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The Credit Crunch and its Consequences
Howard DaviesDirector, LSE
LSE Alumni Lecture Series – Inaugural Lecture
Wolfson Theatre, New Academic Building
19th February 2009
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A Five Act Shakespearian Tragedy
Act One: Subprime
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… real estate prices rise
Source: Tano Santos
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The growth of securitised credit
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Recent ABX BBB Price HistoryPrice
Source: Markit Partners
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Resecuritisation
BBB
A
AA
AAA
Residual/Equity
SUPER SENIOR
AAA
AAA
AA
A
BBB
Equity
Capital Structure Containing Subprime Loans
Subprime Mezzanine CDO Containing BBB Subprime Bonds
100%
28%
20%
11%
7%
0%
11%7%
11%
8.6%
7%
100%
40%
0%
CUMULATIVE LOSSES
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Act Two: Liquidity
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Financial market liquidity
Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill Lynch, Thomson Datastream.
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Act Three: Unravelling
-Bear Stearns, Indymac, Wa mu
-HBOS, RBS
-Fortis, Dexia etc.
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Act Four: Meltdown
• Lehman’s failure leads to
– indiscriminate sell-off of financial stocks
– seizing-up of many markets
– generalised market panic
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Act Five: Pumping
• additional liquidity facilities
• fiscal stimuli
• near-zero interest rates
• quantitative easing
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Act One: Subprime
Act Two: Liquidity
Act Three: Unravelling
Act Four: Meltdown
Act Five: Pumping
The Credit Crisis: A Five-Act Tragedy
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•global imbalances
•loose monetary policy, leading to•mispricing of risk•credit bubble
•‘excess’ growth of financial sector
•‘excess’ leverage, facilitated by procyclical regulation
But what are the underlying causes?
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Global current account balances
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China’s Growth LaggardPersonal Consumption as % of GDP
Source: China National Bureau of Statistics and Morgan Stanley
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Household debt as a proportion of GDP
Source: FSA, ONS, Federal Reserve, Eurodata, Datastream
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UK Saving Rate
Source: ONS; Morgan Stanley Research
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The growth of the financial sector
Source: FSA, Oliver Wyman
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Major UK banks’ leverage
Source: FSA, Bank of England
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“ Bank failures are caused by depositors who don’t deposit enough money to cover the losses due to mismanagement”.
Dan Quayle
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“ The owners of capital will stimulate the working class to buy more and more of expensive goods, houses, and mechanical products, pushing them to take more and more expensive credits, until their debt becomes unbearable The unpaid debt will lead to bankruptcy of the banks, which will have to be nationalised, and the state will have to take the road which will eventually lead to communism.”
Das Kapital
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So what next?• growth prospects have deteriorated
sharply, across the world
• Europe mired in recession
• long downturn the most likely outcome, and (in the UK) anaemic recovery
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Growth Rates: IMF Forecasts
-4
-3
-2
-1
0
1
2
3
4
Germany France US UK
2007
2008
2009
2010
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Source: www.ft.com
European Economic Forecast – April 2008
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Source: www.ft.com
European Economic Forecast – January 2009
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Larger than previous crises
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UK recovery options:• V-shaped: sharp contraction, quick
bounce-back• U-shaped: longer trough, delayed but
strong recovery• L-shaped: Japanese style stagnation• Nike swoosh: sharp downturn, weak
recovery
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Is London Reykjavik on Thames?• Banks big, but not that big in relation to
GDP
• Fiscal position poor, pre-recession, but stock of debt not excessive
• But needed fiscal tightening will mute the recovery.
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Sovereign five-year CDS
Source: Morgan Stanley (as at 21 January 2009)
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General government debt rations in OECD countries in 2008
Source: OECD, Economic Outlook No. 84, November 2008
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UK gross issuance forecast
Source: Morgan Stanley
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Discretionary policy change projected in the PBR
Source: HM Treasury, Pre-Budget Report 2008
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The Credit Crunch and its Consequences
Howard DaviesDirector, LSE
LSE Alumni Lecture Series – Inaugural Lecture
Wolfson Theatre, New Academic Building
19th February 2009