recent changes to the global financial lanscape

8/3/2019 Recent Changes to the Global Financial Lanscape

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RECENT CHANGES TO THE GLOBALFINANCIAL LANDSCAPE

(Jakarta, 31th August 2010)

2008


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CONTENTS

CHAPTER 1: THE CREATION OF FINANCIALASSETS AND MONTARIST VIEW

CHAPTER 2: THE GLOBALIZATION OF FINANCIAL

MARKETS AND MONETARY/FINANCIAL STABILITY CHAPTER 3: NEW WAYS OF DEALING WITH

DEFAULT AND MEDIUM-TERM ISSUES CHAPTER 4: RECENT TRENDS

CHAPTER 5: RISKS CHAPTER 6: INVESTMENT MANAGER BEHAVIOR CHAPTER 7: FINE TUNING (PRUDENTIAL) CHAPTER 8: ROAD TO RECOVERY


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CHAPTER 1

THE CREATION OF FINANCIAL ASSETS


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KEY DRIVERS

Technological change reduces the cost ofinformation transformation and communicationand encourages and facilitates advancements

in financial engineering Deregulation allows for greater access of credit

to a larger group of customers and morecompetition among institutions

Institutional change has amended regulatoryunderstandings as a result of new businessentities like private equity firms and hedge fund

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The Creation of Financial Assets

Financial asset is a claim against the income or wealth of a businessfirm, household, or unit of government, represented usually by acertificate, receipt, computer record file, or other legal document, andusually created by or related to the lending of money

Familiar examples are stocks, bonds, insurance policies, futurescontracts, and deposits held in a bank or credit union

Financial assets do not provide a continuing stream of services to

their owners These assets are sought after because they promise future returns to

their owners and serve as a store of value (purchasing power) Their value rest on faith that the issuer will honor his or her

contractual promise to pay They cannot be depreciated because they do not wear out like

physical goods Their physical condition or form usually is not relevant in determining

their market value (price) Financial assets grow faster than world trade and faster than the

economic system as a whole (cost of storage & transfer of fundsdeclined sharply). Financial assets are fungible


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Different Kinds of Financial Assets(money, equities, debt securities, and derivatives)

Any financial asset that is generally accepted in paymentfor purchase of goods and services is money

Equities (stocks) represent ownership shares in abusiness in a business firm, and, as such, are claimsagainst the firm`s profits and against proceeds from thesale of assets

Debt securities include such familiar instruments asbonds, notes, accounts payable, and saving deposits

Derivatives are among the newest kinds of financialinstruments that are closely linked to financial assets.These unique financial claims have a market value thatis tied to or influenced by the value or return on afinancial asset, such as stocks and bonds, notes, andother loans. Examples: futures, options and swaps.These instruments are often employed to manage risk inthe assets to which they are tied or related


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The Evolution of FinancialTransactions

Financial systems are never static They change constantly in response to shifting demands

from the public, the development of new technology, andchanges in laws and regulations

Competition in the financial marketplace forces financialinstitutions to respond to public need by developingbetter and more convenient financial services

The global system of financial markets has evolved fromsimple to more complex ways of carrying out financial

transactions The growth of industrial centers with enormous capitalinvestment needs and the emergence of a huge middle-class of savers have played major roles in the gradualevolution of the financial system


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Bank-Dominated vs. Security-Dominated Financial Systems

Many lesser-developed financial systems areoften referred to as bank-dominated financialsystems because of the dominance of banks

and similar financial intermediaries in supplyingcredit and attracting savings Many financial systems today are becoming

security-dominated financial systems, in whichtraditional intermediaries play somewhat lesser

roles in the lending and saving process andgrowing numbers of borrowers sell securities(stock and bonds) directly to the public to raisethe funds they need


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BUBBLES Much is at stake in valuing securities correctly Trillions of dollars are invested in stock markets around

the world Firms that once went to banks for capital began raising

funds through public stock markets

An equity culture was emerging where firms traded moreand more with equity investors or their intermediaries

Unfortunately, the growing equity culture is notmatched with a growing understanding of how tovalue securities

Trillions of dollars are lost as a stock market bubbleburst and investors find their savings shrinksignificantly

Allan Greenspan: Once-in-a-century credit tsunami


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The Monetarist View A monetarist is a macroeconomist believes that the economy is self-

regulating and that it will normally operate at full employment,provided that monetary policy is not erratic and that the pace ofmoney growth is kept steady

The monetarist view of policy is the same as the classical view onfiscal policy. Taxes should kept low to avoid disincentive effects thatdecrease potential GDP

Provided that the quantity of money is kept on a steady growth path,no active stabilization is needed to offset changes in aggregatedemand

The deposits of 3 types of depository institution make up thenation`s money: commercial banks, thrift institutions (savings and

loan associations, savings banks, credit unions) and money marketmutual funds

Depository institutions provide 4 main services that people arewilling to pay for: creating liquidity, minimizing the costs of obtainingfunds, minimizing the costs of monitoring borrowers, pooling risks


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Case Study Chapter 1


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Anatomy of a Collapse (1) Stock market bubbles damage economies Mispriced stocks attract capital to the wrong

businesses Companies with poor business models raise cash

too easily, deflecting it from firms that can add valuefor economies

Investors borrow to buy paper (eg, CDSs) rather thanreal productive assets. Note: another structuredproducts: CDOs (Collateralized Debt Obligations), CLOs(Collateralized Loan Obligations), ABSs (Asset-BackedSecurities), SIVs (Structured Investment Vehicles) and

CPBSs (Commercial Paper-Back Securities) Debt burdens become intolerable Banks that feed the borrowing run into trouble Retirement savings are lost and a pension crisis

develops


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Anatomy of a Collapse (2)

The crisis has its roots in the biggest housing andcredit bubble in history

The credit losses on the mortgages that financedthese houses and on the pyramids of complicateddebt products built on top of them are still mounting

In its latest calculations the IMF reckons that worldwidelosses on debt originated in America (primarily related tomortgages) will reach USD 1.4 trillions, up by almost halffrom its previous estimate of USD 945 billion in April2008. So far some USD 760 billion has been written

down by the banks, insurance companies, hedge fundsand others that own the debt

Globally, banks alone have reported just under USD 600billion of credit-related losses and have raised someUSD 430 billion in new capital


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SHRINKING FUNDS HIGH BORROWING AND THE CREDIT CRISIS ARE BAD ENOUGH FOR HEGDE

FUNDS PANICKY CLIENTS ARE WORSE HEGDE FUND ASSETS UNDER MANAGEMENT (TOTAL: USD 1.9 TRILLION)

VICIOUSCIRCLE

MOST FUNDS ALLOW REDEMPTIONS EACH QUARTER

FUNDS-OF-HEDGE-FUNDSFORCED SELLING


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The Economic Turmoil

Took center stage in the US president`s campaign


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CHAPTER 2

THE GLOBALIZATION OF FINANCIAL MARKETS ANDMONETARY/FINANCIAL STABILITY(Greenspan admits errors on regulation)


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KEY DRIVERS (1)

Because of technological capabilities,banks are able to transform the traditionallong-term relationship between a financial

institution and its clients into an arm`slength transaction and a broader clientbase (disintermediation)

This intermediation is a new platformwhich allows risks to be more widelyspread out across a nation`s economy

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KEY DRIVERS (2)

The bundling of diversified loan packagesin the securitization process had created ascenario where the originator of a financial

transaction did not need to be the ultimaterisk holder of the business deal as riskswere re-allocated or spread out in a more

diversified pool

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The Dollar and Its Rivals(International Currency Status)

Before the World War I, the GBP was the leadingcurrency in international use

Subsequently, the dollar came to be used more widely,as the U.S. gained economic power and political prestigerelative to U.K.

