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credit crisis of 2007

Page history last edited by Brian D Butler 11 years, 9 months ago








Credit Crisis of 2007-2009


Yes, it really started in the summer of 2007, continued into 2008 (reached its peak in September), and now continues into 2009.....will it ever end?  how? when? 


see also: 


wikipedia:  http://en.wikipedia.org/wiki/Financial_crisis_of_2007




Series of Crises:

The mortgage crisis, turned credit crisis, turned banking crisis....as More and more loans turn sour as asset prices fall and businesses fail; that in turn saps banks’ capital, forcing further credit contraction....this in turn morphed into a general economic crisis (global)


Potential outcomes?

Among the possible outcomes of this shock are: massive and prolonged fiscal deficits in countries with large external deficits, as they try to sustain demand; a prolonged world recession; a brutal adjustment of the global balance of payments; a collapse of the dollar; soaring inflation; and a resort to protectionism. Martin Wolf


How far does the crisis have to go?


in January 2008 the International Monetary Fund published its $1tn estimate for the losses (that number has been revised upwards).  Newer estimates look much worse.....according to Martin Wolf: "The International Monetary Fund argues that potential losses on US-originated credit assets alone are now $2,200bn (€1,700bn, £1,500bn), up from $1,400bn just last October. This is almost identical to the latest estimates from Goldman Sachs. In recent comments to the Financial Times, Nouriel Roubini of RGE Monitor and the Stern School of New York University estimates peak losses on US-generated assets at $3,600bn. Fortunately for the US, half of these losses will fall abroad. But, the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects."


Nouriel Roubini and Elisa Parisis-Capone (Feb 2009) analysis here...Nouriel Roubini and Elisa Parisi-Capone of RGE Monitor release new estimates for expected loan losses and writedowns on U.S. originated securitizations:


  • Loan losses on a total of $12.37 trillion unsecuritized loans are expected to reach $1.6 trillion. Of these, U.S. banks and brokers are expected to incur $1.1 trillion.


  • Mark-to-market writedowns based on derivatives prices and cash bond indices on a further $10.84 trillion in securities reached about $2 trillion ($1.92 trillion.) About 40% of these securities (and losses) are held abroad according to flow-of-funds data. U.S. banks and broker dealers are assumed to incur a share of 30-35%, or $600-700 billion in securities writedowns.
  • Total loan losses and securities writedowns on U.S. originated assets are expected to reach about $3.6 trillion. The U.S. banking sector is exposed to half of this figure, or $1.8 trillion (i.e. $1.1 trillion loan losses + $700bn writedowns.)
  • FDIC-insured banks’ capitalization is $1.3 trillion as of Q3 2008; investment banks had $110bn in equity capital as of Q3 2008. Past recapitalization via TARP 1 funds of $230bn and private capital of $200bn still leaves the U.S. banking system borderline insolvent if our loss estimates materialize.
  • In order to restore safe lending, additional private and/or public capital in the order of $1 – 1.4 trillion is needed. This magnitude calls for a comprehensive solution along the lines of a ‘bad bank’ as proposed by policy makers or an outright restructuring through a new RTC.
  • Back in September, Nouriel Roubini proposed a solution for the banking crisis that also addresses the root causes of the financial turmoil in the housing and the household sectors. The HOME (Home Owners’ Mortgage Enterprise) program combines a RTC to deal with toxic assets, a HOLC to reduce homeowers’ debt, and a RFC to recapitalize viable banks.

The remaining of this document is restricted to premium subscribers and can be downloaded here.




Moving to recovery:

see our discussion on fiscal stimulus and crisis recovery 2009


Model for recovery from Banking Crisis:  recommendation:  follow the Swedish model for recovery


Case for Optimism....


Under less extreme conditions, with the right kind of government intervention, economies can weather even sizable credit crises. From 1981 to 1983, for example, Federal Deposit Insurance Corporation (FDIC) data show that 258 US banks failed or required assistance. Nonetheless, nonresidential US investment fell by less than 1 percent in all. During the entire 1980s, almost 750 banks failed and more than 1,500 required assistance, as opposed to 35 during the preceding decade. Yet corporate investment increased by an average of 4.5 percent a year in the ’80s.


Today, the real economy goes into the recession surprisingly well prepared: US industrial companies had lower leverage and higher interest coverage than they did going into the dot-com bust, the S&L crisis, or even the oil shocks of the 1970s. How the real economy fares will depend greatly on the way the current policy debate plays out over the next few quarters.





