What happened in the market?

Brandon Davies - Managing Director Global Association of Risk Professionals

LSE - 1st October 2007

The Inevitable

• Origin: – • Bank new loans = 5%, new deposits = 5%

result happiness• Bank new loans = 10% new deposits = 5%

result disaster• A relationship (give or take a lot of

management you can do) is something all banks understand – so did they forget?

The Inevitable• NO• House Price Inflation 2001 = 8.4%, 2002 = 17%, 2003 =

15.7%, 2004 = 11.8%, 2005 = 5.6%, 2006 = 6.3%, 2007 (so far) = 10.2%.

• Nominal GDP Growth = 4% - 6% throughout • So when was the problem recognised?• UK ALMA 11th Annual Conference 29th/30th January

2004 - Liquidity, Liquidity, Liquidity!!• Core Problem asset (esp. mortgage) growth > liability

growth due to affordability, and no sign this will reduce.

The Inevitable

• “obtaining liquidity by selling investments or loans ….called shiftability….management tactics that rely on shiftability are not well suited for systemic liquidity needs.”

• Scenario for liquidity crises inc. loss of “shiftability” and drawdown of property related liquidity lines.

The Defences• Sources of liquidity:-• Net cash flow• Capacity to borrow additional wholesale funds• Stock of marketable assets• Sterling stock liquidity• Constraint on illiquidity:-• Name in market limits• Wholesale borrowing guidelines (reduced 1993 – loss, Oct

98/ Mar 99 Russian Crisis) No funding problems – very credit quality sensitive ‘flight to quality’.

• Commitments – CP backup lines, No Committed lines to competitors for liquidity, Capital to support B/S growth.

Securitisation• Tactic Or Strategy?• Only one UK bank elevated securitisation to a

strategy – Northern Rock• All others maintained it as a tactic, often

despite attacks in the press for loosing market share e.g. Barclays/Woolwich, HBOS.

• Britannia ALCO – Feb 07, concerns about liquidity in markets (note Britannia is the least reliant on market funding of any UK bank).

Liquidity Definitions• Exogenous Liquidity – The liquidity

that comes from your funding base, ability to hold assets even in extreme market or credit circumstances (LIABILITY DRIVEN – an issue of confidence in the Institution)

• Endogenous Liquidity – The liquidity that comes from the ability to fund assets through a market (ASSET QUALITY DRIVEN – an issue of confidence in asset values and availability of short term funds

Total Defaults

Notes for Britannia ALCO Meeting

-100%

0%

100%

1981 1986 1991 1996 2001

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Securitisation as a strategy• A bad idea – and virtually everyone knew it!• Why? • Market Liquidity• UK has none of the financial infrastructure

necessary to support mass securitisation.• B of E support operations conducted against

(primarily) government obligations i.e. it supports the UK Sterling stock rules.

• ECB much wider discount role, but it is not lender of last resort (so is more a Fannie Mae).

Securitisation as a strategy• US has Fannie Mae and Freddie Mac – lenders

of first resort against conforming mortgage assets.

• Note mixing LOLR and liquidity support produces ‘moral hazard’ – haircut Sir? (No 3 and they can pay, No 1 and they can’t).

• So should we have? – must be thought through remember tail does not wag dog, unless you let it!

• Could validate Securitisation as strategy. OK only if you want the consequences.

So what did happen in markets?• More or less what the scenarios predicted.• “Flight to quality”.• Refusal of uncommitted lending.• Big banks held on to cash.• Real unwillingness to give liquidity support,

BofE may be able to tell illiquidity from insolvency, commercial banks find it very difficult (information asymmetry + role of interest rates in solvency of market funded bank ).

Effect of LIBOR

• LIBOR is an ‘index’ against which many market contracts re-price e.g. derivative contracts.

• Much of the price ‘action’ is in re-pricing the internal balance sheet. Libor is the transfer price between deposit and lending businesses for (all) UK banks.

• This has real economic effects inc. an (unintended) tightening of monetary policy.

• Particularly hard on SME borrowers.