Since World War II, the USD has been the clear choiceas the leading international currency

A new challenger was created on the first day of 1999:the Euro (EUR), the currency of the European Economicand Monetary Union (EMU)

Because the EUR has become the home currencyamong a set of countries that are collectively almost aslarge as the U.S., it could aspire eventually to rival theUSD as an international currency


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INNOVATION Innovation in domestic financial markets reduces the cost differential

between the rate return paid to the investor and the cost of capital paid bythe ultimate borrower

Innovation in international financial markets works similarly and therefore,like liberalization, increases the degree of capital mobility across nationalborders

The original key innovation was the development of the Euromarkets, out ofreach of regulation by national authorities Innovation can be driven by exogenous technological developments, such

as those in telecommunications and computers Often innovation is an endogenous response to some new problem in the

financial environment, such as uncertainty Exchange rate variability and interest rate variability have been higher in the

decades since 1973 Uncertainty in exchange rates and interest rates creates risk for

international investors In response, a variety of new ways to protect against risk in exchange risks

and interest rates were developed


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THE FORWARD EXCHANGE MARKET The most standard technique for dealing with exchange rate risk is by

means of the forward exchange market This market enables transactors, after they commit themselves to a

transaction but before payment is made, to protect themselves against achange in the exchange rate

They can protect themselves against it by hedging, or selling the currencyforward. This involves entering into a contract with a bank, under whichthey agree to sell foreign currency for their own currency, with the exchange

to take place in 90 days but the price set at the time the contract is agreedon The price received is the currency stated forward exchange rate, as

opposed to the uncertain spot exchange rate that will prevail in 90 days There are other market participants in addition to exporters and investors for

whom hedging on the forward exchange market is often beneficial In each case, the party obliged to pay foreign currency in the future can

avoid the risk of changes in the exchange rate by hedging, which in thiscase means buying the currency forward In this way, the future cost of the obligations in terms of domestic currency

is lock today The ability to hedge risk on the forward exchange market has meant that

the high degree of volatility exhibited by exchange rates has not been ascostly as it otherwise would have been to firms engaged in international

business. Once hedged, they are immune


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COVERED INTEREST ARBITRAGE The third set of participants in the forward exchange market, after hedgers and

speculators, are called covered interest arbitragers Covered interest arbitrage is a powerful force in forward exchange marketequilibrium under modern conditions in well-developed financial marketswithout barriers to international transactions

Covered interest arbitrage is sufficiently powerful that it can be considered thesole determinant of the forward exchange rate, provided the spot rate and theinterest rate are taken as given

In addition to the market in forward exchange, there is also an active market inforeign exchange futures. Like a forward contract, a futures contract is acommitment to buy foreign exchange in the future. One difference is that adeposit must be put down to buy a futures contract. Then, each day, thecontract is marked to market. This means that if the market rate moves thewrong way, the investor receives a margin call requiring payment for anylosses. A forward contract, by contrast, does not have to be settled untilmaturity. Another difference is that futures contracts mature on specific dates:the third Wednesday of March, June, September, and December. Forward

contracts, by contrast, are tailored to the customer seeking foreign currency,for example, 90 days into the future, regardless of the starting date. Anotherdifferences is that futures contracts are traded on centralized exchanges, likeCME, whereas forward contracts are arranged through banking system. A largeinvestor or importer who wants to lock in the rate on foreign currency neededin the future may use the forward market. A small speculator buying and sellingforeign exchange on a short-term basis in anticipation of exchange ratechanges is more likely to use the futures market


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Securitization (1)

There will be a need for new institutions to facilitate thecontinuing trend toward securitization of many of thecredit-related assets held by lending institutions andother corporations

The success of mortgage-backed securities over thepast three decades demonstrates that a financialinstitution can more easily take some of the loans it hasmade and use them as collateral for borrowing moneythrough the sale of securities

Today, they are loan-backed securities collateralized bysuch diverse assets as commercial and residentialmortgage loans, mobile home loans, credit-cardreceivables, auto and boat loans, home equity loans, etc


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Securitization (2) The future may bring even greater use of loan-back

securities because this device opens up additionalfunding sources for financial institutions and for many oftheir corporate customers, adding liquidity anddiversification

Securitization is also likely to support the on-going shift

of nonfinancial companies away from traditional types ofcredit obtained through financial intermediary (a bank orsavings and loan association) and toward self-financingand self-borrowing directly from investors in the openmarket.

Banks, insurance companies, and other traditionalintermediaries will have to continue their development ofnew services to offset the potentially damaging effects ofthis trend away from their traditional services on theirfuture probability


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MONETARY/FINANCIAL STABILITY

As leaders of the Group of 20 nations meet on 15 November 2008 inWashington, we are faced with the financial crisis of the century

The stability of financial and capital markets must be the first priority ofeconomic policy today

Whatever solution is proposed, it is clear that competition and capital flowsbased on free market principles should continue to serve as the foundation ofgrowth

We must also address the failure of government regulators around the world tokeep pace with the innovation and globalization of financial products Concerted action to coordinate various countries` policy efforts has now

become an unavoidable challenge First, an early and thorough disclosure of NPLs held by banks, based on fair

valuation and reliable standards, and the removal of those loans from theirbalance sheet

Second, capital injections into banks with public funds must be accompaniedby proper mechanisms to provide sufficient credit and to limit actions againstmanagement in the event the losses were caused by factors outside theircontrol

Third, the supply of liquidity from central banks (note: the smooth and amplesupply of USD liquidity must be maintained)


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Hedge funds Hedge funds are a type of investment pool that

solicits funds from (wealthy) individuals and otherinvestors (eg, commercial banks) and invest thesefunds on their behalf

Hedge funds are similar to mutual funds that they arepooled investment vehicles that accept investor`s money

and generally invest it on a collective basis Hedge funds are not required to register with the SEC They are subject to virtually no regulatory oversight

(eg, by the SEC under the Securities Act and InvestmentAdvisors Act) and generally take significant risk

Hedge funds are also not subject to the numerousregulations that apply to mutual funds for theprotection of individuals

Hedge funds do not have to disclose their activitiesto third parties (note: they offer a high degree of

privacy for their investors)


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Redemptions Hedge funds already hurt by market volatility, newly

introduced short-selling restrictions, are getting hitby a sharp uptick in redemptions De-leveraging, counterparty risks, short-selling

restrictions and redemptions are affecting theindustry

Hedge funds in Asia are particularly vulnerable, becausethey tend to hold more long positions, markets are lessliquid, counterparty risks are perceived higher andmanagers have less experience

In efforts to stem losses, some hedge funds have been

changing redemption policies, angering investors in theprocess Hedge funds investors said some hedge funds have

taken steps that effectively extended redemption periodsand lengthen investors` market exposure against theirwill


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Panic

The Fed has a lot of tools, but it cannot fix a primalhuman emotion: panic Financial panics (short term), acute market

upheavals that often coincidence with long-termrecessions were common as the U.S. economydeveloped

There was the Panic of 1857 (prompted by railroad-bonddefaults), the Panic of 1873 (sparked by a stock crash inVienna) and the Panic of 1907, which started whenshaky New York City banks quit lending (The U.S.Federal Reserve was created in the wake of the 1907

Panic) There is no precise economic definition of a market

panic, it is more a psychological than a fiscalphenomenon, simultaneously anticipatory (we thinksomething terrible will happen) and retrospective

(we think we have waited too long to avert disaster)


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Global Credit Contraction It is already clear that many more write-downs lie ahead The demise of the investment banks, with their far

higher gearing, as well as de-leveraging among headfunds and others will add to a global creditcontraction of many trillions of dollars

The IMF`s base case is that American and Europeanbanks will shed some USD 10 trillion of assets,equivalent to 14.5 per cent of their stock of bank credit in2009

In America overall credit growth will slow to below 1 percent, down from a post-war annual average of 9 per cent

That alone can drag Western economies` growth by 1.5percentage points. Without government action along thelines of America`s USD 700 billion plan, the IMF reckonscredit could shrink by 7.3 per cent in America, 6.3 percent UK and 4.5 per cent in the rest of Europe


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Global Macro Funds At least half of all hedge funds in Asia are equity long-

short funds, meaning they focus on taking either long orshort positions in stocks

Adding to the distress, many funds are long-biased holding mostly long positions

Equity long-short hedge funds have seen by far the mostredemptions

Not all hedge funds strategies are hurting badly; globalmacro and managed futures funds are seeing gains andinflows of funds, but such strategies are less common inAsia

Markets in Asia are less liquid, so it is harder for fundsfacing redemptions have been forced to sell blue chipstocks that are more liquid, cutting further into returns(reducing their borrowings and because of pressure frombanks tightening credit)


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Money Markets: Thawing Out

LIBOR

(TICKING DOWN SLOWLY)