Solving the Banking Crisis:

How to get out of this mess...options...


see our discussion on Banking crisis



How the government should be involved:


When private banks no longer are willing to lend money to each other, there is a credit crisis.  In response to the recent credit crisis, we witnessed a situation where investors were only willing to invest in US Treasuries.   Even the "safe" money market mutual funds came under attack as investors fled and poured money into Treasuries.  As a result of a massive "flight to safety", the yield on US treasuries has dropped to record lows. This happens when everyone wants to buy these assets, which drives up the price, and has an inverse effect of driving down the "yield to maturity".    With all this money pouring into US government bonds, there is little credit left over for banks to lend to eachother.  The US Central Bank has the responsiblity (unlike the ECB) to act as the "lender of last resort" in a situation where there is a banking freeze, and if US banks are unwiling to lend to each other.  In this function, the US Central Bank has been acting exactly as it should have by lending to banks when they wont lend to each other.  Think about it....if investors decide on a mass scale that they only want to pour money into the government, then its the governments responsibility to turn around and invest that money back into the market.  This is why I dont understand the argument put forth by congressmen (and many in the media) that they are against a government bailout of the markets.   This argument makes no sense, because the Fed and the Treasury are acting as they should.  If investors are only willing to pour money into the Treasury, then its the resonsibility of the government to turn around and offer that liquidity back to the market.  In this function, they compensate for the dysfunction and fear in the market just as they are intended to do as the "lender of last resort".




1. Creat a BAD BANK:


a bad bank, “which would purchase assets from financial institutions in exchange for cash and equity.”


Federal Reserve officials are focusing on the option of setting up a so-called bad bank that would acquire hundreds of billions of dollars of troubled securities now held by lenders. That may allow banks to reduce write-offs, free up capital and begin to increase lending. Paul Miller, a bank analyst at Friedman Billings Ramsey & Co. in Arlington, Virginia, estimates that financial institutions need as much as $1.2 trillion in new aid.  read more here:  http://www.marketwatch.com


The Swiss bank UBS set up a bad-bank last year to fight off trouble. 


Problem with a bad-bank: "So long as a bank can rely on the government to prevent a run (thanks to the government’s guarantee that creditors of large banks won’t take losses; i.e. “no more Lehman’s”) the banks current owners may prefer to sit on its toxic assets and hope the market recovers. Finding private buyers doesn’t solve this problem. No bank has much incentive to sell its toxic assets at a price that would leave the bank bankrupt. Not selling is one way of gambling for redemption."  Brad Setser




2. TARP - $700 bn...


Buy toxic assets from banks (original Paulson idea).  Remove toxic elements...to get banks to trust lending to each other again...


In the U.S., the initial proposal for TARP was to buy hard- to-value assets such as subprime residential mortgage-backed securities, debt linked to commercial mortgages and collateralized debt obligations. Departing Treasury Secretary Henry Paulson abandoned it in favor of capital injections as a faster method of deploying the funds.


The departing Bush administration used most of the first $350 billion of the Troubled Asset Relief Program for buying stakes in banks. The declines in bank shares show that the strategy has failed to shore up the banking system’s solvency. 


3.  Recapitalize banks directly (British plan)


large injections of cash direclty into banks.  Shore up confidence.


4. Nationalization of banks


State takes direct control of banks.  A more radical alternative would be the nationalization of some banks. Sweden used that option during a crisis in the 1990s.  In addition, the government created a bad bank that bought troubled assets at a discount, while leaving financial institutions to manage their more-liquid holdings.



Table of Contents:





What caused it to happen?


"The crisis of Credit Visualized" :  The Short and Simple Story of the Credit Crisis. By Jonathan Jarvis. Crisisofcredit.com The goal of giving form to a complex situation like the credit crisis is to quickly supply the essence of ...


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The process that led to the boom in risky assets was indirect: Central bank demand for safe assets drove down the return on safe assets and encouraged private sector risk taking.  James Kwak of The Baseline Scenario writes:  


All of the U.S. dollar reserves held by all of these countries were effectively loans to the U.S. Treasury bonds were loans to our government; agency bonds were loans to our housing sector. This large appetite for U.S. bonds pushed up prices and pushed down yields, lowering interest rates and thereby fueling the U.S. bubble. Even though the money didn’t go directly into subprime lending, it lowered the costs for all the investors who were investing in subprime. so at the same time that irrational beliefs about asset prices were driving those prices up, the increased availability of money looking for things to buy also drove prices up. Looking at it counterfactually, if there had not been so much global demand for U.S. assets, it’s unlikely that even the once-divine Alan Greenspan could have kept 30-year mortgage rates as low as they were, since the only lever he had control over, the Fed funds target rate, is an overnight rate. And if mortgage rates hadn’t been so low, the bubble couldn’t have been as big.


see more about the causes of the credit crisis below....






