Jungmann sagemann financial crisis in eastern europe; road to recovery (2011)

This caused severe losses for banks and investors which were exposed to the real estate market via subprime- and Alt-A mortgage loans, MBS or Collateralized Debt Obligations CDO and othe

Jens Jungmann / Bernd Sagemann (Eds.)

Financial Crisis in Eastern Europe

GABLER RESEARCH

With a foreword by Michael Müller-Wünsch

and an epilogue by Dirk Schreiber

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detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.

1st Edition 2011

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At the end of the first decade of our new century the global economic system was buffeted by unexpected events The global economy had not been prepared for such developments At the outset the imminent disruption might have been dis-cussed within the confined circles of political committees and intellectual societies, but never in depth by senior general management in the global business commu-nity or the public sector But this global crisis is comprised of many regional jigsawpieces and the events were triggered and accelerated by the so-called domino effect as a consequence of the interlinking and interlocking worldwide financial and trade systems Nevertheless they need to remain fitted together if our global system is to function in the future too In such circumstances we routinely tend to place our focus on regions like the US, mainland Asia, South America, Middle East

or Western Europe

This book addresses an area of great economic interest in a manner never seen before Eastern Europe is one of the jigsaw pieces and dominos which fall into the maelstrom of the global developments Yet, this is also a very specific region with var-ious culture differences on one hand and manifold different economic foun dations

on the other The editors, Dr Bernd Sagemann and Jens Jungmann, took the oppor tunity to combine their personal knowledge of this region with local knowledge gathered from experts on the ground to bring about a compelling and comprehen-sive status report with regard to Eastern Europe The thorough analyses and the depth of each country description contained in the book provide an overview of the financial and economic potential and capabilities of the Eastern European region which has never been the case before

-Therefore, we would like to thank the editors and the individual authors for their efforts and contributions in generating a valuable and enhanced understanding

of this region, which along with the BRIC countries, is one of the most fascinating developing regions of our hemisphere This book is a unique conception and should become a standard for the evaluation of the financial and economic status of the region for practitioners and likewise for the scientific community

With the in-depth knowledge derived from these comprehensive essays, we should hopefully be more prepared for future economic developments, and events such as the global financial meltdown should no longer be such a surprise.

I expect that many readers will appreciate the straightforward and accessible style with which this publication treats this complex matter

Berlin, December 2010

Prof Dr.-Ing Michael Müller-Wünsch

“The story of the boom and crash of 1929 is worth telling for its own sake Great drama joined in those months with a luminous insanity But there is the more som ber purpose As protection against financial illusion or insanity, memory is far better than law

When memory of the 1929 disaster failed, law and regulation no longer sufficed For protecting people from the cupidity of others and their own, history is highly utilitarian.”

John Kenneth Galbraith (The Great Crash 1929)The end of a journey always comes back to its beginning Why do financial crises occur? Do they have the same root causes? Are the solutions the same? Ten years af-ter the Asian financial crisis 1997-98 ended, the US subprime crisis in autumn 2008 had plunged the world into a deep recession The parallels to the previous regional and global crises, especially the great Depression of 1929-33, are obviously The world financial crisis 2008-2010 has hit Central and Eastern Europe harder than the rest of the world – the Eastern Europe financial crisis resembles the Asian financial crisis of 1997-98 within the same fundamental problems of excessive inflows of short-term bank credits, enticed by pegged exchange rates, leading to large private foreign debt.This publication firstly gives a general overview about the great subprime credit crisis and its spill-over to Eastern Europe Subsequently the countries Bulgaria, Czech Republic, Hungary, Lithuania, Poland, Romania, the Russian Federation, Serbia, Slovakia and Ukraine are analyzed with regard to their individual situation before this era, the impacts being faced, their attitudes and forces against the effects and their position afterwards, giving an outlook for the upcoming years

Special thanks are given to the authors of the country profiles and their lasting spur during editing Particularly many thanks to Ms Agnieszka Ogórkiewicz and

Mr Richard Scalé, Rödl & Partner, who both rendered the timely publication possible with their great commitment

Hamburg, December 2010

Foreword _ 5Preface _ 7Overview _ 9List of Abbreviations _ 11

The World Financial Crisis 19

The Great Subprime Credit Crisis and its Impact on Eastern Europe 21Bernd Sagemann & Peter Reese