THE FED: USD 540BNTHE ECB: EUR 773.2BN

World`s Banking System(Kept Alive)

With the help of generous infusionsOf State Capital & Liquidity


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CHAPTER 3

New Ways of Dealing With Default Riskand Medium-Term Issues(THE SHORT-LIVED RELIEF THAT CAME FROM THE BANK BAILED-OUTS HAS PASSED)


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KEY DRIVERS (1)

The growth of disintermediation and thefall of regulatory barriers to the capital flowacross markets has led to greater

connectedness between marketsworldwide

Liquidity is now at the global level and no

longer restricted to the availability of localliquidity

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KEY DRIVERS (2)

Investors now have achpcess to a widervariety of investment vehicles with allranges of risk and return profiles

To reduce default and/or interest ratesrisks, banks take risks associated withliquid loans off their balance sheet by

selling these transactions to theinvestment banking sector for re-distribution of risk or re-packaging of loans

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KEY DRIVERS (3)

This reintermediation process allows banks towork more efficiently by focusing on transactionsfor which they have a comparative advantage

The selling of liquid assets has encouragedsome lenders, such as mortgage lenders, tostart dealing with more illiquid transactions, suchas subprime mortgages, in order to generate

more revenue as seen during the currentfinancial crisis

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New Developments: Derivatives(The Size is not as Shocking at It Looks)

If some banks are too big too fail, USD 600 trillion has become thenumber too big to question That`s USD 600 trillion-the rough figure cited in many years reports for

the total size of the derivatives market, now blowing up to suchalarming effect

At a time of mind-boggling turmoil on Wall Street, perhaps it is notsurprising that few stop to ponder how a market for obscure financial

products, or any product, could be quadrupled in size since 2002, andnow measures more than 12 times the size of the world economy(official figures haven`t been released, but surveys reveal the markethas grown to at least USD 668 trillion-most are interest-rate swaps-total notional value of USD 393 trillion-and a market value of USD 7.2trillion. These are relatively plain-vanilla hedges against changes ininterest rates-the only sector the of the derivatives market that is

imploding are the CDSs-notional value, USD 55 trillion-which areparticularly risky) But the good news is that most of it is not real money. This market is

at least a bit less in comprehensively huge, and dangerous, than the15-figure numbers suggest (the total world market value ofderivatives-the money these promises are actually worth today-ismore in the neighborhood of USD 15 trillion (that is still huge, slightly

larger than the U.S. economy)


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Regulating Derivatives Proposals for a makeover of the financial system include reform of the credit

derivatives market, which offers over USD 50 trillion of default insurancecoverage The seller of protection in a credit derivatives contract receives a premium

from the buyer of protection until maturity, or until default of the namedborrower

Contracts are negotiated over the counter, not on an exchange, so it is difficultto know how much insurance exists on each borrower, or to know who hasinsured whom, and for how much

That privacy is not unusual in the normal course of business contracts. What isunusual is the size of the potential claims If a large bank or insurance company does not have enough capital to cover

settlement claims, then its failure, or the threat of it, can cause mayhem, as wehave just seen

The largest credit derivatives positions are held by big-bank credit derivativesdealers. Because they intermediate between sellers and buyers, dealers oftenhave nearly offsetting positions

The Fed is pressing dealers to quickly establish clearing in credit derivatives.The dealers have expressed an interest in using their own clearingcounterparty, the Chicago Clearing Corporation

Public disclosure can nevertheless be a good disinfectant wheneversufficiently severe conflicts of interest lead to inefficient control of risk (moralhazard) or to unfair exploitation of counter parties (default losses to the lenderwould be passed on to credit derivatives counterparties, who my not be aware

of the conflict of interest)


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COLLATERALIZED DEBTOBLIGATIONS

A collateralized debt obligation (CDO) is a way of creatingsecurities with widely different risk characteristic from aportfolio of debt instrument

Collateralized debt obligations (CDOs) are similar to CLNs inthat the issuer transfers a credit-risky return to an investor.

However, they are different in the following respects: First, the CDO issuer is transferring exposure to many moresecurities, perhaps 230 or more.

Second, CDOs are typically issued by a special-purpose vehicle(SPV), also known as special-purpose corporations (SPCs) orspecial-purpose entities (SPEs). These entities are legallyseparate from their parent and thus not exposed to the parent'scredit risk. They are also usually AAA rated.

The CDOs usually provide tranched returns, with investorschoosing the tranche that provides a return that best fitstheir risk profile.


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Synthetic CDOs

Corner of trouble: synthetic CDOs are investments tied tocompanies` credit-worthiness; nearly nonexistent a decadeago, they grew popular in recent years as a way for insurers,banks and others to invest in a diversified portfolio ofcompanies without actually buying the bonds or stocks

Instead, synthetic CDOs provide investors with income by

selling a kind of insurance against debt defaults, typically on apool of 100 or more companies Many synthetic CDOs contain a heavy dose of exposure to

financial companies, including Lehman, U.S. thrift WashingtonMutual Inc.,and recently nationalized Icelandic banks GlitnirBank hf, Kaupthing Bank hf and Lansbanki Islands hf

Hedge funds and other investors are heading for the exits amidworries about how bad the losses and downgrades will be,causing the market value of synthetic CDOs to slide

Dealers are offering about 50 cents on the dollar or less forsome pieces of synthetic CDOs that used to be rated triple-A


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Fishing for the Bottom and CDSs Fritz Meyer, senior market strategist for mutual fund giant Ivesco Aim, says a

number of metrics he keeps his eye on-including the of new lows on the NYSEand the CBOE`s Volatility Index (the so- called fear index)-tell him that marketpessimism has gone too far

Barry Ritholtz, director of equity research at Fusion IQ, a NY financial researchfirm, says that while we may be at a nadir, the crisis now weighing on the market

an epic de-leveraging wave, a broken financial system, and a housing bust isfar more complex and fast-moving than either the dot-com collapse or oil shockrecession of the early 1970s

Exchanges have their eyes on the next opportunity: in early October 2008, theChicago-based company announced it was teaming up with Citadel, the hedgefund, to form an electronic marketplace and CCP for CDSs within 30 days

The ICE (InterContinental Exchange), the electronic exchange based in Atlanta,struck a deal with The Clearing Corporation a clearing house backed by bigusers of credit derivatives such as Goldman Sachs, Citigroup and JPMorgan tocreate a global clearing solution for CDSs

In Europe, Liffe, a subsidiary of NYSE Euronext, plans to start a CCP (Central

Clearing Counterparty) by the end of the year (2008), a head of Eurex, theEuropean derivatives exchange, which is aiming to launch by the middle of 2009 Without bank`s supprt, CME`s (Chicago Mercantile Exchange) solution may be

struggle to make inroads, as the CDSs market in the U.S. is dominated by asmall number of large dealers. On the other hand, the crisis has put a strain onthe dealers` ability to fund a CCP

Nasdaq OMX is investing USD 20 million in International Derivatives ClearingGroup, a venture that aims to be the first exchange to trade and clear OTC

interest-rate swaps, a much larger than the CDSs


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Credit Default Swap (1)

A protection buyer (say A) pays a premium(single or periodic payments) to the protectionseller (say B), but if a credit event occurs theseller (B) will compensate the buyer.

A - buyer B - seller

premium

Contingent payment

Reference asset : Bond


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Investing in a risky (credit-sensitive) bond isequivalent to investing in a risk-free bondplus selling a credit default swap.

For instance, that the risky bond sells at $90and promises to pay $105 in one year. Therisk-free bond sells at $100. Buying the riskybond is then equivalent to buying the risk-free

bond at $100 and selling a credit default swapworth $5 now. The up-front cost is the same,$100. If the company defaults, the final payoffwill be the same.



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It is important to realize that entering acredit swap does not eliminate credit riskentirely. Instead, the protection buyerdecreases exposure to the reference

credit but assumes new credit exposureto seller.