Real estate bubble burst:


see globotrends page on Real estate


In textbook markets for goods, price increases lead to a fall in demand and to substitution. By contrast, rising asset prices tend to be seen, within limits, as a cause to buy.


People thought (wrongly) that assets prices would always go up...which allowed them to lend off of those assets...and securitize,and repackage...and lend some more...but that one assumption turned out to be wrong, and all the lending had to be undone...


Good while it lasted:


Asset prices pull themselves up by their own bootstraps. As houses become more valuable, house owners feel richer. If they then spend more, companies make more money, which in turn increases the value of shares and bonds. Profitable companies invest and create jobs. As the economy thrives, there are fewer defaults. Lenders are therefore willing to lend more on easier terms. This extra credit makes asset markets liquid: if ever you need to sell something, there always seems to be a ready buyer. Ample credit also tends to feed into spending and asset prices. That makes people feel richer. And so it goes on.


Bubble was born


Going into the present crisis, the US economy was more exposed to real estate than ever before. In the run-up to the S&L crisis, the total stock of US residential property was worth around 104 percent of GDP, and mortgage debt financed a third of that property. In 2001, it was worth around 121 percent of GDP11 and more than 40 percent of it was financed by mortgages. At the end of 2007, Harvard’s Joint Center for Housing Studies estimates, the total stock of US residential property was worth $19 trillion, around 140 percent of US GDP, and more than half was financed by mortgages. If commercial mortgages are included, total mortgage debt was $14.4 trillion, more than 100 percent of GDP.





see our discussion on securitization of mortgages




Credit Default Swaps



Counter-party risk

When people talk about losses in finance, they are often thinking about only one side of these contracts. In fact, for every loser on a credit-default swap, for example, there is a corresponding gainer. These are bets, remember: if the punters are down, the bookies are up by the same amount. In the jargon, the claims “net to zero”. That sounds safe enough. Yet the winners and losers behave differently. The winners’ extra spending may not offset the losers’ retrenchment. And the losers may not be able to afford to pay out, either because they do not have the money—they are insolvent—or because they cannot easily raise the money—they are illiquid. This “counterparty risk”, which grows with the volume of bets, has been the outstanding feature of this crisis.



Increased Regulations


Demands for more capital in the banks leads to less lending....see our discussion on financial system regulation




Time line of events



Leading up the "credit crisis" of 2007, we first had a housing market boom in the USA.   The root cause of the housing boom was the low interest rates which can be traced back to the early 2000's...


After the internet bubble burst, there was a following bursting of the Telecom market, and a small recession in 2001, then the terrorist attacks, and massive corporate accounting scandals (Enron, etc).  The result?  In order to spur the economy out of recession, the Federal Reserve cut interest rates, and excess liquidity flowed into the market.  But,  Americans had lost their appetite for risky internet stocks (due to the internet bubble bursting) and for the stock market in general (due to the Enron scandals), and for anything foreign (due to the terrorist attacks of 2001).  


But, with extra money to spend (due to the rate cuts), and few "safe" options to choose from, they parked their money in "safe" assets such as real estate. 


Why was there so much extra liquidity?  Its not just because the Fed was cutting rates, but also largely because China (and other emerging markets) were lending massive amounts of money by buying up US debt (in a process to keep their currencies undervalued vs the USA).   This, mixed with the Feds rate cuts led to extraordinarily low interest rates to boost the economy, and led many Americans to re-finance their mortgages, and to invest in real estate.  In response to this flood of cheap money (and the wrong belief that real estate was a "safe"investment) ....the asset bubble went up and up. 


In Miami, we saw housing prices nearly double in 5 years as everyone and their sister became housing speculators, building up condos, knocking old hotels down to make room for new skyscrapers. 


Then came along the financial innovators that got greedy.  In an effort to extend credit to more and more people, they found out a way to offer "subprime lending mortgages", which were essentially mortgages with rates that were (initially) ridiculously low, and teased people into signing up.  Most people signed up these mortgages with the intention of "flipping" their property (reselling it again in a few years for a massive profit), so they really didn't worry about ever having to pay the actual interest payments after the rates went up.  As long as house prices continued to climb, it was a sure way to make lots of money. 


The main risk was that house prices might not continue to rise, and if that happened, these "subprime borrowers" would get stuck with a house they couldn't afford (and were unable to "flip"). 


And guess what happened?  House prices stopped climbing, and buyers started to fear a bubble.  And people (lots of people) got stuck with expensive mortgages they couldn't afford.  Defaults started rising. 



Financial Innovations extended the troubles...


