Transcript Slide 1

Day After tomorrow: The Financial
Crisis
Stephen Y L CHEUNG
Professor (Chair) of Finance
Dean, School of Business
Hong Kong Baptist University
Contents
• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
• Consequences
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Origins
• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
• Financial crisis derives from the US housing market
• Housing market in US
• An unparalleled boom in 2007
• Negative real interest rates in US
• Excess liquidity offered by financial innovation
• High leverage
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
Real interest rate
Current Account Balance of Emerging Markets and US
Real Interest Rates (Fed Funds Rate minus US CPI-Urban)
• Graph
CAB
Real_IR
1%
0
0%
-100
-200
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2008
100
2007
2%
2006
200
2005
3%
2004
300
2003
4%
2002
400
2001
5%
2000
500
1999
6%
1998
600
1997
7%
1996
700
-1%
-2%
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
Financial Innovation
Housing Loans
Sub-prime borrows
Structured Derivatives
• Housing loans offered at back loaded teaser interest rates
• Assuming that borrowers could refinance the sub prime loans
through gains in home equity
• But loan originating banks were smart …
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What is Sub-prime loans?
• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
(1) low credit scores
(2) No 20% down-payment for a home
(3) Disable to fully document their income
No Conventional mortgages
No Best market interest rates
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What did the banks do?
• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
• Offloaded the sub-prime loans through instruments like
Collateralized Debt Obligations
• Modus Operandi of banks (loan originators)
•
•
•
•
Pool together mortgages, including sub prime loans, into CDOs
Get top notch credit ratings for senior tranches
Retain the highly rated senior derivatives through SIVS
Repackage the lower rated derivatives to transform them into
synthetic CDOs
• Investors : Hedge funds, money market and pension funds
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
How did the investors buy?
Sharp rise in derivatives CDO and CDS issuance
CDO
Derivatives Industry
2004 - $25 billion
2002 - $ 103 trillion (3 X Global GDP)
2007 - $186 billion
2007 - $ 450 trillion (9 X Global GDP)
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The boom begins to
unravel from 2004
• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
• US Fed reacts to rising consumer and asset prices by
monetary tightening from second half of 2004
• Housing prices begin to fall by end of 2006
• Rising interest rates and falling housing prices lead to
rise in subprime mortgage delinquencies & foreclosures
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Overloading…
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
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Suffering…
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
“Do you know the true balance sheet of
US Investment banks?”
There are two sides on the balance sheet:
the left side and the right side.
On the left side, there is nothing right.
and on the right side, there is nothing left.
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
“Yes, it’s true that the Chinese have been
selling us toxic toothpaste, toxic pet
food, toys with toxic lead paint —”
“but all the while US was selling them
toxic investments.”
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• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
China and India
are the Saver
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Policy implications
• Causes of sub-prime crisis
• Consequences
• China and India
• Policy implications
• More hazard
• A new financial order
– Financial innovations
– Credit rating agencies
• Regulatory framework
– Highly leveraged institutions
– Regulator quality
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Consequences
• Liquidity squeeze => Excessive liquidity
• Asset bubbles; stock and property
prices
• Commodity prices up
• Inflation?
• Loose monetary policy is likely to end
• Interest rates up?
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Consequences
• Economy not recovered yet
• Gap between real economy and
financial markets
• Total exports declining
• High interest rates, negative impact on
the fragile economy
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Day after tomorrow:
• Incentive system; how to compensate
senior management?
• Exit strategy?
• Financial markets will be different
• Risk management
• Corporate governance
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The End
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