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The Credit Crisis of 2008
“You Fail, We Bail?”
Southwest Chapter PLUS
Educational Seminar
Seán Mooney, Chief Economist
October 2, 2008
www.guycarp.com
It’s about time our team
started winning!
Guy Carpenter
1
Emergency Economic Stabilization Act of 2008
RIP September 29
 The Act
– Treasury buys troubled loans
– Helps lenders by reducing uncertainty about their balance sheets
– Increases flow of credit in the economy
– Insurance of troubled assets
 Impact
– Overall result not that different from before
• Bail-outs on a case by case basis
• Values still dependent on real estate recovery
• Given uncertainties, Act could exacerbate the problem in the near-term
- Lenders hold back until they see how current and/or future Treasury
Secretary implements the plan
Guy Carpenter
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Emergency Economic Stabilization Act of 2008
Insurance of Troubled Assets
 Program to guarantee troubled assets, issued prior to
March 14, 2008
 Treasury collects premiums, set at actuarial level to meet
anticipated claims
Guy Carpenter
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Agenda
 Overview of the Financial Market Debacle
– how the problems developed, implications for the broader economy
 Impacts on the insurance industry, ranging from credit
enhancers, to D&O and E & O
 Possible regulatory responses impacting our industry
Guy Carpenter
4
The Evolution of the Crisis
 First phase, 2007: The subprime mortgage fiasco.
The figure of $400 billion from Bernanke still appears about correct.
About $300 billion of this has been reported.
 Second phase, 2008: The broader credit crisis.
As lenders reshaped their finances to meet regulatory and accounting
standards credit dried up in lot of areas, e.g., commercial paper, M & A
financing and auto loans. The broader risk of Credit Default Swaps
(CDS) emerged.
 Third phase, August 2008: The insolvency phase.
 Broader still. The first two phases create a world wide financial crisis,
which, coupled with oil and food crises, triggered a longer term
economic downturn.
In Phase Three, but not
heading to a depression
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First Phase
Subprime Fiasco: Why?
 Housing boom
– Investors cycle from tech stocks to housing, following technical bust of
2000
– “Free” money in first half of current decade
– Price of homes has never declined (current dollars)
– Secondary market creates break in link between debtor and ultimate
mortgage holders. (Forget Bedford Falls!)
– Hedge funds seeking outsized returns
– Globalization increases flow of funds to the sector
– A positive force, risk classification, turned into a negative, with no docs and
option ARMs
 A good word about subprime
– Risk classification from an insurance perspective
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First Phase
Subprime Fiasco…By The Numbers
 US unemployment rate: 6.1%
 GDP: $13 trillion
 Financial Assets: $40 trillion+
 Financial impact
– 2 million foreclosures @ $200,000 =$ 400 billion
– Reported: $280 billion
 Economic impact
– Housing construction: 6% of economy
– Wealth Effect: 6% of wealth change.
• Drop in housing prices: 10% implies GDP cut by 0.5%
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Long Upward Trend in Home Prices
Price drops 1.4% in 2007, and 9.5%
in 2008
200,000
175,000
150,000
125,000
100,000
75,000
50,000
25,000
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05
20
00
19
95
19
90
19
85
19
80
0
8
The Evolution of the Crisis
 Second phase: The broader credit crisis.
As lenders reshaped their finances to meet regulatory and
accounting standards, credit dried up in lot of areas, e.g.,
commercial paper, M & A financing and auto loans.
The broader risk of Credit Default Swaps (CDS) emerged.
“Derivatives are financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially
lethal.” Warren Buffett, Letter to Shareholders, 2002
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Second Phase
Pressures on banks
 Subprime defaults
 Credit Default Swaps: Notional Base of $62 trillion, up from $1 trillion in
2001
 Problems at GSEs: Debt of $1.5 trillion
 Fair-Value Accounting
 Off-balance items to on-balance (SIVs)
 Other exposures Consumer debt at record levels: $2.5 trillion, 22% of
Personal Income
 A credit-quality crisis, not a deflationary policy. The Feds are pushing on
a string. Last instance in 1990/91.
Guy Carpenter
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Banking: Tier 1 Risk-Based Capital Ratio (%), Second
Quarter 2008
13%
12.4%
US standard at 5%.