The story would end there, except that the financial innovations involved selling off that subprime debt in fancy investment vehicles, and much of it was shelled out to greedy investors looking for slightly higher returns.  The ratings agencies gave AAA ratings to some of this securitized mortgage paper, and banks all around the world bought into it. 


In the past decade, there has been a boom (especially in the USA) of structured finance, in which banks offloaded their risk to specialist vehicles such as "conduits".  Because they had innovated a way to remove the risk from their own balance sheets, they therefore didnt need to worry as much about the credit worthiness of their borrowers (for homes).   But, when the subprime lending crisis broke out, they quickly discovered that the risk was not entirely removed from their company, and that it could come back to bite them.  And, bite them it did, with the troubles coming right back to their balance sheets.  In this manner, the banks mispriced the credit risk of their customers. 



What happened next?


But, with people defaulting on a massive scale on their mortgages, there were banks everywhere that had worthless paper.  But, since most of it was "off balance sheet", the problem was that banks no longer trusted lending to each other because nobody knew who to trust.  This lack of trust has caused the commercial paper industry to freeze up, and the federal reserve bank (and central bankers around the world) were forced to come to the rescue.  




What happened in video (funny take on the situation):


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GloboTrends blog commentary on the crisis:




Effects of the (USA) credit crunch:


Less money to lend, less money to borrow


After the subprime lending crisis in the US, banks became more fearful that borrowers may not be as credit-worthy as they may appear.  As a result of deleveraging, there was a subsequent reduction in credit available to all borrowers.  This led to a fear of recession (Possible recession in 2008)




Global effects


One of the biggest effects is that companies in emerging markets that need to raise new money will find it more difficult to do so.   Per the Financial Times (09/2008): "Of the $111bn in bonds that will mature between now and the end of 2009, $24bn worth are held by junk-rated groups that have almost no hope of tapping a market that has become averse to risk."


Is there "decoupling"?


Other than countries that were direct buyers of US asset-backed securities (mortgages), I don't see much of a contraction of credit in emerging markets


Let's look at Brazil for example;  In May of 2008 (6+ months into the "credit crisis"), I see no contraction of credit conditions at all.  In fact, there is an ongoing explosion of credit available to consumers in Brazil (even if the industrial credit markets are still as tight as ever).  On the consumer side, however, it appears as if Brazil is swimming in available credit, in spite of the so-called "credit crisis".  Maybe the troubles are not as global as some analysts are predicting.  Not directly anyways.


Mexico is another example.  According to a recent article from the Economist magazine, lending in Mexico "has ballooned.  Credit to the private sector has nearly tripled since 2001, while consumer credit has increased by around seven times."  This is hardy a global credit crisis.  Again, it seems to be localized just to banks that were buyers of mortgage backed securities, or other financial innovations.    But, in Mexico, the article goes on to explain that there has been an increase in the sophistication of the credit markets, as there has also been a massive growth of mortgage-backed securities markets, and improved credit ratings systems.  But, in contrast with the US, there has been a very minimal housing price increase (even less than inflation). 


So, in spite of a credit crunch, it appears as if the phenomenon is mostly US-based one. 



Not safe yet - my "titanic" theory, and the danger I see ahead


Emerging markets are not out of the woods yet.  see my "titanic theory" here...My skepticism about the “decoupling” argument:


In a recent article in the Economist; “The Bank of Japan consensus seems to be that the worst of America’s financial turmoil is now over, but that uncertainty now hangs over its real economy, with risks for Japan. Export volumes to the United States are falling, while the growth in exports to Asia and Europe is slowing. A stronger yen is beginning to squeeze company profits.”


In other words, the initial shock of the impact may be over, but the real trouble may be just about to begin. Think about the initial financial crisis in the USA as the moment when the Titanic first struck the ice berg. At that moment, serious damage was done, but the real life effects were not felt until much later. As the real economy in the US slows, and as the credit conditions contract, we should expect to see a slowdown in the US consumer market (who are big consumers of imported Japanese, and Chinese goods, for example).


Then, in order to spur the US economy out of the doldrums, the Fed has cut interest rates, which has only increased the downward pressure on the value of the US dollar. With a weaker US dollar, we have seen the benefit in the US of increased exports, which is helping to narrow the current account deficit (a good thing).


But the reduced value of the USD has led to reduced imports. Slower consumer demand mixed with a weaker US dollar, and its clear that China and in other SE Asian “tigers” that focus on “export oriented growth” models, will suffer. Maybe the suffering wont be as deep as it would have been in the past due to diversification, but if you take away the significant export market of the USA, then many countries around the world will surely see reduced exports of consumer goods to the US (it will take as long as it takes for global supply chains to be re-configured). The impact? No longer can emerging markets focus on exporting to the US, but instead are forced to compete with the US producers in the global marketplace.