To be effective, there has to be a low

correlation between the default risk of theunderlying credit and of the counterparty



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Medium-Term Issues

First, so long as the global imbalances persist, the international currencysystem will remain vulnerable. Countries heavily dependent on exports for theirgrowth should adopt self-sustaining, domestic demand-led growth models

Second, the IMF`role in monitoring in monitoring financial markets and itsearly-warning functions to detect financial and economic crises in their initialstages need to be improved

Third, international development financial institutions should play an activerole in stabilizing the world economy Fourth, the governance structures of the IMF, World Bank and other bodies-

including the issues of quota shares and share of voting rights-need to bereviewed, to reflect properly the economic realities of the world today

Fifth, the Financial Stability Forum-an assembly of the financial supervisoryauthorities, fiscal authorities and central bankers of various countries

Sixth, the International Accounting Standards Board now stands at the centerof work which aims to achieve convergence in the accounting standards ofvarious countries

Seventh, rules governing credit rating agencies are being tightened, mainlythrough the International Organizations of Securities Commissions


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International Currency The major disadvantage to a country having its currency used

as an international currency is the demand for money may besubject to larger fluctuations than before The major advantage is that the country earns seignorage on

the other countries` holdings of its currency The other countries have to give up real goods and services to

add to their currency balances

It has been estimated that roughly 60 per cent of U.S. currency,is held abroad The U.S. currently profits whenever people in other countries

hold dollars that do not pay interest. Europe would give upgoods and factories in exchange for mere pieces of paper(dollar). Today Asia (China, Japan) plays the role of dollar

accumulator The USD`s status as a vehicle currency explains why dollarforeign exchange trading is such a high proportion of the total

A major activity for banks is trading with other banks. Longer-term positions are apparently considered too risky by banks


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Dollar Draws Strength Rather than sinking under the financial-sector bail out the USD is buoyant

That is a surprise to many who expected rising government spending and atanking U.S. economy to cripple the dollar Instead, the USD has benefited from the global flight from risky assets as well

as the unwinding of bets made with borrowed cash The scope of the crises also has helped (it is clear that economic and banking

woes are not unique to the U.S.) Since the start of September 2008, the USD has strengthen 8 % against a trade-

weighted basket of 26 currencies, according to a Federal Reserve Index The USD has risen so rapidly that investors warn that is due for a breather.Just as the USD benefited from the tumult in global markets, stabilization couldsee it give back some recent gains

In the longer term, the USD`s health remains dependent on foreigners` appetitefor U.S. assets, which may be tested as the economy falters and governmentspending grows

The dollar`s recent climb is part of a massive reversal of longstanding

investing trends, such as buying emerging-markets or wagering on risingcommodity prices. When investors retreat from such investments, they oftenselling them in exchange for dollars. After sending money overseas for years,U.S. investors now are bringing it home. In July and August, the latest monthsfor which Treasury Department data are available, U.S. investors sold USD 57billion more in foreign stocks and bonds than they bought the largest-eversuch repatriation


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COMMODITIES CONTRACTS

Commodities trades are rushing their private bilateral contracts intoexchanges and clearing houses as they race to reduce theircounterparty risk amid a deepening financial crisis

The transfer of the opaque over-the-counter deals comes as observerswarn that commodities, where trading has ballooned in the past fiveyears, could be the next market hit by counterparty failures

Martin Abbott, Chief Executive at the London Metal Exchange, said thecrisis was bringing new business into the LME as traders tried toreduce their risk

The LME`s move comes as other exchanges are pushing into OTCclearing business, in part to capitalize on the strong backing thatregulators have given to the creation counterparty model for the creditderivative markets

The aim is to reduce the systemic risks inherent when creditderivatives are negotiated bilaterally between traders by having aclearing house guarantee against default. Regulators` focus is on theUSD 58,000bn credit default swaps market. The commodities OTCmarket is market is estimated at USD 9000bn, according to the Bank ofInternational Settlements


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Fears Escalate on Corporate Problems

Fresh Signs of RecessionSlam Stocks

Japanese InvestorsAre Repatriating their Savings to Japan

(lifting JPY as a result: 93.06)

A SevereShock to Global Growth


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A Taxonomy of Trouble

Emerging Markets

Exports(Goods & Services)

Short of USD Cut Spending


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The Way Out (Joseph Stiglitz)

How We Got Here: the troubles we now face were caused largely by thecombination of deregulation and low interest rates. After the collapse of thetech bubble, the economy needed a stimulus. The Bush tax cuts didn`tprovide much stimulus to the economy. This put the burden of keeping theeconomy going on the Fed, and it responded by flooding the economy withliquidity

The economy had already overinvested, so the extra money was not put to

productive use. Low interest rates and easy access to funds encouragedreckless lending, the infamous interest-only, no-down-payment, nodocumentation subprime mortgages. It was clear that if the bubble gotdeflated even a little, many mortgages would end up under water with theprice less than the value of the mortgage. That has happened-12 million sofar, and more every hour. Not only are the poor losing their homes, but theyare also losing their life savings

The climate of deregulation that dominated the Bush-Greenspan yearshelped the spread of a new banking model. At its core was securitization:mortgage brokers originated mortgages that they sold on to others

Borrowers were told not to worry about paying the ever mounting debt,because house prices would keep rising and they could refinance, takingout some of the capital gains to buy a car or pay for a vacation


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The assumption: that house prices could continue to go up at arapid pace looked particularly absurd in an economy in which mostAmericans were seeing their real incomes declining

The mortgage brokers loved these new products because theyensured an endless stream of fees

They maximized their profits by originating as many mortgages aspossible, with frequent financing Their allies in investment banking bought them, sliced and diced

the risk and then passed them on-or at least as much as they could Bankers forgot that their job was to prudently manage risk and

allocate capital

They misallocated capital, with massive amounts going into housingthat was ultimately unaffordable Loose money and light regulation were a toxic mixture. It

exploded


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A Global Crisis: What made America`s recklessness truly dangerous isthat they exported it A few months ago, some talked about decoupling-that Europe would carry

on even as the U.S. suffered a downturn Wall Street was able to sell toxic mortgages around the world It appears that about half of the toxic mortgages were exported

Had they not been, the U.S. would be in even worse shape Moreover, even as the U.S. economy went into a slowdown, exports kept

the U.S. going But the weakness in America weakened the dollar and made it more difficult

for Europe to sell its goods abroad Weak exports meant a weak economy, and so the U.S. exported the

American downturn just as earlier the U.S. had exported its toxic mortgages But now the problems are ricocheting back The bad mortgages are contributing to forcing many European banks into

bankruptcy As market participants realized that the fire had spread to Europe, there

was panic (part of the concern is psychological)


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Recapitalize Banks

Stem the Tide of Foreclosures

Pass a Stimulus that WorksCreate an effective Multilateral Agency

(Global Summit:15 Nov 2008)

Restore Confidence

Through Regulatory Reform


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CHAPTER 4RECENT TRENDS IN THE GLOBAL CAPITAL MARKETS AND

BANKING INDUSTRY

BEAR MARKETS AND THEIR SUBSEQUENT RECOVERIES RARELY HAVE ACLEAR V SHAPE AND THIS ONE IS TRICKIER THAN USUAL


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KEY DRIVERS (1)

In order for capital markets to functioneffectively and in order for systemic risk tobe managed, there must be transparency

Without access to data, uncertainty arises,leading to unnecessary volatility andinefficiency

A goal of any financial regulation shouldbe to promote the transparency ofinformation

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KEY DRIVERS (2)

The technological breakthrough caused bythe eruption of e-banking and e-finance

Worldwide consolidation and consequent

restructuring

Increasing competition in terms of bothmarkets (geographic diversification) and

products A progressive relaxation of regulations and

huge interindustry acquisitions59


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KEY DRIVERS (3)

A slowing population growth andincreasing average life expectancy andper capita income

Since Western governments need to cutexpenditures for old-age benefits to keepdeficits under control, there will be an

increase in the importance of privatepensions, mutual funds, and privatebanking operations

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KEY DRIVERS (4)

The growing importance of a clear strategic intent in thebanking industry

Bank especially commercial banks, will be obliged torethink their strategic positioning

While some banks are opting to offer a vast variety ofproducts or services on a global scale, others arefocusing on some specific market segment (retailbanking. private banking, corporate banking) or specific

geographic area New competitor are entering the financial service

business

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The Monetary-Policy Maze In the world that existed before the financial crisis, central bankers were

triumphant They had defeated inflation and tamed the business cycle (the tool was short-

term interest rate and the target was price stability) The minimalist formula fitted the laissez-faire temper of the times. A growing

array of financial markets could price risk and allocate credit efficiently. Central bankers had merely to calibrate their interest-rate tools and all other

markets would automatically adjust.