Merrill at 7.6%
11.6%
12%
10.8%
11%
10.2%
9.3%
10%
9.1%
8.8%
8.7%
8.3%
9%
8.0%
8%
7%
6%
5%
4%
MS
Guy Carpenter
UBS
GS
CS
DBK
JPM
HSBC
Citi
BofA
Wach
11
Second Phase:
Recent Capital Market Crises
12
2007
10
8
2001
1990
6
1994
1987
4
1997-99
Duration in Quarters
Guy Carpenter
Subprime
Dotcom/Enron
Asia, Russia
Mexico
Junk Bond
0
Black Monday
2
Severity in Quarters
12
Phase Three: The insolvency phase
Muddle Through
5.00%
4.00%
Recession
3.00%
2.00%
1.00%
0.00%
-1.00%
Guy Carpenter
2009F
2008E
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
-2.00%
13
Worst case scenarios
 Depression
– Not likely because:
• Bernanke wrote the book on causes of the Great Depression.
• Among most free market economists, the key cause of the great
depression was a failure of monetary policy. Following the
stock market crash of 1929, banks were threatened by runs.
The Federal Reserve was limited in the loans it could make to
member banks, partly by philosophy, but also because the law
required partial gold backing of its credits to member banks.
9,000 banks failed (one third). This theory is supported by
Bernanke, including a major academic article published in 1995.
• Other factors: Cheap credit that fueled excess capacity for
consumer goods, trade decline, dust bowl, and the Smoot
Hawley tariff act. (June 1930). These factors are all well
understood by policy makers so the probability of repeating is
low.
Guy Carpenter
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Deflation Japanese style
• Japan in 1990s: Economic growth at 1.3%, inflation at 0.2%
• The causes of deflation include:
- Aging of the population
- By 2020, Japanese working age population will be 10
percent smaller, ours will be 30 % larger.
- Young people needed for economic growth.
- Cheap goods from China and other South East Asian nations.
- Deflation as a self fulfilling prophecy (money in mattresses
rather than in the bank.)
- Bailout of banks and corporations
- Need to rationalize Japanese banking system.
Guy Carpenter
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Oil Demand
Million Barrels Per Day
Guy Carpenter
2002
2008
OECD
48.1
49.8
Non-OECD
29.8
37.7
Total
77.9
87.5
16
Agenda
 Overview of the Financial Market Debacle
– how the problems developed, implications for the broader economy
 Impacts on the insurance industry, ranging from credit
enhancers, to D&O and E & O
 Possible regulatory responses impacting our industry
Guy Carpenter
17
Impacts on Insurance
 Direct relationships
– Credit enhancers ($3,300 billion)
– D & O and E & O
 Economic relationships
– Driving & auto insurance
– Employment and WC
– Recession and Fraud
– Housing bust and arson (?)
 Indirect relationships
– Stock Market and Surplus
– Interest rates and pricing (long tail)
Guy Carpenter
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Subprime Impact on Insurer Capital
90
25
80
20
70
USD Billions
60
15
50
40
10
30
20
5
10
0
0
Andrew
WTC
Insured Loss
Guy Carpenter
KRW
Subprime
% of industry capital
19
Miles Traveled Down in 2007 and 2008
Annual VMT
3500
Billions
3000
2500
2000
1500
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2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1000
20
Commercial Lines
Competition is heating up!
Guy Carpenter
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Rate Decreases Continue for Commercial Lines
Source: Council of Insurance Agents & Brokers 2nd Qtr. 2008 Survey - Chart: Lehman Brothers Equity Research
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Pressures on pricing
 Reduced supply
 Higher catastrophes in 2008
 Reduced investment income, as stock markets weaken
 Write-downs for problem assets reduce capital
These pressures may be offset to some extent by concerns
of counter party credit quality and by possible increased
move to self-insurance by well capitalized players
Guy Carpenter
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Agenda
 Overview of the Financial Market Debacle
– how the problems developed, implications for the broader economy
 Impacts on the insurance industry, ranging from credit
enhancers, to D&O and E & O
 Possible regulatory responses impacting our industry
Guy Carpenter
24
Regulatory response
 Federal regulation
– Knee jerk response (Senators Sununo and Johnson)
– New York State action on CDS
 Higher capital ratios
– Raise costs of doing business
– Disproportionate impact on newer more thinly capitalized ventures,
such as Bermuda start-ups
– Search for “Black Swans”
• Earthquakes
• Liability (Nano, Climate change)
– Pressure on reserves
Guy Carpenter
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The Future
 “Fasten your seat belts, it’s going to be a bumpy ride.”
Guy Carpenter
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Subprime Plus
Southwest Chapter:
PLUS
Educational Seminar
Seán Mooney, Chief Economist
October 2, 2008
www.guycarp.com