-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
1/19
Credit Crunch:
Causes, Effects & Implications
Ian Clarke, 29 th May 2008
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
2/19
Credit Crunch2
A review of the causal process
Impact of the Credit Crunch
Longer term implications ?
Credit Crunch: Causes, Effects and Implications
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
3/19
Credit Crunch3
The Credit Crunch: Causal Process
Background
Sustained low-interest environment and liquidity
Residential asset bubble in U.S. (subprime)
Originate-and-hold mortgages to originate-and-sell
Mispricing of risk/Conflicted ratings agencies
US sub-prime residential mortgage market
Problems began as early as Feb 2007
Initially unknown exposures
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
4/19
Credit Crunch4
Sub-prime debt: The simple mechanics
Regular repayments Problems in repayments
Source: BBC Source: BBC
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
5/19
Credit Crunch5
Impact of the Credit Crunch on the Debt Market
Liquidity
Interbank lending, Bond issuance, Bank lending, Leveraged borrowing,
Leverage Lending moves to a more conservative basis
Cost of Funds
Easier to assess based on pricing of pre-existing debt such as bonds Asset Backed Debt
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
6/19
Credit Crunch6
Impact of the Credit Crunch: Irish Stock Market
1997-2007 Irish stock market consistently returned 8% p.a.
Lost 26bn in value during 2007
Why was the Irish stock market so badly affected?
Further volatility in the market as a result of speculation
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
7/19
Credit Crunch7
Impact of the Credit Crunch: LiquidityReflected in Interbank lending margins
3.5
4
4.5
5
5.5
6
6.5
7
28/05/2007 23/07/2007 17/09/2007 12/11/2007 07/01/2008 03/03/2008 28/04/2008
Date
I n t e r e s
t R a t e ( % )
UK12 M LIBORUK 1yr Govt Bonds
LIBOR Risk Free Differential
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
8/19
Credit Crunch8
Impact of the Credit Crunch: LeverageLeverage squeeze
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
9/19
Credit Crunch9
Impact of the Credit Crunch: LeverageStill a huge volume of Sub-Investment Grade debt in market (primarily US)
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
10/19
Credit Crunch10
Impact of the Credit Crunch: Leverage And even some sub-investment grade bonds still being issued
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
11/19
Credit Crunch11
Impact of the Credit Crunch: Cost of FundsImportant to place increased cost of funds in historical context
US$ BB 5Y Spreads ov er time
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
31/05/2000 31/05/2001 31/05/2002 30/05/2003 31/05/2004 31/05/2005 31/05/2006 31/05/2007
Date
S p r e a
d a
b o v e
U S t r e a s u r y s
t r i p s
%
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
12/19
Credit Crunch12
Impact of the Credit Crunch: Cost of Funds
US$ BBB 5Y Spreads over time
0.0
0.5
1.0
1.5
2.0
2.5
3.0
01/06/00 01/06/01 01/06/02 01/06/03 01/06/04 01/06/05 01/06/06 01/06/07 01/06/08
Date
S p r e a
d a
b o v e
U S t r e a s u r y s
t r i p s
%
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
13/19
Credit Crunch13
Impact of the Credit Crunch: Cost of FundsBut we have witnessed more than a doubling of the risk margins which have appliedin recent years
US$ BB 5Y Spreads over t ime
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
28/05/2007 09/07/2007 20/08/2007 01/10/2007 12/11/2007 24/12/2007 04/02/2008 17/03/2008 28/04/2008
Date
S p r e a
d a
b o v e
U S t r e a s u r y s
t r i p s
%
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
14/19
Credit Crunch14
0
1
2
3
4
5
6
7
AAA: AA: A+: A: A-: BBB+: BBB: BBB-: BB+: BB: BB-: B+: B: B-:
Credit r ating
1 w a v e r a g e
s p r e a
d %
Flight to Quality can be seen in risk margins for various ratings
Impact of the Credit Crunch: Cost of Funds
US Industrial : Average Risk Margins (Week to 26 May 2008)
Investment Grade
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
15/19
Credit Crunch15
Longer Term Implications
What will be the economic impact?
Other Implications
Capital Adequacy Levels in Banking industry
Credibility of LIBOR
Rating Agencies
Risk Modelling as a whole?
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
16/19
Credit Crunch16
Longer Term ImplicationsCapital Adequacy Levels in Banking industry
Tier 1 capital ratio of 8% (6% on a core Tier 1 basis) is increasingly seen as the comfort
level for European banks.
In April Royal Bank of Scotland announced Europes biggest ever rights issue (12bn).
Irish banks have so far resisted undertaking rights issues
5.7%Bank of Ireland7.5% AIB8.5% Anglo Irish
Ireland4.5% (pre rights issue)Royal Bank of Scotland5.1%Barclays
UK
Core Tier 1 Capital Adequacy RatioMarch/April 2008
Bank
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
17/19
Credit Crunch17
Longer Term Implications
LIBOR
Questions in the market regarding the credibility of LIBOR.
LIBOR calculated as an average of what 16 banks think their own funding
costs are rather than on the basis of actual deals.
As long-term funding deals dried up, banks increasingly relying on estimation
when submitting their figures.
No evidence that banks kept LIBOR low but there is at least a perception in
the market that some banks have an incentive to report lower figures.
EURIBOR?
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
18/19
Credit Crunch18
Longer Term Implications
Rating agencies
Agencies act as market regulators and as a sales force while providing
independent opinions
Did rating agencies methodologies keep up with increasingly sophisticated
debt instruments issued by banks?
-
8/12/2019 080529 Credit Crunch_ Causes, Effects and Implications
19/19
Credit Crunch19
Longer Term Implications
Risk Modelling
A really complicated model must be right
Endogenous risk
So what is the point of (say) Basel II Guidelines requiring a greater and
greater degree of modelling?