Global Financial Order - Reasons for Crisis, Current Status, The BIG Shifts- Public Debt, Global De-leverage, Wealth Concetration & Creation.
Talk Delivered at Fore School Of Management, new Delhi
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After the storm- Global Financial Crisis 27 aug 2010
1. Time for storytelling…
After the storm
Gaurav Sharma
http://in.linkedin.com/in/gauravsharma1978
Email: sgaurav.sharma@rediffmail.com
27 August 2010
FORE School of Management, New Delhi
1
4. Global Financial Crisis -Timeline of Crisis 2007/08….
The recent financial crisis is categorized as the worst since the Great Depression. Some of
the major events related to the crisis are mapped to the Dow Jones Industrial Average
4
5. The turmoil was not merely another
turn of the business cycle but a
restructuring of the economic order.
5
6. Causes: US Housing Market Collapse
Many experts believe that the global crisis was triggered by the US housing market collapse
Easy access to credit: Falling interest rates and rising availability of mortgages, combined with rising
housing prices encouraged consumers to buy homes
Relaxed lending standards: To cater to the growing number of mortgage seekers, lenders relaxed
standards and issued a large number of sub-prime loans
Inadequate regulations: Regulations did not keep pace with innovations in US financial
products, leading to much higher complexity, poor transparency and greater risk
Complex credit derivatives: The invention and use of complex debt derivatives such as CDOs1
made it difficult to identify and contain the sub-prime lending problem, once default rates began to
Rise
Market collapse: The property boom led an over-supply of housing and prices could no longer be
supported. Just like the self-perpetuating behaviour that led to the rise, the crash was also self-
perpetuating. As prices fell, more foreclosures started taking place, increasing the supply of homes on the
market. Lenders started to tighten their standards and fewer consumers could qualify for mortgages and
help reduce the supply
6
8. Historically low global interest rates after the bursting of the dot-
com bubble sparked greater global liquidity…
Sources: Federal Reserve System; ECB statistics
0
5
10
15
20
Japan
FF
ECB
1977 9787 07
Global interest rates %
Global rates hit
historic lows in
aftermath of dot-com
bubble burst
0300
Fed and ECB
monetary easing
created greater
liquidity and
helped global
rebound after the
tech-bubble burst
8
9. A vicious cycle completed to drive further illiquidity
Risk aversion
of investors
Falling
asset
prices
Announce-
ment
of losses
Banks reduce
funding to
other banks
Banks pay
inflated price for
liquidity
Investors
avoid lending
to banks
Banks/
hedge
funds
need to
liquidate
positions
Rising losses in
subprime market
9
10. Genesis of a Crisis
Scant Regulatory
Oversight
Originate-and-
Distribute Model
Deterioration of
Underwriting
Standards
Mortgage
Securitization
Mispricing of
Risk
Credit
Default
Swaps
Excess
Global
Liquidity
CrisisExcessive
Financial
Leverage
Low
Interest
Rates
Drive to Increase
Investment Returns
Rising Real
Estate Prices
10
11. Regulatory Balkanization – Failure of Oversight
Office of
Thrift
Supervision
Federal
Deposit
Insurance
Corporation
Individual
States
Department
of Labor
Office of the
Comptroller of
the Currency
Federal
Reserve
National Credit
Union
Administration
Securities and Exchange
Commission
Commodity Futures
Trading Commission
Commercial
Banks
Thrifts
Insurance
Companies
Securities
and
Exchanges
Futures
Credit
Unions
Industrial
Loan
Companies
Bank
Holding
Companies
11
12. Global Financial Crisis
Proximate causes
Sub-prime lending
Originate and distribute model
Financial engineering, derivatives
Credit rating agencies
Lax regulation
Large global imbalances
Fundamental cause
Excessively accommodative
monetary policy in the US and
other advanced economies (2002-
04)
0
2
4
6
8
10
Jan-90
Dec-90
Nov-91
Oct-92
Sep-93
Aug-94
Jul-95
Jun-96
May-97
Apr-98
Mar-99
Feb-00
Jan-01
Dec-01
Nov-02
Oct-03
Sep-04
Aug-05
Jul-06
Jun-07
May-08
Percent
Effective Federal Fund Rate in the US
US Monetary policy too loose during 2002-04; aggregate
demand exceeded output; large current a/c deficit;
mirrored in large surpluses in China and elsewhere.
12
13. • Low interest rates
• Excessive financial leverage
• Complexity of financial products
• Lack of effective risk management at large institutions
• Inadequate appreciation/regulation of derivatives risk
• Conflicts of interest at rating agencies
• Mark-to-market accounting
• Lack of access to liquidity
• Poor corporate governance practices
How Did We Get in the crisis?
