amounts
46
Putting a Picture in Context

• 2007 face value of derivatives outstanding was
  600 Trillion.
• This is 1100 of global GDP.
• 1997 face value of derivatives outstanding was
  75 Trillion.
• This was 250 of global GDP.
• Growth in 2007 alone was almost 50.

47
More Staggering Statistics

• The outstanding value of credit default swap
  (CDS) contracts was in excess of 50 trillion by
  2007.
• This was 500 the outstanding principal of global
  corporate bonds.
• As at 2004 the CDS market was only 85 of the
  size of the corporate bond market.

48
CDS Outstanding by Type - Trillion
49
Things to Consider

• Hedge funds are estimated to represent 33 of all
  sold CDS.
• It is estimated that the replacement cost of
  outstanding CDS lies in the range of 2 Trillion
  - 3 Trillion.
• Top ten dealers are counterparties on 98 of
  outstanding CDS.
• Estimated loss impact per notional 2 trillion
  CDS writer counterparty failure 50 billion.

50
LBO Mania
51
LBO Purchase Price Multiples
52
Mean Debt to EBITDA Ratios US Euro LBOs gtUS
50m
53
B Rated or Below New Issues
54
Cumulative Default Experience
55
Hi Yield Historical Default Rates Recession
Periods in US
56
Putting it Together
Expected Default Rate Increase
Increase In Defined Default Events
Clearer Insight Into Effectiveness Of CDS Hedges
Clearer Insight Into Counterparty Risk
Concentration
57
(No Transcript)