SpeciƂ c Areas of Crisis in Eastern Europe _63

Bulgaria: The Deferred Crisis 65Minko Karatchomakov

Czech Republic: Crisis Postponed – Navigation to Recovery 109Rene Vazac

Hungary: A Country Hit Hard 177Roland Felkai

Lithuania: The Return of Opportunities 257Tobias Kohler

Poland: (Po)Land of Opportunity 315Jens Jungmann

Romania: Politics do matter 377Joerg Gulden

Russian Federation: The Rocky Road _ 413André Scholz

Serbia: Serial Tensions amidst Recovery _ 471Nicole Arnold

Slovakia: Small Land of Big Changes 517Maroš Tóth

Ukraine: Impact and Recovery from the Crisis 581Klaus Kessler

Epilogue 621

Financial Crisis in Eastern Europe: Road to Recovery 623

Editors` Vita _ 631Authors` Vita 633

List of Abbreviations

bbl Barrell

BG Bulgaria

CESEE Central East and South East Europe

DE Germany

ECOFIN Economic and Financial Affairs Council

HUD Department of Housing and Urban Development

IR Ireland

IRB Investiêná a rozvojová banka

km Kilometer

MAV Hungarian State Railways

No Number

NSZZ Niezaleŏny Samorzâdny Zwiâzek Zawodowy „Solidarnoıä” –

Independent and Self-Governing Trade Union Solidarnoıä

OLAF European Anti-fraud Office

Q Quarter

RO Romania

SIEPA Serbia Investment and Export Promotion Agency

SLO Slovenia

TN Trenêiansky Region (Slovakia)

Democratà Maghiarà din România

Uniunea Nationala pentru Progresul Romaniei

USA United States of AmericaUSD US-Dollar

y-o-y year-on-year

The World Financial Crisis

The Great Subprime Credit Crisis and its Impact on Eastern Europe

Bernd Sagemann & Peter Reese

22 | Bernd Sagemann & Peter Reese

“Collateralized debt obligations … have gotten much too sophisticated, are priced

by extraordinary mathematical models, and are very difficult to value I think people are going to be frightened to deal with those things for a long time

A lot of them are just going to disappear, because they’ve been tried; they don’t work.”1

Alan Greenspan, September 2007

The current global financial crisis is the worst the world has seen since the Great Depression during 1929-33 In 2008, clouds were gathering on the financial hori-zon US house prices had peaked in 2006 and adjustable mortgage rates had risen, damaging the balance sheets of highly indebted households and undermining faith

in mortgage-backed securities (MBS) It became evident that a variety of tized assets, some quite highly leveraged, were far riskier than advertised

securi-Prior to September 2008, global aggregate demand had remained robust Trade was not in rapid decline The biggest problem many countries were facing was the spike in commodity prices in the previous 18 months, peaking in the spring and the summer of 2008.2 The burst of the bubble and the following subprime credit crisis evolved into a global credit crunch with a prolonged impact on the financial archi-tecture as well as the real economy worldwide In particular in the Eastern Euro-pean countries, emerging after the fall of the ‘iron curtain’ and some of them after joining the European Union, have been suffering considerably

1 Kevin Phillips, Bad Money, 2008, p 96.

2 Commission on Growth and Development, Post-Crisis Growth in Developing Countries, A Special Report of the Commission on Growth and Development on the Implications of the 2008 Financial Crisis, 2010, p 5.

J Jungmann, B Sagemann (Eds.), Financial Crisis in Eastern Europe,

2 The Great Subprime Credit

Crisis and its Global Impact

The severe worldwide recession – which in most countries began to show up

in 2008 – was triggered by the housing bubble in the USA This kind of economic bubble affected a vast part of the US housing market On the domestic level, US house prices more than doubled from 2000 to 2006 but started to decline from summer 2006 onwards Between July 2006 and June 2009 the S&P/|Case-Shiller Home Price Index shows a price drop of about 33% for average US house prices For 2008 only, the average US house prices fell by nearly 20% which is the largest annual decrease in the index history.3

As a result the average foreclosure rates among US homeowners more than pled from about 1|million per month in 2006 to above 3 million per month in 2008 This caused severe losses for banks and investors which were exposed to the real estate market via subprime- and Alt-A mortgage loans, MBS or Collateralized Debt Obligations (CDO) and other securitized debt instruments which were financing the housing bubble The extent of the losses resulting, led to a severe credit crisis which has become publicly known as ‘the subprime credit crisis’

tri-The subprime credit crisis triggered unprecedented turmoil in the worldwide capital markets The crisis started to become public for the first time on 4 March