Central banks still cared about financial stability and full employment, butcould argue these were the best served by stabilizing prices-withoutinterference from politicians

The financial crisis has upended all that. The business cycle was supposedlysubdued, yet the world is in the deepest recession since the 1930s

Deflation has become a more dangerous enemy than inflation; with interestrates in many countries at or close to zero, central banks have had to reach for

other tools Note (IMF): The April 2009 issue of the Global Financial Stability Report (GFSR)estimates that credit write-downs on U.S.-originated assets by all holders sincethe start of the crisis will total USD 2.7 trillion. Including assets originated inother mature market economies, total write-downs could reach USD 4 trillionover the next twoyears, approximately two-thirds of which may be taken bybanks


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The Fiscal Policy - Macroeconomists From the 1930s through the 1960s, most macroeconomists agreed that

government-spending increases and tax cuts-so-called fiscal policy-wereessential for avoiding deep recessions But over time, the conventional wisdom swung to the idea that interest rate

cuts by the Federal Reserve-monetary policy-were the best way to fightdownturns

The financial crisis arose, in large part, because companies and householdsborrowed too much. Macroeconomists should develop models that did allow

for the possibility of risks such as bubble in lending or a deterioration ofcredit standards (note: in early September 2008, the median growthforecast for the 4th qtr was 0.2%, the actual outcome was a 6.3% annualizeddecline. The Fed didn`t do any better. In July 2008, Fed officials projectedunemployment in the 4th qtr 2008 would end up between 5.5% and 5.8%.The actual number was 6.9%. Their projection for the 4th qtr of 2009, doneat the same time, was for a range of 5.2% to 6.1%. Today, withunemployment at 8.5%, most forecasters expect the rate to be nearingdouble digits by the end of 2009)

Now that fiscal policy is back on the table, economists are fighting over thesize of the ripple effect-or multiplier-of increased government spending

Obama Administration officials believe that their fiscal policy is on the righttrack

CHANCELLOR OF THE (WORLD)


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CHANCELLOR OF THE (WORLD)EXCHEQUER ~ G20

The world`s 20 most powerful economies ended their summit Thursday (02April 2009) with a set of measures that are hoped to function as a panaceato immediately cure the failing global economy

Key measures:1. G20 countries expect to have spent USD 5 trillion to counter the economic

crisis by the end of 20102. Multilateral agencies will get financing boost worth USD 1 trillion. Thisincludes a three-fold rise for IMF capital to USD 750 billion

3.The IMF will sell billions of dollars of gold reserves to help finance poorcountries

4.To smooth the trade flow, an extra USD 250bn will be allocated for tradefinancing

5. A concerted effort to shame and name blacklisted tax havens6. Setting out new rules on pay and bonuses for corporate executives7. Agreement to act urgently to conclude the WTO`s Doha round8. Establish a new Financial Stability Board (FSB) with a strengthened

mandate


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Financial Stimulus IMF officials say that aggregate G20 fiscal stimulus is so far worth 1.4 per

cent of GDP for 2009 and 2 per cent of GDP looks like what is needed USA: USD 787 billion (5.5% of GDP) Britain: USD 28.45bn (over 15% of GDP) Germany: USD 102.4bn (3.25% of GDP) Italy: USD 8.85bn (0.45% of GDP) France: USD 32.87bn (1.3% of GDP)

Canada: USD 31bn (2.5% of GDP) Russia: USD 62bn (5.4% of GDP) China: USD 585bn (13.3% of GDP) South Korea: USD 49.28bn (5.7% of GDP) Japan: USD 122.9bn (2% of GDP) Australia: USD 33.59bn (2% of GDP)

Indonesia: USD 6.1bn (1.3% of GDP) India: USD 4bn (0.4% of GDP) South Africa: USD 75bn (38% of GDP) Argentina: USD 30bn (?) Turkey: USD 0.43bn (1.5% of GDP)


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OBAMAS EXPENSIVE AGENDA

US Congressional Democrats overwhelmingly embraced President BarrackObama`s ambitious and expensive agenda for the nation on Thursday,endorsing a USD 3.5 trillion spending plan that sets the stage for thepresident to pursue his most far-reaching priorities

It might be as well as be spring: Banking firms like Wells Fargo, GoldmanSachs and JPMorgan Chase have pulled off a rare feat for banks lately:making profits.

Given what we have been through in 2008, it is understandable that we`dseize on any positive signs, be they the glimmers of hope PresidentObama detected in mid-April or Bernanke`s green shoots

We`ll know the recovery is real when some of the measurable activitybegins to match the rhetoric, when giant banks write checks ply to theTreasury to repay the cash they took last fall instead of simply promising todo so, when the rising expressions of consumer confidence begin to ring up

at the nation`s malls, and when the stock market rally is ratified by growth incompanies` underlying earnings Clearly, we`re not there yet. March retail sales disappointed-down 1.1

percent from February-and home foreclosures are on the rise again. Andthe month is likely to end with a deluge of dispiriting economic data morebig job losses and a rising unemployment rate

Catalyst of Risk (Lloyd Blankfein)


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Catalyst of Risk (Lloyd Blankfein) Risk management should not be entirely predicated on historical data. The

industry must do more to enhance and improve scenario analysis and stresstesting

Too many financial institutions and investors simply outsourced their riskmanagement. Every financial institution that participated in the process has toaccept its share of the responsibility

Size matters. Consequences of a miscalculation are obviously much bigger ifwe have higher exposure

Many risk models incorrectly assumed that positions could fully hedged. Wedid not, as an industry, consider carefully enough the possibility that liquidity

would dry up, making it difficult to apply effective hedges Risk models failed to capture the risk inherent in off-balance sheet activities,such as structured investment vehicles. It seems clear now that managers ofcompanies with large off-balance sheet exposure do not appreciate the fullmagnitude of the economic risks they are exposed to; equally worrying, theircounterparties are unaware of the full extent of these vehicles and, therefore,could not accurately assess the risk of doing business

Complexity got the better of us. The industry let the growth in new instruments

outstrip the operational capacity to manage them. As a result, operational riskincreased dramatically and this had a direct effect on the overall stability of thefinancial system

Financial institutions did not account for asset values accurately enough. Thefair value accounting which assigns current values to financial assets andliabilities is one of the main factors exacerbating the credit crisis. If moreinstitutions had properly valued their positions had properly valued theirpositions and commitments at the outset, they would have been in a much

better position to reduce their exposures

NEW MARKET EFFICIENCY LANDSCAPE


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NEW MARKET EFFICIENCY LANDSCAPE(MEMBERS OF THE EXCHANGE)

Establishing/improving benchmarks, which enable the pricing of bonds

Using auction-based systems to sell bonds, run according to internationallyaccepted principles

Encouraging financial institutions to engage in active liquidity management,for which they are likely to hold government debt. The deepening of thedomestic market for government debt will further strengthen thedevelopment of benchmark yields)

Concentrating debt instrument in a small set of standardized and liquidbenchmark issues, and setting a predictable issuing calendar Strengthening domestic money markets (market for repurchase

agreements, asset-back securities) Establishing/improving future contracts on government debt Encouraging the establishment of broker-dealer networks Improving clearing and settlement systems Improving credit rating agencies Improving monitoring and supervision capabilities of financial institutions

engaged in capital markets and enforcing accounting, auditing anddisclosure standards

Clearly defining a consistent legal and regulatory framework (see: CompanyLaw, Securities Law, etc)


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Integrity (Philip Armstrong) Integrity is key to gaining good governance. Recent failures in risk

management and poor decisions on credit exposures, setting in motion theglobal financial implosion, are some of many issues triggering questions aboutthe efficacy of corporate governance

Entire businesses lacked parental supervision, with rouge wunderkidsrecklessly gambling away capital

There are questions, too, about the shareholders and their poor exercise ofpower, if not impotence, in influencing board composition, conduct anddecisions.