13
14. Differences Between Financial Crisis in US/Europe and India
What has not happened here
No subprime
No toxic derivatives
No bank losses threatening capital
No bank credit crunch
No mistrust between banks
Our Problems
Reduction in capital flows
• Pressure on BoP
• Stock markets
• Monetary and liquidity impact
• Temporary impact on MFs/NBFCs (Sept-Oct)
• Reduction in flow from non-banks
• Perceptions of credit crunch
14
15. But do we really understand the real reason for crisis ?
The conventional wisdom used to be that the basic cause of the crisis was bad incentives in the mortgage
industry , while it’s tempting to blame what happened on just a few greedy bankers who took
irrational risks
But is that the real reason....
The large global impact of the crisis suggests that the problems with subprime mortgages were a symptom
rather than the cause
The main causes are :
-Flawed global financial order in which the incentives to take on risk are incredibly out
of step with the dangers those risks pose.
-System where growing inequality and thin social safety net creates tremendous political
pressure to encourage easy credit and keep job creation robust, no matter what the
consequences to the economy’s long-term health
-Unequal access to education and health care in the united states and other countries
(including India) puts everyone in deeper financial peril.
15
17. Global banking trends after the crisis
The near-term prospects for US and European banks are decidedly grim. The
global financial crisis will bring about the most significant changes to their operating framework banks have seen in
decades. There will be fundamental re-regulation of the industry, ownership structures are shifting towards heavier state
involvement and investor scrutiny is rising strongly. Equity ratios will be substantially higher. As a result, growth and
profitability of the banking sector as a whole are likely to decline.
Lean years lie ahead for US banks. Performance improvements during the last 15 years have often been
due to strong lending growth and low credit losses. As private households reduce their indebtedness, revenue growth in
some European countries but especially the US may remain depressed for several years. With weak loan growth and a
return of higher loan losses as well as a fundamentally diminished importance of trading income and modern capital
market activities such as securitisation, banks may be lacking major growth drivers.
Consolidation to continue but with a different focus. While there will still be a considerable
number of deals, transaction volumes are likely to decline and restructuring stories rather than strategic M&A may
dominate. The probability of domestic deals has increased, while that of cross-border mergers has declined.
Internationalisation of banks likely to slow. Uncertainty about the future prospects especially of
foreign markets and strictly national banking sector stabilisation programmes are triggering a re-orientation towards
domestic markets. This is more relevant for European banks that have greatly expanded into other European countries
recently, while American banks overall may continue to target the national market rather than going abroad.
17
18. Private Equity is a cyclical business
Global Private Equity
Since it emerged as a major asset class in the 1980s, PE has experienced three major booms.
In the 1980s, the PE industry capitalised on the sale of many poorly run public companies and
corporate divestitures available at low cost and largely financed with junk bonds.
From private equity’s heyday a few years ago when deal makers were riding high, to the gut-
wrenching drop in deal making through last year’s recession, this industry knows what it’s like to
ride the roller coaster. Private equity has always been a cyclical industry, and signs of a nascent
rebound in 2010 underscore that fact.
During the 1990s, debt financing played a less
prominent role. PE industry returns were driven
mainly by gross domestic product growth and
expanding price-to-earnings multiples during the long
economic expansion.
Over the past decade, PE rode a credit bubble
inflated by low interest rates to record deal values.
That boom, of course, came to an abrupt end with the
mortgage-led debt crisis that froze credit markets in
2008 and triggered a global recession affecting nearly
every industry.
18
19. India’s economy has experienced a robust and broad-
based recovery from last year’s financial slowdown
Fund-raising has been on the rise
again, particularly, from the domestic fund houses.
While the core infrastructure sector and the
telecommunications sector continued to attract PE
investment, we are experiencing the revival of the real
estate sector. Other sectors like consumer products and
retail, financial services and technology are also showing
signs of improved deal activity.
There were 11 PE-backed IPOs thus far in 2010 —
compared to seven total in 2009 — as the companies
leveraged the rising stock market to raise capital.
More PE-backed IPOs in the coming months if the stock
market remains favourable.
Looking ahead, valuations are an expected
concern, accentuated by the fact that stock markets
continue to soar.
Top deals see global funds
participate; emerging
consumer-driven sectors
Private Equity - India
19
20. • Private equity’s ―golden age‖ of low interest rates, abundant leverage, mega-deal making and effortless
returns is over, and will not soon return. Global PE investments sank to a level not seen since the last
downturn. All regions and industry sectors suffered.