EUR LIBOR the interesting dates

Date 1w 1m 3m ECB08-Aug-07 4.14 4.17 4.35 4 09-Aug-07 4.28 4.29 4.46 4 10-Aug-07 4.25 4.29 4.42 4 13-Aug-07 4.38 4.46 4.40 4 14-Aug-07 4.35 4.46 4.40 4 15-Aug-07 4.29 4.46 4.41 4 16-Aug-07 4.30 4.46 4.58 4 17-Aug-07 4.28 4.46 4.67 4 20-Aug-07 4.28 4.45 4.65 4 21-Aug-07 4.28 4.45 4.66 4

Date 1w 1m 3m ECB22-Aug-07 4.31 4.46 4.67 4 23-Aug-07 4.30 4.51 4.71 4 24-Aug-07 4.35 4.57 4.72 4 28-Aug-07 4.32 4.61 4.72 4 29-Aug-07 4.33 4.60 4.71 4 30-Aug-07 4.36 4.52 4.72 4 31-Aug-07 4.42 4.52 4.81 4 03-Sep-07 4.42 4.52 4.81 4 04-Sep-07 4.42 4.52 4.81 4 05-Sep-07 4.62 4.54 4.82 4

EUR LIBOR the interesting dates

Date 1w 1m 3m ECB06-Sep-07 4.37 4.54 4.82 4 07-Sep-07 4.28 4.47 4.8 4 10-Sep-07 4.34 4.50 4.8 4 11-Sep-07 4.37 4.51 4.81 4 12-Sep-07 4.33 4.49 4.80 4 13-Sep-07 4.24 4.48 4.79 4 14-Sep-07 4.22 4.49 4.79 4 17-Sep-07 4.27 4.48 4.80 4 18-Sep-07 4.32 4.48 4.80 4

Date 1w 1m 3m ECB

19-Sep-07 4.39 4.47 4.78 4 20-Sep-07 4.42 4.47 4.78 4 21-Sep-07 4.40 4.47 4.78 4

24-Sep-07 4.45 4.47 4.78 4 25-Sep-07 4.45 4.57 4.89 4 26-Sep-07 4.52 4.47 4.79 4 27-Sep-07 4.39 4.57 4.85 4

USD LIBOR the interesting dates

Date 1w 1m 3m Fed 08/08/07 5.38 5.39 5.41 5.25 09/08/07 5.73 5.52 5.52 5.25 10/08/07 5.8 5.7 5.7 5.25 13/08/07 5.65 5.66 5.64 5.25 14/08/07 5.62 5.72 5.68 5.2515/08/07 5.45 5.65 5.55 5.25 16/08/07 5.45 5.64 5.54 5.25 19/08/07 5.38 5.62 5.5 5.25 17/08/07 5.38 5.62 5.5 5.25 20/08/07 5.44 5.62 5.47 5.25

Date 1w 1m 3m Fed21/08/07 5.47 5.65 5.46 5.25 22/08/07 5.47 5.64 5.48 5.25 23/08/07 5.52 5.66 5.56 5.2524/08/07 5.47 5.65 5.54 5.2528/08/07 5.58 5.68 5.56 5.2529/08/07 5.68 5.7 5.62 5.2530/08/07 5.8 5.8 5.7 5.25 31/08/07 5.95 5.97 5.81 5.2503/09/07 5.95 5.97 5.81 5.2504/09/07 5.95 5.97 5.81 5.25

USD LIBOR the interesting dates

Date 1w 1m 3m Fed05/09/07 6.02 5.97 5.85 5.2506/09/07 5.92 5.97 5.85 5.2507/09/07 5.92 5.98 5.83 5.2510/09/07 5.92 5.92 5.8 5.25 11/09/07 5.87 6.02 5.81 5.2512/09/07 5.6 5.92 5.81 5.2513/09/07 5.5 5.86 5.77 5.2514/09/07 5.35 5.72 5.75 5.25 17/09/07 5.47 5.65 5.6 5.25

Date 1w 1m 3m Fed18/09/07 5.42 5.6 5.6 5.2519/09/07 5.12 5.37 5.3 5.25 20/09/07 5.15 5.23 5.26 4.7521/09/07 5.15 5.17 5.23 4.7524/09/07 5.20 5.2 5.22 4.7525/09/07 5.20 5.21 5.27 4.7526/09/07 5.20 5.23 5.24 4.7527/09/07 5.09 5.20 5.30 4.75 28/09/07 5.10 5.20 5.27 4.75

