The Credit Crunch and its Consequences

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The Credit Crunch and its Consequences

• Howard DaviesDirector, LSE

LSE Alumni Lecture Series Inaugural
Lecture Wolfson Theatre, New Academic Building
19th February 2009
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A Five Act Shakespearian TragedyAct One
Subprime
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real estate prices rise
Source Tano Santos
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The growth of securitised credit
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Recent ABX BBB Price History
Price
Source Markit Partners
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Resecuritisation
Capital Structure Containing Subprime Loans
Subprime Mezzanine CDO Containing BBB Subprime
Bonds
100
100
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SUPER SENIOR AAA
CUMULATIVE LOSSES
8.6
40
AAA AA A BBB Equity
28
20
11
11
7
7
7
0
0
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Act Two Liquidity
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Financial market liquidity
Sources Bank of England, Bloomberg, Chicago
Board Options Exchange, Debt Management Office,
London Stock Exchange, Merrill Lynch, Thomson
Datastream.
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Act Three Unravelling

• Bear Stearns, Indymac, Wa mu
• HBOS, RBS
• Fortis, Dexia etc.

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Act Four Meltdown

• Lehmans failure leads to
• indiscriminate sell-off of financial stocks
• seizing-up of many markets
• generalised market panic

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Act Five Pumping

• additional liquidity facilities
• fiscal stimuli
• near-zero interest rates
• quantitative easing

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The Credit Crisis A Five-Act Tragedy
Act One Subprime Act Two Liquidity Act
Three Unravelling Act Four Meltdown Act
Five Pumping
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But what are the underlying causes?

• global imbalances
• loose monetary policy, leading to
• mispricing of risk
• credit bubble
• excess growth of financial sector
• excess leverage, facilitated by procyclical
  regulation

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Global current account balances
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Chinas Growth LaggardPersonal Consumption as
of GDP
Source China National Bureau of Statistics and
Morgan Stanley
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Household debt as a proportion of GDP
Source FSA, ONS, Federal Reserve, Eurodata,
Datastream
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UK Saving Rate
Source ONS Morgan Stanley Research
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The growth of the financial sector
Source FSA, Oliver Wyman
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Major UK banks leverage
Source FSA, Bank of England
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• Bank failures are caused by depositors who
  dont deposit enough money to cover the losses
  due to mismanagement.
• Dan Quayle

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• The owners of capital will stimulate the
  working class to buy more and more of expensive
  goods, houses, and mechanical products, pushing
  them to take more and more expensive credits,
  until their debt becomes unbearable The unpaid
  debt will lead to bankruptcy of the banks, which
  will have to be nationalised, and the state will
  have to take the road which will eventually lead
  to communism.
• Das Kapital

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• So what next?
• growth prospects have deteriorated sharply,
  across the world
• Europe mired in recession
• long downturn the most likely outcome, and (in
  the UK) anaemic recovery

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Growth Rates IMF Forecasts
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European Economic Forecast April 2008
Source www.ft.com
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European Economic Forecast January 2009
Source www.ft.com
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Larger than previous crises
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• UK recovery options
• V-shaped sharp contraction, quick bounce-back
• U-shaped longer trough, delayed but strong
  recovery
• L-shaped Japanese style stagnation
• Nike swoosh sharp downturn, weak recovery

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• Is London Reykjavik on Thames?
• Banks big, but not that big in relation to GDP
• Fiscal position poor, pre-recession, but stock of
  debt not excessive
• But needed fiscal tightening will mute the
  recovery.

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Sovereign five-year CDS
Source Morgan Stanley (as at 21 January 2009)
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General government debt rations in OECD
countries in 2008
Source OECD, Economic Outlook No. 84, November
2008
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UK gross issuance forecast
Source Morgan Stanley
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Discretionary policy change projected in the PBR
Source HM Treasury, Pre-Budget Report 2008
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The Credit Crunch and its Consequences

• Howard DaviesDirector, LSE

LSE Alumni Lecture Series Inaugural
Lecture Wolfson Theatre, New Academic Building
19th February 2009