Management proposals generally pass and uncontested directors receive mostof the votes Activism has risen, but the evidence suggests that investor activism alone has

not improved companies long-term operating or share price performance There is much blame to go round, particularly with share prices in free fall Best practice dictates that effective boards provided strategic vision, monitor

management and act transparently to ensure full accountability toshareholders

Directors must have a well-articulated view of the business, market conditionsand main performance metrics

Fiduciary obligations include identifying and monitoring risks, with incentivesthat reward prudence

Internal controls must ensure that financial and operational reports are basedon accurate, truthful information


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Integrity cont`d Sound corporate governance practices inspire investor and lender

confidence, spur domestic and foreign investment and improve corporatecompetitiveness When trust deteriorates in a board and the company it governs, investors

run in panic from the falling knives Despite the justifiable scepticism, it is only through corporate governance

abiding by the letter and the spirit of a regime in which the interest of theowners are a directors reliable compass that trust and confidence can be

restored It starts with shareholders. They own the company (PLCs and Members of

the Exchange). Only when all shareholders act as owners will companies bebetter managed (part of the solution to restore trust and rebuild capitalmarkets)

Boards need to communicate better and engage shareholders. Meaningfulchange will come only when shareholders are perceived as worthy peers

Skilful, detached navigation builds trust with management internally andinvestors, vendors, customers, and other stakeholders externally

Integrity (character) drives how we behave. Character cannot be instilled byregulation or law. It is built by meeting life with honesty and courage,learning through successes and failures


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Ranking the Devils Washington delayed until too late the clear post-Lehman solutions: rapid

liquidity injections by the Federal Reserve, mortgage-rate cuts,transparency for credit default swaps, mark-to-market allowances forregulatory capital, an uptick rule, and active enforcement of tradingregulations

The consequence is a federal government expansion that locks the U.S.into huge deficits and national debt, spelling abridged economic freedomsand deep government intrusion into the pursuit of happiness

Regarding a U.S. comeback, we`re told debt is worse than dollar weakness.Debt has been demonized, yet bigger debt markets and more mortgagesare a necessary part of the solution

A large deficit is inevitable because of the recession`s wallop to federal taxreceipts

In contrast, dollar weakness isn`t inevitable It would be another bad Washington choice, a hammer blow to living

standards and a terrible denouement to already devastating job losses andeconomic contraction

During the 2002 2007 Bush-era expansion household debt grew fromUSD USD 8.5 trillion to USD 14 trillion, an increase of 65% versus only a33% increase in personal income


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Ranking cont`d Liquid assets, such as savings bonds time deposits and direct stock

holdings, grew 68% in that same period, from USD 15 trillion to USD 25trillion

Consumption growth was generally less in this expansion than in the 1990s,where three-year-average real consumption growth hit 5% versus a peak of3.4% in the 2000s

America`s bank may well need more help. Most lenders cannot borrowwithout state guarantees

The IMF has just had a stab at estimating the size of the new equity that isneeded. This is based on writedowns of USD 550bn over the next two years(on top of the USD 510bn already booked)

It concludes that American banks need USD 275bn to keep their tangiblecommon equity above a floor of 4% of assets

The Treasury has only USD 110bn left in its bail-out kitty

That suggests the heavy lifting will be done by hybrid instruments, such aspreference shares, which are classified as tier-one capital but which actmore like debt. America`s ten biggest banks have USD 300-odd billionworth, about half of it from the state. Their capacity to absorb losses wouldrise if this was converted into common stock, which is the purest form ofcapital since it need not pay dividends


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NEW CORPORATE FINANCE LANDSCAPE

Maintain adequate funding positions Solidity core banking relationships while reducing

overall reliance on bank credit Extent debt maturity profile

Review dividends and share buybacks Drive value through consolidation and asset sales Adjust cost of capital Review capital structure

Protect credit rating Improve cash management and working capitalmanagement

Diversify funding resources

CHAPTER 5 RISKS


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CHAPTER 5 RISKS(HOPE FOR A FIGHT-BACK)

KEY DRIVERS (1)


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KEY DRIVERS (1) Banks transfer or offload risks, such as interest rate

risks or default risk, to other institutions by sellingloans

If more conventional (vanilla) type risks were beingtransferred and in turn replaced with complicatedrisks, a bank`s balance sheets may become less

transparent Risks-transfer does not completely eliminate risks

from a bank`s balance sheet Therefore, it may be advantageous for banks to hold

on to some default risks in order to monitor risks forimproving loan quality and to be used as referencepoints for potential buyers

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KEY DRIVERS (2)


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KEY DRIVERS (2) As a result, risk-transfers are

at times being replaced with amore advantageous risk-

warehousing since there is noindication that transferringrisk makes banks any safer

In some cases, banks mayactually become riskier

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S


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The Swap Exchange Jeffrey Sprecher`s ICE is the front-runner in the new frontier for exchanges:

credit default swaps (CDSs) CDSs are the new frontier for exchanges. The esoteric instruments-whose

values are pegged to the performance of an underlying security or indexare essentially insurance policies if borrowers fail to make debt payments.The market for such instruments became so large and complex in recentyears that some firms lost track of their deals

The government has spent months untangling the web of contracts sold by

insurer AIG. That`s why industry players, at the best of regulators, arepushing to create a more transparent exchange, not unlike those for stocksand bonds

So far, only ICE has a system up and running, with CME Group, NYSEEuronext, and Eurex planning to launch similar ventures in the comingmonths. In March, Sprecher started the ICE Trust, a clearing house forCDSs that processes and guarantees trades between firms. If one party

goes belly-up, the clearinghouse covers the losses. CME Group, which has joined up the hedge fund Citadel, plans to entice bigbanks to its exchange by cutting costs and expanding the list of tradedinstruments. CME says it will allow firms to trade swaps tied to theperformance of indexes (like ICE) but also swaps tied to individualcompanies

Beautiful Bonds


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Beautiful Bonds(Out of the piles of Dubious Mortgages)

Wall Street, the rating agencies, and regulators were blinded bythe science of securitization (bundling ordinary debt like creditcard balances, car loans, and mortgages into vast pools, thenissuing bonds backed by those pool)

It was a gigantic money machine for the Wall Street, but itcreated a system that was unprecedented in its complexity and

opacity Complex securities are often priced from models that assume,in what may be the apogee of wishful economic thinking, thatthe underlying assets will behave exactly as they havehistorically

That has always been a weakness of model-based valuation,

but it is particularly problematic when the securities are newand untested When the complexity of a security has the effect of decoupling

of its value from that of the underlying asset, it can be verydifficult to know what that security is truly worth

Recession


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Recession A common definition of recession is a period during which real GDP decreases

its growth is negative for at least two successive quarters The most recent recession began in the first quarter of 2001 and ended in the

3rd quarter of 2001. This recession lasted for three quarters The recession of 2001 was milder than recessions of 1990 1991 and 1982, but

compared to earlier recessions these recessions were mild The biggest decrease in real GDP occurred during the Great Depression of the

1930s A large decrease also occurred in 1946 and 1947, after a huge World War II

expansion

In more recent times, serious recessions occurred during the mid 1970s andduring the early 1980s Each of these economic downturns was more severe than those in 1990-1991

and 2001 Rescue Plans: U.S. (Total: USD 700bn, recapitalization: USD 250bn, guarantee:

USD 250 K/account, liquidity injection: USD 900bn); U.K. (Total: USD 691bn,recapitalization: USD 64bn for 3 banks, guarantee for interbank loans: USD439bn, guarantee for deposits: USD 87,857, liquidity injection: USD351bn),Germany (Total: USD 680bn), Irlandia (Total: USD 544bn), France (Total: USD492bn), Russia (Total: USD 200bn), Asia (Total: USD 80bn)

IMF (April 22, 2009; website): The global economy is in a severe recession inflicted by amassive financial crisis and acute loss of confidence. While the rate of contraction shouldmoderate from the second quarter onward, world output is projected to decline by 1.3 percent in 2009 as a whole and to recover only gradually in 2010, growing by 1.9 per cent.Achieving this turnaround will depend on stepping up efforts to heal the financial sector,while continuing to support demand with monetary and fiscal easing

A Fate Worse than Debt


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A Fate Worse than Debt

What hurts finance affects the rest of the economy in spades Tim Bond, of Barclay Capital, reckons that, thanks to the

gearing effect, a short fall of bank capital of around USD 170billion may reduce the potential supply of credit by USD 1.7trillion

A cut in overall lending would be a complete reversal of trend Morgan Stanley reckons that total debt (ie, the gross debt ofhouseholds, companies and government) has risen inexorably

since 1980 to more than 300% of GDP, higher than it was inDepression

The danger is of a second-round effect, as crisis in financeaffects the economy, leading to further problems in finance.