2007 when HSBC announced a write-off of 11 billion USD in subprime related mortgage debt, which was followed by a series of banks and hedge funds that had

to declare huge losses and were forced to recapitalize In summer 2007 the crisis infected several money market funds which invested in structured credit securities and in consequence were impelled to close the fund In 2008 the crisis developed further: firstly the collapse of Bear Stearns in March and later Washington Mutu-

al, which were both taken over by JPMorgan The crisis culminated in September

2008 when Lehman Brothers went bankrupt – the largest bank bankruptcy in tory so far – and Merrill Lynch had to sell itself to the Bank of America (BoA) At the same time the two remaining American investment banks, Goldman Sachs and

in the value of the residential real estate market in 20 metropolitan regions across the US To measure housing markets, the indices use the repeat sales pricing technique developed by Karl Case and Robert Shiller This methodology collects data on single-family home re-sales, capturing re-sold sale prices to form sale pairs Cf Standard & Poor’s, S&P/|Case-Shiller Home Price Indices, 2009, http://www2.standardandpoors.com/spf/pdf/ index/CS_HomePrice_History_063055.xls (retrieved on 25 July 2009).

Morgan Stanley, applied for a bank license and were seeking financial support from outside investors ending up selling stakes to Warren Buffet and Mitsubishi Finan-cial Group respectively.

In the following months several of the world’s largest banks and financial tutions had to be bailed out by the taxpayer and as a result were (partly) national-ized – among those banks Citigroup Corp., BoA, AIG, Royal Bank of Scotland, Hali-fax Bank of Scotland/|Lloyds TSB, Fortis, Dexia, Hypo Real Estate or Commerzbank From the beginning of the crisis in 2007 until the first half of 2009 just in the US the total number of regional banks which had to declare insolvency and got under the receivership of the FDIC went up to 74.4

insti-To many the burst of the global crisis has come up as a surprise, wondering how this severe global credit crisis could happen, how seriously and long lasting

it would be and what implications were to come in the future for the financial dustry and the world economy Its background and furthermore its impact on other sectors of the financial markets and the broader financial industry when ultimately spilling over to other economies causing a global recession, are in the focus

The reasons for this crisis are varied and complex The crisis can be attributed to

a number of factors which emerged over several years and which were pervasive in both, the housing and the credit markets This includes the inability of homeowners

to make their mortgage payments, primarily due to risky mortgage products Otherreasons were, e.g overstrained lenders and speculation as well as overbuilding during the boom period High personal and corporate debt levels, financial prod-ucts that distributed and concealed the risk of mortgage default also played a role Finally monetary policy, international trade imbalances and government regulation,

or the lack thereof, also fuelled the crisis.5 Further major catalysts of the subprime

4 Cf.|Federal Deposit Insurance Corporation, Failed Bank List, 2009.

http://www.fdic.gov/bank/individual/failed/banklist.html (retrieved on 24 July 2009).

5 Cf.|J.E Stiglitz, Commentary: How to prevent the next Wall Street crisis, 2008, http://edition.cnn.com/2008/ POLITICS/09/17/stiglitz.crisis/index.html (retrieved on 19 March 2009).

crisis were the influx of huge amounts of money from the private sector, banks tering into the mortgage bond market and predatory lending practices of mortgage brokers, specifically the adjusted rate of mortgage loans.6

en-Ultimately moral hazard lay at the core of many of the causes.7 The credit crisis can be seen as the consequence of aggressive risk taking by several financial insti-tutions Banks increased their leverage up to levels indefensible in a severe down-turn and thereby funded unsustainable economic growth The reasons behind this dynamic were several widely held misconceptions: e.g the strong creditworthi-ness of borrowers, reliable ratings and investors sophisticated enough to efficiently assess and price the risks of complex financial assets Another underlying flawed assumption was that prices for houses in one region would be largely uncorrelated

to prices of real estate in other regions and therefore the underlying risk could be adeptedly diversified.8

In addition, it was widely believed that rating agencies used the right models and correct assumptions and were able to produce reliable ratings reflecting the true risk of default of the underlying assets Finally, it was assumed that credit risk was well distributed via innovative financial instruments to thousands of investors all over the world This bundle of severe delusion and flawed assumptions caused the crisis by misleading regulators and central banks and by providing the wrong incentives to banks and investors

Fannie Mae and Freddie Mac are the biggest underwriters of home mortgages

in the US These entities do not lend money directly to consumers but instead, they purchase loans from banks on the so called secondary market The names of Fan-nie Mae and Freddie Mac are based on their corporate acronyms; FNMA (Federal National Mortgage Association) and FHLC (Federal Home Loan Corporation) Fan-nie Mae was founded in 1938, during the Great Depression, when millions of fam-ilies could not become homeowners or faced losing their homes In 1968 Fannie Mae was partially privatized, and in 1970 Freddie Mac was created as a wholly pri-

6 Cf.|Senator C Dodd, Create, Sustain, Preserve, and Protect the American Dream of Home Ownership, 2007, http://dodd.senate.gov/?q=node/3731 (retrieved on 5 March 2009).