• The dynamics underlying the decline differed by region. In North America and Europe, economic
uncertainty and frosty debt conditions constrained deal making. In emerging markets, the massive
dislocation of value brought about by declining economic growth and tumbling equity markets led to a
mismatch of buyer and seller expectations. In both regions, the rapid rebound of equity markets did not
give valuation and deal multiples a chance to reset.
• PE firms readjusted their investment focus to the opportunities 2009 presented, favoring carve-
outs, growth equity, acquisition finance, balance-sheet restructurings and distressed debt investments.
• Fund-raising declined across all major PE asset classes and was weak in every region. Despite their
continued commitment to PE, the ―denominator effect‖ and the paucity of PE distributions squeezed LPs’
liquidity and impaired their ability to commit to new funds.
• The downturn forced significant markdowns in portfolio valuations, causing short-term PE returns to
decline by double digits; recent vintages were hit hardest.
• Leading PE firms that laid the groundwork during the downturn should be positioned well for market
conditions in 2010 and beyond.
Key takeaways from Private Equity Industry
20
21. Countries in the fire zone are likely to face severe economic pressures as they increase public
debt to greater than 90% over the next few years, which will in turn stall growth
Imagine earning $100 to pay $90-110 rupees as interest on debt….
BIG SHIFTS: Increase in Public debt might trigger another crisis
21
23. The spectre of deleveraging has been haunting the global economy since the credit crunch reached crisis
proportions in 2008.
BIG SHIFTS: Debt and Deleveraging (1/3)
The deleveraging process may just be
getting under way and is likely to exert a
significant drag on GDP
What’s more, analysis of deleveraging
episodes since 1930 shows that virtually
every major financial crisis after World War
II was followed by a prolonged period in
which the ratio of total debt to GDP
declined significantly. The one exception
was Japan, whose bursting asset bubbles in
the early 1990s touched off a financial crisis
followed by many years...
The fear: an unwinding of unsustainable debt burdens will drag down growth rates for years to
come. So far, reality has been more benign, with economic growth recovering sooner than expected in some
countries, even though the financial sector is still cleaning up its balance sheets and consumer demand
remains weak.
23
26. China
Hong Kong
India
Indonesia
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand
0 11,000 13,000 19,0002,000 22,0004,000
* Assessment including key product penetration (credit card, life insurance), openness to foreign banks, market consolidation, financial stock per capita
** Financial stock includes bank deposits, government and corporate debt and equity
Sources: MGI; WMM;
Size of 2009
financial stock**
Degree of market
maturity*
GDP per capita, 2009
€
High
Medium
Low Vietnam
Mature market with high
penetration of banking and
insurance products
Emerging fast-growing markets
with under-developed banking
sectors; growth driven by
product penetration and
increase of bankable population
Transition markets with fast
maturing market structure and
fast growth
Asia is not a homogeneous region; it consists of markets at different
stages of development
Consumer Credit Markets- ASIA
26
27. 27
Asia’s population(Some countries) is aging rapidly …
200
1
202
1
205
1
10 working
adults*
support
1 retiree**
6 working
adults*
support
1 retiree**
3 working
adults*
support
1 retiree**
* Working adults are adults from 15 to 64 years old
** Retirees are adults 65 years old and above
Sources: Data up to 2021 from Asian Demographics; data for 2051 from Firm estimates
Population over 65 years old %
20
16
7
20
15
7
14
5
9
10
14
20
2021E2001
Singapore
Need for retirement investment
increases with time
Hong Kong
India
Taiwan
Korea
China
which will create pension-related wealth management opportunities
28. Important banking trends for Asia (1/2)
1. Asia is fragmented, and markets have distinct characteristics: Asia is not one homogeneous
market, but rather a fragmented region of independent markets at different stages of development.
2. The bulk of Asia’s growth will come from a few large markets, though selected smaller markets
have high growth rates: China, India, Korea, and Taiwan account for 80% of the financial assets in Asia
(excluding Japan) and will be key growth drivers. However, smaller markets such as Vietnam and
Indonesia are expected to grow rapidly.
3. Consolidation is happening at varying paces across the region: Malaysia, Korea, and Thailand have
made good progress in banking consolidation, while countries like Taiwan are still highly fragmented.
4. Persistent boom-bust cycles have been observed in the capital markets: Historically, the growth of
Asia’s capital markets has not been linear; the region is likely to face boom-bust cycles in the future.
5. Large and profitable pan-Asian foreign franchises have emerged: Citibank, HSBC, Standard
Chartered, and GE Capital have created material Asian franchises with a median share of 1.7% in active
Asian markets and 40%-50% PBT margins in 2009.