Mortgages may be the problem asset of the moment but nextyear the worry may be about credit cards, car loans andcorporate debts

The Bush administration`s rescue plan aims to arrest this de-leveraging cycle

` S


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Depression and Keynes` Solutions From 1929 through 1933, the United States saw real

economic output fall by nearly a third andunemployment soar from 3 per cent to 25 per cent Stock prices took a quarter century to regain their

peak. Since then, referring to an economic downturnas a depression has been seen as alarmist

Even the worst postwar downturn, from 1973through 1975, saw US output , from quarterly peak totrough, fall by almost 3 per cent and unemploymentrise to 8.3 per cent, but a different order ofmagnitude entirely

Keynes` solutions, including greater public spending(funded by borrowing), pumping money back to intothe economy by some means. The criticisms thatthis will fuel inflation and raise budget deficits arestill heard but are increasingly as irrelevant (?)

Vi l f R t S i


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Violence of Recent Swings Many market players have never before seen a world where almost all asset

classes can swing wildly in value These days a new phrase is needed to describe these Not-So-Moderate-After-

All times (The Great Panic, perhaps?) The gyrations of the yen, euro, sterling and dollar have also been wild, pushing

levels of currency volatility to heights barely seen in decades The cost of the recently announced bail-out and funding programs for the U.S.

financial system looms over the U.S. government bond market

But the timing is far from ideal because issuance is about to surge just at atime when the ranks of dealers has thinned and their capacity to buy new debtis impaired

Just how much new Treasury issuance enters the market depends on theultimate cost of bail-outs for banks, the deterioration of taxation receipts andthe rise in government spending as the economy weakens and as the FederalReserve`s balance sheet expands

Before the recent upheavals, the U.S. budget deficit for the fiscal 2009 financialyear starting this month was estimated between USD 400bn and USD 450bn.Some economists now expect now expect that figure to reach USD 1 trillion.That will push Treasury debt sales sharply higher

James Jackson, portfolio manager at RiverSource Investments: It is prettyconservative to say that the cost of the bail-out will be USD 1,000bn and by thetime all the programs have been tallied, it could be USD 2,500bn

CHAPTER 6


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CHAPTER 6

INVESTMENT MANAGER BEHAVIOR

KEY DRIVERS (1)


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KEY DRIVERS (1)

Market integration was the product of keychanging forces that had allowed for a wider yetless sophisticated pool if investors

There are incentives to take hidden tail risksbecause these risks are not only unobservableto investors, with low probability of occurring andhigh alphas , but also typically are not included

in the comparison benchmark

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KEY DRIVERS (2)


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KEY DRIVERS (2)

Herding occurs when investment managersfollow the trend and adopt similar investmentstrategies of their peer group

While banks were able to receive large cashinflows and subsequently facilitated liquidityback into the system during the downturn in1998, banks were reluctant to provide liquidity to

borrowers even after the Central Bank hadinjected billions of dollars during 2008 to avoidlosses due to uncertainty

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Th B t R i B tt W d II


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The Best Recipe Bretton Woods II

Since the closure of Lehman Brothers triggered a global bankingpanic, political leaders in the US and Europe have successfullythrown a cordon round their banks to prevent financial meltdown

What they have not done yet is to co-ordinate macroeconomicpolicies to stop a steep global downturn (note: this is the urgentagenda). A US downturn will not be avoided

US households cannot continue to spend more than their income asthey have in recent years, even if the credit crunch eases.Household consumption is bound to fall steeply

The write downs in US household wealth from the reversals inhousing and equities will probably reach USD 15,000bn and theresulting steep decline in private consumption and investment could

reach about one-tenth of that amount Some other economies will also suffer home-grown recessionsbecause they too allowed a housing bubble to develop, which hasnow burst. This to appears to be the case in Australia, the UK,Ireland and perhaps Spain.

U S F d` N I iti ti (1)


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U.S. Fed s New Initiative (1)

The U.S Fed dramatically stepped up its efforts to support strained creditmarkets, unveiling USD 800 billion in new programs aimed at boostingconsumer credit and the market for mortgage-backed securities

The moves effectively push the Fed further into realm of quantitative easing-essentially creating cash and using it to fund new lending facilities-at a timewhen official interest rates are approaching historic lows

Under the TALF (Term Asset-Backed Securities Loan Facility), the NY Fed

will extend as much as USD 200 billion in non recourse loans to holders ofasset-backed securities backed by highly rated consumer and small-business loans. Government officials said they hope to have the program.Mr. Paulson called that USD 200 billion figure a starting point and said theprogram could be expanded. Treasury is providing USD 200 billion in fundsunder the TARP (Troubled Asset Relief Program) as credit protection for thenew lending facility. That leaves only USD 20 billion of the original USD 350

billion allocated under TARP that has not already been committed to avariety of programs Mr. Paulson said that there is no timeline for officials to request the second

USD 350 billion available under the financial rescue plan passed byCongress last month.

U S F d N I iti ti (2)


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U.S. Feds New Initiative(2) The USD 20 billion commitment of TARP funds limits Treasury`s

ability to take further steps under the financial-rescue plan unless itasks Congress for the second USD 350 billion installment of thefunds

With the November 25, 2008`s USD 20 billion commitment, theTreasury has now used USD 330 billion of the original USD 350billion that was authorized under the law, including USD 250 billion

in capital injections to the banking industry, USD 40 billion to AIGand USD 20 billion to Citigroup The Fed also said it will purchase as much as USD 100 billion in

indirect debt of Fannie Mae, Freddie Mac, and the Federal HomeLoan Banks and as much as USD 500 billion of mortgage-backedsecurities backed by Fannie, Freddie and Ginnie Mae (GSEs =

Government Sponsored Enterprises) The fed-funds rate is currently 1 %. A growing chorus of economistssay the fed could reduce that rate to zero by January, making stepssuch as Nov 25, 2008`s critical to stabilizing markets and stimulatingthe economy

F f D fl ti


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Fears of Deflation

The spectre of looming deflation drove government bond yields on bothsides of the Atlantic to historic lows yesterday as nervous investors soughtsanctuary from the turbulence in equities and other asset classes

Some U.S. Treasury bills were quoted at 0 per cent, while the 2-year noteand the 30-year bond recorded their lowest yields since they were firstregularly issued in the 1970s. The 5-year note was at its lowest since 1954,based on historical data from the Federal Reserve. In the U.K., the two-year

gilt dropped to its lowest level since since the second world war Buying government bonds as a safe heaven investment has dominated

flows in the recent months. The latest moves come as increasingly worryingeconomic data point to rising unemployment and plunging inflation

Given the recent deflationary data, not just in the U.S globally, the world isstarting to build in a Japan-style deflationary scenario, said Jim Caron,head of interest rate strategy at Morgan Stanley.

Recently, the Federal Reserve`s effective Fed funds rate has traded ataround the 0.25 percentage point level, well below the target rate of 1 percent

Bill O`Donnell, a strategist at UBS, said the bond market was reacting to thevery low effective Fed funds rate and the possible start a deflationary period

A i ` A t ti Big Th


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America s Automotive Big Three Intense lobbying effort by Chrysler and its two bigger Detroit-based rivals-

General Motors and Ford-to persuade US lawmakers to approve USD 25bnrescue package (note: latest news: USD 15bn?)

Congress aimed at averting the collapse of the industry that accounts forabout 4 per cent of GDP but is quickly running out of cash

Were either GM or Ford to go bankrupt, it would mark the biggest businessfailure in US history. The Detroit carmakers operate 105 US assembly andcomponent plans, with close to 240 K employees. They provide healthcare

benefits for 2m Americans and pensions for almost three-quarters of amillion people Carmaking has one of the largest multiplier effects of any industry for

every job, at least seven more people are employed indirectly Which way to turn: for a rescue: economic impact from job losses, chain

reaction (other bankruptcies), cost/benefit (tax and welfare drain),quality/efficiency already better, national interest (as in aerospace); against:

history (bad at Chrysler), moral hazard (more aid pleas later), reward formediocre management, resources freed for better sectors, precedent(would airlines be next?)