7 Cf B Brown, Uncle Sam as sugar daddy: The moral Hazard problem must not be ignored, 2008, ketwatch.com/story/moral-hazard-uncle-sam-as-sugar-daddy (retrieved on 24 July 2009).

http://www.mar-8 Cf R.J Shiller, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It,

2008, pp 34-38.

vate company to improve competition Since then, both are privately owned by shareholders but regulated by the US Congress They are also often referred to as Government Sponsored Enterprises (GSEs), due to the fact that they have been cre-ated to serve a public aim and are exempt from state and local taxes.

In addition their securities generally benefit from a state guarantee Therefore the GSEs are able to borrow money more cheaply than other banks The state guar-antee plus the tax advantage are an indirect federal subsidy This advantage is esti-mated to be worth about 6.5 billion USD p.a In return, the GSEs were expected to serve ‘public purposes’, including helping to make home buying more affordable For many years there was significant political influence on this two major US mortgage banks to provide cheap refinancing of mortgages to other banks by pur-chasing so-called ‘affordable loans’ to the lower middle class By expanding the type of loans they would buy, both were hoping to spur banks to provide more loans to people with less-than-stellar credit ratings

In 1992 – under the Clinton Administration – the Department of Housing and Urban Development (HUD) became the responsible regulator of Fannie Mae and Freddie Mac The Clinton Administration had a clear political agenda to put more low-income and minority families into their own homes In 1995 the HUD agreed

to let Fannie Mae and Freddie Mac purchase affordable-housing credit which cluded loans to low-income borrowers The idea was that this would spur granting

in-of loans and increased lending would benefit many borrowers who did not qualify for conventional loans The agency therefore required Fannie Mae and Freddie Mac

to purchase far more ‘affordable loans’ made to these borrowers Since then the GSEs have been supposed to buy a certain portion of ‘affordable’ mortgages each year made to underserved borrowers

In the 1990s the GSEs had already expanded homeownership for millions of families by reducing the requirements for down-payments Nevertheless, in 1999 Fanny Mae was facing increasing pressure from the Clinton Administration to fur-ther expand mortgage lending to low- and moderate-income people and felt pres-sure from stockholders to maintain its phenomenal profit growth For example, the HUD requested that by 2001 50% of the GSEs portfolio should be made up

of loans to low and moderate-income borrowers At the same time HUD was vestigating allegations of racial discrimination in the automated underwriting sys-tems used by the GSEs to determine the credit-worthiness of credit applicants In addition, banks, thrift institutions and mortgage companies had been pressing Fan-nie Mae to help them grant more loans to subprime borrowers, whose incomes, credit ratings and savings were not good enough to qualify for conventional loans

in-This group of borrowers could only get loans from finance companies that charge much higher interest rates (premiums ranged from 3% to 4%) To continuously increasing homeownership rates among minorities and low income consumers Fannie Mae finally announced that it will further ease the credit requirements on loans purchased from banks and other lenders The program included 24 banks in

15 regions and was intended to encourage the institutions to extend home gages to individuals whose credit would generally not be good enough to qualify for a conventional mortgage loan.9

mort-For years the HUD stuck with an outdated policy allowing Freddie Mac and Fannie Mae to count billions of US-Dollars they invested in subprime loans as a public good that would foster affordable housing and which could be repackaged and refinanced based on public guarantees Only every four years, HUD reviews the goals set to the GSEs to adapt them to market changes and neglects to examinewhether borrowers could make the payments on the loans that Freddie and Fannie classified as affordable From 2004 to 2006, the two GSEs purchased secu-rities backed by subprime loans worth|434|billion USD, creating a market for more such lending.10