But, amid the financial crisis affecting the developed world, we are seeing a bull market run in countries such as Brazil. Why?


Business in Brazil is booming because the world is demanding more and more commodities. Right? Yes, partly this is true, but at the same time, there is also a boom in the commodities markets that is partly fueled by speculation, and partly fueled by a global capital flight to “safety” as investors flee the wreckage in the US market, and hope that they can find “safety” in the commodities markets.


This displacement and speculation may be effecting the commodities markets positively for now, but like all bubble markets, you should be careful if it bursts.


If the US market is like the “titanic” ship that is sinking, and the “iceberg” impact was the initial financial crisis in the US, then commodities countries such as Brazil can be thought of as the dry-spot on the boat where passengers congregate in order not to get wet in the other parts of the ship. Remember the scene in the movie where the musicians continued to play, in spite of the rising waters, and in spite of the clear personal dangers lurking?


As investors flock to the commodities markets in hopes of finding “safe haven”, it is wise to be wary of analysts that predict that this time is different because of the rise of middle classes in India and China that will always need more raw materials to feed the booms that are going on there. Although there is some very strong logic involved in these arguments, it is also a bit of wishful thinking by those who hope that the Titanic isnt really sinking, and that hope that global speculation in commodities markets is justified. While it may be true that the global demand for commodities will only increase over time, it is also foolish to ignore the influx of speculators and displaced global investors that are rushing to “dry land” in hopes that they wont get wet.


Remember, when the Titanic goes down, everyone gets wet! It’s best to be in a life boat, wearing a life vest, and not joining in with the band to enjoy the party.


read more about  decoupling






China uses the Credit crisis to avoid market reforms



Subprime crisis in the US, and what its effect is on China


Interestingly, the subprime lending crisis in the US, and the ensuing credit crisis has given the Chinese another excuse to avoid opening up their financial market to Western banks.  This is a shame for two reasons, (1) it would benefit the chinese consumers, and (2) Western governments want to open up China to capitalism and their banks in exchange for opening up their markets to Chinese products


Subprime crisis may ‘pause’ China reforms

April 2 2008:  Hank Paulson, the US Treasury secretary, acknowledged on Wednesday that the fall-out from the subprime crisis in the US had “no doubt” given the Chinese “pause” about the benefits of financial liberalisation.  read more from  FT.com


    see more:  Changes are happening in China





Responding to the Crisis:

What should entrepreneurs be doing?


great advice here: Angel Investor Ron Conway Emails His Portfolio Companies Over Financial Meltdown





How to invest during this crisis:

Stock picks to ride out the storm: see our Investing strategies for 2009:


what to look for?


1.  Financial resources: 

  • low leverage:
    • new current assets as % of stock price
    • low debt to equity ratio

2.  Cash return to shareholders

  • dividend yield
  • stock buyback yield

3.  Profitable business model:

  • profit margin
  • free cash yields
  • high net income margins

4.  Outperforming sector

  • pricing power
  • market dominance
  • counter-cyclical profile
  • revenue visibility
  • secular story outweighing cyclical troubles.






Effects on Venture Capital and Private Equity


Private equity deals have been more difficult to close, and some Mergers and Acquisitions have been more difficult to finance.  Both in the US and around the globe...




Sure, the market stinks—but company valuations will at last approach levels at which investors can earn attractive risk-adjusted returns. The thinning of the herd will also separate the serious companies with scalable technologies from the pretenders. Imagine you had just been offered a $1 million house in Bakersfield, CA and just 12 months later, for the same price, you can get beachfront in Malibu.


The opportunity to apply new technologies to solve critical issues with multi-billion dollar addressable markets has never been riper. Breakthroughs in batteries and utility-scale energy storage, more efficient power electronics, and generation technologies like advanced nuclear and clean coal will yield billion dollar companies.


source: http://www.pehub.com/28353/cleantechs-coming-reset/




European private equity takes a tumble

The credit crunch took its toll on European private-equity deals during the fourth quarter of 2007. Deals plummeted from $65 billion in the third quarter to $35 billion in the last three months of the year, making it the worst quarter for private-equity investments in several years. Morningstar/Dow Jones Newswires (01/28)


Asia falls off in M&A and IPO

Billions of dollars of Asia's private-equity deals have been canceled in the last few weeks, causing some market furor. Loans are becoming harder and harder to obtain, causing buyers to pull back from previous agreements, and fears of weak reception have numerous IPOs falling through. Wall Street Journal/Dow Jones Newswires (01/24)



















































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