It is the largest experiment of social re-engineering that any country hasever undertaken (John Plant, CEO of Partsmaker TRW): the failure tomaster small cars, failure to cut costs, failure to get though with the UAW,failure to improve fuel efficiency (the failure to learn)

Secures Loan


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Secures Loan Indonesia has secured USD 5 billion in standby loans

from several parties to help plug the budget deficit andkeep the economy growing amid the global financialcrunch that has made it difficult to raise funds

Loans from Australia, the Asian Development Bank andthe World Bank could be drawn upon whenever

Indonesia needed them The 2009 budget deficit is earmarked at IDR 53 trillion(USD 4.55 billion), half of which will be financed byissuing bonds

The remaining USD 2.8 billion is expected to be obtained

from bilateral and multilateral institutions In addition to the standby loans, Indonesia has signedbilateral swap agreements (BSA) with Japan, China andSouth Korea worth USD 6 billion, USD 4 billion and USD2 billion respectively, to support a possible liquidityshortage

E t C it l R t C t St k M k t


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Extra Capital-Rates Cuts-Stock Markets Europes fight against recession: The bloc`s 27 ministers decided to raise

the EIB (European Investment Bank)`s capital by Euro 67 billion to Euro 232

billion The NBER (National Bureau of Economic Research) said that a 73-montheconomic expansion that started in November 2001 had ended inDecember 2007

The question for many economists now is how long and severe therecession will be

Australia` central bank cut its official cash rate by one percentage

(02/12/08), its fourth reduction in a s many months, with economistspredicting more cuts next year as the country attempts to stave offrecession

The pound lost ground against the USD and weakened against the Euro.Last month the BoE slashed rates by 150 bps to 3 per cent. The BoEslashed further 100 bps of rates cuts. The ECB slashed rates by 75 bps to2.5 per cent. The Central Bank of NZ cut rates by 150 bps to 5 per cent

This year has been a disaster for savers. The value of stock marketsaround the world has fallen by almost half and is now about USD 30 trillionbelow its peak. The prices of corporate bonds and commercial propertyhave plunged. Anyone who diversified into commodities, hedge funds andprivate equity has also lost out. Even those shrewd enough to stick theirmoney in a savings account have had to worrty about their safety of thebanks

CHAPTER 7


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CHAPTER 7

FINE TUNING (PRUDENTIAL)

KEY DRIVERS (1)


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KEY DRIVERS (1)

One micro-prudential reason for supervisionincludes protection of investors; however, thereseems to be no interest in public policy to protectinvestors who are not afraid to invest with thehedge funds

On the other hand, the basis of macro-prudentialsupervision, such as regulations, to prevent

herding behavior that would cause massiveasset price shifts in the market or serioussystemic threat, is well-founded

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KEY DRIVERS (2)


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KEY DRIVERS (2)

Instruments for prudent supervision include toolsfor monitoring, disclosures, capital requirements,and incentives

Going forward, capital requirements should alsotake into consideration tail risk for extremecorrelation, such as 2008 downturn

Nonetheless, while these capital levels may

provide a possible safeguard to insolvency forthe institution, they have a limited impact onilliquidity

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KEY DRIVERS (3)


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KEY DRIVERS (3)

Capital should act as a budget constraint for the risk thatan institution ultimately takes

The level of the capital re inflation, requirements onmortgage lending should be in line with changes in home

prices relative to core inflation, while capitalrequirements for lending to construction and propertyshould be set in accordance with changes in propertyvalues

Having the right incentives for investment managerscould be another effective prudential supervisionmanagement

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KEY DRIVERS (4)


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KEY DRIVERS (4)

Incentives should be designed to make sureinvestment managers are taking control of risks

Issues related to these incentives will need to be

addressed to make sure managers are notoverly conservative in their investmentdecisions, taking excessive risk in order toincrease asset value, and/or manipulating

accounting rules in an effort to increase stockprices

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Global Imbalances


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Global Imbalances The world has run out of willing and creditworthy private borrowers

The spectacular collapse of the western financial system is a symptom ofthis in fact In the short run, governments will replace private sectors as borrowers But that cannot last for ever. In the long run, the global economy will have to

rebalance. If the surplus countries do not expand domestic demand relativeto potential output, the open world economy may even break down. As inthe 1930s, this is now a real danger

To understand this, one must understand how the world economy hadworked over the past decade A central role has been played by the emergence of gigantic savings

surpluses around the world In 2008 according to the forecasts from the IMF, the aggregate excess of

savings over investment in surplus countries will be just over USD 2,000bn In 2008: The oil exporters are expected to generate USD 813bn. China

(USD 399bn), Germany (USD 279bn), Japan (USD 194bn). As a share ofGDP, China`s current account surpluses is forecast at 9.5 %, Germany`s at7.3 %, and Japan`s at 4 %. In 2008, the big deficit countries are the U.S.,Spain and the U.K., France, Italy and Australia. The U.S. is far and awaythe biggest borrower of them all. The six countries are expected to runalmost 70 % of the world`s deficits

Damages


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Damages The damage will vary from one person to the next, depending on where

they have put their money, so figures on pooled portfolios are pretty muchthe only way of estimating savers` pain The Investment Company Institute, the national association of American

mutual funds, says value assets in was USD 9.6 trillion at the end ofOctober 2008, USD 2.4 trillion less than at the end of 2007

The Congressional Budget Office (CBO) calculated in October thatAmerican calculated in October that American pension funds had dropped

in value by USD 2 trillion in the previous 18 months. By the way ofcomparison, the BoE estimates that USD 2.8 trillion has been lost in credit-related instruments, the devices that dragged the financial system down inthe first place

Financial Services: this is the heart of the heart of darkness for AIG. Thedivision wrote more than USD 2.7 trillion in derivatives contracts. Investorsused one kind-called credit-default swaps-to hedge against bonds going

bad. Banks bought the swaps, reassured by AIG`s AAA debt rating, to fulfillcapital requirements. When the bonds AIG insured against started to tankand the insurer`s own rating was cut, it all came crashing down

Why it`s a risk: AIG is still on the hook for as much as USD 300bn inpotential CDS losses. Yet the company has a book value of only USD 50bn.That means if AIG has to pay out on those contracts, it will go bankrupt

Adding Up The Global Bailout


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US: USD 700bn for bank bailouts; USD 300bn more in guarantees for mortgages. The Fedcut benchmark from 5.25% to 1 %. Has increased its bank lending and other assets by USD1.3 trillion over the past year. Stimulus package: USD 150bn

UK: Tax cuts worth USD 23bn expected, USD 116bn to recapitalize banks and USD 311 bnearmarked to allow banks to exchange illiquid securities for government debt. GuaranteedUSD 389bn in new bank debt

Ireland: Government has pledged to guarantee all loans and deposits at Irish banksthrough 2010, a commitment that could total USD 554bn. Banks must aside USD 2.5bn tocover losses

Benelux countries: money injected into 6 troubled banks France: USD 13bn spent to recapitalize banks with a pledge of USD 37bn more if needed;

USD 403bn is available to guarantee interbank transactions Spain: USD 48bn stimulus package, USD 63bn to buy bank assets, USD 127bn in

guarantees for new bank lending Germany: USD 25bn in tax breaks for new cars, capital investment, and infrastructurespending, USD 101bn in new capital for banks, USD 25bn to cover bad loans, guaranteedUSD 504bn in interbank loans

Switzerland: provided USD 5bn in capital infusions and will assume USD 60bn in toxicsecurities from UBS, USD 1.3bn stimulus plan

Russia: includes USD 50bn credit line to refinance corporate debt; USD 88bn in loans tobanks; USD 19bn to support stocks

India: USD 4bn in loans to mutual funds, USD 37bn in new money for loans China: two-year stimulus package (1/3 for rural infrastructure and social services, forrailroads, highways, and airports; the rest to be spent on health, education, housing andmore

South Korea: USD 25bn stimulus package, USD 55bn in loans (exporters), USD 100bn inguarantees for banks

Japan: two stimulus packages include tax cuts, tax breaks on new mortgages, lowerhighway tolls, and credit guarantees for small businesses. An additional USD 322bn in loanguarantees (SMEs)

IMF WORLD BANK


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IMF-WORLD BANK To protect the poorest, the Bank has set up the Vulnerability Financing Facility

recent changes to the global financial lanscape

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