Professional Documents
Culture Documents
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Deregulation
Markets were becoming more competitive than ever as a result of a number of deregulation efforts in the United States The repeal of the Glass-Steagall Act of 1933 eliminated the last barriers between commercial and investment banks, allowing commercial banks to enter areas of more risk Increased deregulation also put pressure on existing regulators such as the Federal Deposit Insurance Corporation (FDIC)
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The Housing Sector and Mortgage Lending New market openness and competitiveness allowed many borrowers to qualify for mortgages that they would not have qualified for previously Structurally, some mortgages re-set a high interest rates after a few years or had substantial step-ups in payments after an initial period of interest-only payments
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Credit Quality
Mortgage loans in the U.S. marketplace are normally categorized (in increasing order of riskiness) as:
Prime (or A-paper) Alt-A (Alternative A-paper) Sub-prime
The sub-prime category is difficult to define. In principle, it reflects borrowers who do not meet underwriting criteria and have a higher perceived risk of default normally as a result of credit history
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Credit Quality
Sub-prime mortgages are nearly exclusively floating-rate structures, and carry significantly higher interest rate spreads over the floating bases such as LIBOR Sub-prime borrowers typically pay a 2% premium over prime the subprime differential
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Credit Quality
Subprime lending was itself the result of deregulation Growing demand for loans or mortgages from sub-prime borrowers led more and more originators to provide the loans at above market rates Sub-prime loans became a growing segment of the market by the 2003-2005 period
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Asset Values
One of the key financial elements of this growing debt was the value of the assets collateralizing the mortgages the houses and real estate itself As the market demands pushed up prices, housing assets rose in market value The increased values were then used as collateral in re-financings or second mortgages Many mortgage holders became more indebted and participants in more aggressively constructed loan agreements Mortgage brokers and loan originators, driven by additional fee income, pushed for continued refinancings
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Credit Enhancement
A final element quietly at work in credit markets beginning in the late 1990s was the process of credit enhancement. Credit enhancement is the method of making investment more attractive to prospective buyers by reducing their perceived risk. Bond insurance agencies were utilized as guarantors in the case of default. Beginning in 1998 a more innovative approach to credit enhancement was introduced in the form of subordination. This was the process of combining different asset pools of differing credit quality into different tranches by credit quality.
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Global Contagion
Although it is difficult to ascribe causality, the rapid collapse of the mortgage-backed securities markets in the United States definitely spread to the global marketplace. Capital invested in equity and debt instruments in all major financial markets fled not only for cash, but for cash in traditional safe-haven countries and markets. Equity markets fell worldwide, emerging markets were hit particularly hard. Currencies of the more financially open emerging markets felt a significant impact.
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Global Contagion
By January 2009, the credit crisis was having additionally complex impacts on global markets and global firms. The crisis, which began in the summer of 2007 had now moved to a third stage, that of potential global recession of depression-like depths. Constricted lending had impacted borrowing and importantly investing. Prospects for investment returns of all types were dim; corporates failed to see returns on investments. As a result there was widespread retrenchment among industrialized nations as corporates slashed budgets and headcount.
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Mark-to-Market Accounting
One of the continuing debates about the global credit crisis is whether the use of mark-to-market accounting contributed significantly to the failure of financial institutions. A long-term practice of the futures markets, the method requires that a financial institution re-value all financial assets and derivatives daily, even though there is no intention to liquidate the asset at that time. The problem is that many instruments do not trade in markets, or trade only in very thin markets. When markets are in crisis, establishing a value can be a very difficult task.
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LIBORs Role
The global financial markets have always depended upon commercial banks for their core business activity. The banks in turn have depended on the interbank market for liquidity which had historically operated on a no-names basis but rather a tiered basis with respect to individual banks. In the summer of 2007 however, much of this changed, increasing focus on each individual institution and its particular credit risk profile.
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LIBORs Role
The British Bankers Association, the organization charged with the daily tabulation and publication of LIBOR Rates, became worried about the validity of its own published rate. The growing stress in the financial markets had actually created incentives for banks surveyed for LIBOR calculation to report lower rates than they were actually paying. As the crisis deepened, many corporate borrowers began to publicly argue the LIBOR rates published were in fact understating their problems. In its role as the basis for all floating rate debt instruments of all kinds, LIBOR rates have the potential to cause significant disruptions when they skyrocket as they did in September 2008.
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Exhibit 5.13 The U.S. Dollar TED Spread (July 2008January 2009)
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LIBORs Elements
Amidst the credit crunch of 2007 and 2008, the Bank for International Settlements in Basle, Switzerland, had published a study of the LIBOR markets behavior of late. The study described the risk premium added to interbank quotes as: Risk Premium = Term Premium + Credit Premium + Bank Liquidity + Market Liquidity + Micro
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LIBORs Elements
The term premium is a charge for maturity The credit premium is a charge for the perceived risk of default by the borrowing bank Bank liquidity premium is the access of the individual lending bank to immediate funds The market liquidity premium is a measure of general market liquidity A micro premium is a charge representative of the market micro-structure of how banks conduct interbank lending
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So where now for the global financial markets? Dismissing the absolute extremes, on one end that capitalism has failed, and on the other end that extreme regulation is the only solution, what practical solutions fall in between?
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Chapter 5
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Exhibit 5.14 Three-Month Money Market and Credit Spreads (Bank for International Settlements) in Basis Points
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