6. New local “empowered” players are seeking regional and global growth: Many local market leaders
are going beyond their home markets (e.g., DBS, ICBC, CCB, Chinatrust, Kookmin, CIMB, OCBC).
7. Rapid influx of new bankable customers in large markets (China, Indonesia, and India):
Approximately 600mn new ―bankable‖ customers will enter the market in the next 5-10 years.
28
29. Important banking trends for Asia (1/2)
8. Extremely high wealth concentration: Less than 1.5% of Asian households control about 50% of
personal financial assets (PFA); this privileged segment is growing rapidly, and its wealth could match
that of the segment’s Continental European counterparts by 2010.
9. “Flipped” risk-return perception of financial investments: 40%-60% of Asian PFA is still held in
low-interest-earning deposits due to ―flipped‖ risk-return perception; this perception is driven by a fear
of investment risk, perpetuated by poor historical performance of the underlying capital markets. As a
result, consumers are stuck at the awareness stage of the sales funnel for most investment products.
10. Many billion-dollar product markets have emerged: Significant revenue and profit pools across many
markets have created an opportunity for selective players to create large and profitable niche businesses.
11. Demand has increased for borrowing among consumers; consumer finance is still highly
underpenetrated in Asian markets (except for Taiwan and Korea): The younger generation is more
open to borrowing and believes that borrowing can improve lifestyle. This belief, coupled with existing
low penetration of credit products, suggests that consumer credit will experience exponential growth in
the Asian banking sector.
12. Rapidly aging populations have increasing retirement needs: Asia’s populations are aging rapidly.
Concerns about meeting retirement needs will drive the development of innovative pension
products, subject to conducive regulatory environments.
29
31. Key take away from this session
The Global Financial System is still not out of the woods (European
crisis, consumer credit, public debt etc ): the hidden fractures still threaten the world
economy… the FAULT LINES are to be fixed.
Global Debt and leverage reduction will result in slow growth.
The Economic Wealth shift happening to East
Private equity’s “golden age” of low interest rates, abundant leverage, mega-deal
making and effortless returns is over, and will not soon return.
Technology (Internet and Mobile) is reshaping the world of financial services.
The Asian financial markets are projected to grow very fast.
31
33. Federal Reserve under Alan Greenspan (Easy Money)
Fannie Mae, Freddie Mac & Congress: GSEs supporting affordable housing – increased demand
for subprime and Alt-A loans
Borrowers at best were uninformed; at worse, lied about their financial condition
Mortgage Brokers, Appraisers, Realtors: Overvalued properties and pushed borrowers into
gimmick or complex mortgages
Rating Agencies misrepresented security/asset values
Large Commercial and Investment Banks demonstrated poor risk management practices
Regulators (Banking & SEC) allowed excessive leverage and failed to criticize the large
institutions’ business models; no regulation of derivatives
Separation of Ownership from Origination:
Securitization allowed loan originators to care less about the quality of the loans they
originated
Mark-to-Market Accounting forced unreasonable
valuations of securities when there was no liquidity
How Did We Get Here?
33
34. How the story unraveled…
•In the aftermath of the dot-com bubble burst, growth of liquidity and easy credit
availabilities, combined with novel structuring of financial assets drove a dramatic expansion of structured
credit; investors chased yield and bet on real asset performance in residential real estate and didn’t
properly understand true credit risk
•Even while the economy remained strong, housing prices ceased to rise, and many subprime borrowers
began to struggle to service their debt
•Default rates of RMBS and CDO began to rise dramatically, and financial asset valuations were strongly
impacted by market reaction against in-transparency and complexity in the instruments, and a failure of
trust in their credit ranges
•Downgrades in financial asset values helped spur a reduction in market liquidity. A reinforcing
cycle, based on loss of confidence and transparency, drove further deterioration in financial asset value as
well as a crisis in funding liquidities
•The devaluation of financial asset values, combined with a funding liquidity crisis, hit the capital market
participants in various ways. Many players exited the markets
•Central banks injected capital to secure the availability of funding liquidity, and held or reduced interest
rates to support the capital market. The side effect was to expose the real economy loop to the risk of
inflation
•Regardless of the scenario, there will be some winners and many losers as the cycle continues to unravel.
34
35. What caused the bubble?
The monetary policies of central banks particularly the US Federal Reserve and the ECB in some
countries were too loose – they focused too much on consumer price inflation and ignored asset
price inflation
Global imbalances – the Asian crisis of 1997 and the policies of the IMF led to a desire among
Asian governments to save funds
35
36. Growing Importance of Finance
Note: Financial services and insurance accounted for 7.8% of U.S. GDP in 2009.
36