GBP LIBOR the interesting dates

Date 1w 1m 3m BoE08-Aug-07 5.93 5.95 6.14 5.7509-Aug-07 6.10 6.01 6.15 5.7510-Aug-07 6.30 6.15 6.25 5.7513-Aug-07 6.35 6.20 6.25 5.7514-Aug-07 6.20 6.20 6.30 5.7515-Aug-07 6.10 6.20 6.25 5.7516-Aug-07 6.07 6.35 6.30 5.7517-Aug-07 6.10 6.35 6.32 5.7520-Aug-07 6.10 6.35 6.35 5.75

Date 1w 1m 3m BoE21-Aug-07 6.08 6.35 6.50 5.7522-Aug-07 6.08 6.35 6.50 5.7523-Aug-07 6.07 6.35 6.50 5.7524-Aug-07 6.07 6.40 6.55 5.7528-Aug-07 6.00 6.40 6.50 5.7529-Aug-07 6.01 6.40 6.50 5.7530-Aug-07 6.10 6.55 6.60 5.7531-Aug-07 6.18 6.80 6.85 5.75 03-Sep-07 6.18 6.80 6.85 5.75

GBP LIBOR the interesting dates

Date 1w 1m 3m BoE04-Sep-07 6.18 6.80 6.85 5.7505-Sep-07 6.15 6.8 6.9 5.7506-Sep-07 6.07 6.75 6.95 5.7507-Sep-07 6.07 6.75 7 5.7508-Sep-07 6.07 6.8 7 5.7509-Sep-07 6.07 6.75 7.1 5.7510-Sep-07 6.07 6.75 7.1 5.7511-Sep-07 6.07 6.75 7.1 5.75 12-Sep-07 6.07 6.75 7 5.7513-Sep-07 6.03 6.7 6.95 5.7514-Sep-07 6.03 6.75 6.9 5.75

Date 1w 1m 3m BoE17-Sep-07 6.05 6.60 6.85 5.75 18-Sep-07 6.05 6.60 6.8 0 5.75 19-Sep-07 6.45 6.45 6.50 5.7520-Sep-07 5.95 6.30 6.40 5.7521-Sep-07 5.90 6.35 6.40 5.7524-Sep-07 5.90 6.35 6.40 5.75 25-Sep-07 5.97 6.35 6.45 5.75 26-Sep-07 5.95 6.35 6.40 5.75 27-Sep-07 6.00 6.25 6.40 5.75 28-Sep-07 6.00 6.30 6.40 5.75

Unintended consequence• GBP Libor v USD Libor v EUR Libor, beginning

8th Aug & ending 28th Sept no evidence GBP Libor tightens more than USD or EUR.

• EUR = rose 25bp to 55bp against ECB rate • USD = rose 20bp to 35bp against (lower) Fed

rate• GBP = rose 5bp to 25bp against BoE rate• I urge you all to “mine” these figures for all

they are worth, there is a lot to learn from them. For Example:-

Unintended consequences• Was there more tightening in GBP Libor than

there could have been? • Was this tightening caused by certain B of E

actions/inactions?• Needs more evidence than I have, but a

question I asked of the data:-• Did the naming (and shaming – well that’s

how it came out) of Barclays for accessing the emergency facility on 29th August have an effect?

Unintended consequences• GBP 1.3bn is a lot to be short but NOT when

everyone else is long and the Crest (Gilt) payment system has failed to settle. It just shows you are not holding on to liquidity.

• But I would not be caught twice!• Lets look at the GBP Libor data after 29th

August (see ‘bold numbers Slide 16 & 17). • By the way the share price data tells at most a

one day story, professional investors understood?

Unintended ConsequenceBarclays share price around

29th August 2007

RBS share price

So how should the markets be supported?• I learned crisis management in the biggest FX

trading room in the UK, when the cable rate really mattered!

• Chris Bennett – “Don’t panic”, “the guy who got you into the mess is often the best one to get you out”, “it’s the shareholders whose interests matter, right and wrong has nothing to do with it”, “its about learning so learn and teach”, “vengeance (if appropriate) is mine and when I choose”

So how should the markets be supported?• Providing liquidity is vital and the up to 5 days only is

nonsense as is 1 month (forget the ‘Sterling stock’ regime think like Fannie Mae), bus tickets have a value - OK not that far! But mortgages do!

• How about helping the market value some of those difficult to value assets some banks are holding (if the central bank agrees a value it should be good enough for the auditors).

• Remember if you want to sell that rusty old banger a bit of filler and a re-spray work wonders, a 6 month warranty miracles.