Through creating a secondary market for housing loans by purchasing gage loans from other banks or mortgage brokers, these banks provide loan orig-inating institutions with ‘fresh money’ to make new loans and to dispose of the credit risk connected to the loans sold The GSEs then repackage these loans as MBS, stamp them with a government guarantee and sell them to investors In effect, they are acting as a bridge between mortgage lenders and capital market in-vestors Since the government guarantee assures that interest and principal will be paid – whether or not the original borrower pays – investors considered MBS from Fannie Mae and Freddie Mac as ‘safe’ investments comparable to treasury bonds Because the GSEs partly passed their funding advantage on to the institutions that originated the loans, these parties could offer housing loans at very low rates Al-most all US mortgage lenders, from huge financial institutions like Citigroup or BoA

mort-to small, local banks, rely on the GSEs for low-cost funding for their mortgage ness The two GSEs are giants in the US housing system and used to guarantee or own roughly half of the about 12|trillion|USD US mortgage loan market Today with 5.3|trillion USD in outstanding debts, Fannie Mae and Freddie Mac are financing approximately 40% of all US mortgages

busi-9 Cf.|S.A Holmes, Fannie Mae Eases Credit To Aid Mortgage Lending, in: New York Times, 1busi-9busi-9busi-9, p.|C2.

10 Cf.|C.D Leonnig, How HUD Mortgage Policy Fed The Crisis: Subprime Loans Labeled, Afforable, in: Washington Post, 2008, p A01.

2.1.2 Central Banks Fuelled the Crisis

Alan Greenspan was chairman of the United States Federal Reserve Board of Governors (FED) from 1987 to 2006 In his 18 years at the helm of the world’s most important central bank he became famous for fighting economic downturns and fi-nancial crises always with the same recipe: in the face of a crisis he sharply lowered the interest rates and as a result the monetary supply was overabundant

In addition to the political assistance via the GSEs the FED fuelled the real estate bubble, too By keeping interest rates at or close to historically low levels the FED tried to support economic growth after the downturn that followed the burst of the internet bubble and after 11 September 2001

Probably one of the biggest misconceptions was that Alan Greenspan believed innovation and globalization were enhancing productivity and competition in a way that would be sufficient to permanently curb inflation for the next several years Therefore the FED’s interest rate policy could be focussed more on economic growth by keeping interest rates at low levels for long periods without generating inflation or even expectations of inflation

As a result of this assumption it was widely believed that in the case that growth slowed down central banks could be expected to cut interest rates, encouraging more spending through more borrowing and hence spur growth This role of the central demand manager has become part of what central banks are expected to do

in a downturn This role has been accepted by different central banks to a varyingdegree The European Central Bank (ECB) still seems to be more reluctant to uni-laterally support growth while neglecting the extension of monetary supply aggre-gates The ECB at least partly seems to still follow the tradition of the Deutsche Bundesbank, which was renowned for its strict control of monetary supply

In the US the FED appeared to be less scrupulous about accepting the role of

FED, Alan Greenspan always cut interest rates and expanded the monetary supply whenever a severe financial crisis (i.e the stock market crash of October 1987, the Asian crisis or the combined internet and 9/11 crisis) was happening

Generally prices of financial assets are not normally distributed and extremely large changes occur much more often (and are followed more often by more ex-tremely large changes in the same direction) than theory suggests Modern capi-

11 Cf.|G Cooper, The Origin of Financial Crises – Central Banks, Credit Bubbles and the Efficient Market Fallacy,

2008, p 79.

tal markets theory is based on the assumption that markets are efficient and

pric-es follow a random path so that movements (returns) tend to be normally uted In the real world price distributions are showing much more extreme events

distrib-or ‘fat tails’.12 Therefore, a deep recession or even depression could be expected to happen even much more often Thanks to Greenspan’s standard policy of cutting rates and flooding the markets, all these crises did not develop into any long lasting economic disaster Market participants learned this lesson well and were more and

In the aftermath of the dotcom-crash and 9/11 the FED not only tolerated the massive over-supply of cheap mortgage loans to home buyers The FED even ap-proved that homeowners could often use the cheap mortgages not only to buy a family home but to leverage-up their existing house and extract the equity to fund consumption – or invest in additional real estate and speculate on further price in-creases This was regarded as an effective tool to stimulate the growth of the US economy, which is largely dependent on consumption.14

The FED was certainly aware of the existence of asset bubbles (i.e in 1996 when Alan Greenspan questioned if there is ‘irrational exuberance’ in stock prices).15Nevertheless, Greenspan was convinced that asset price bubbles would not seri-ously harm the long-term stability of the economic development or the financial system as a whole Alan Greenspan claimed that

“ […] we were not facing a bubble but froth – lots of small local bubbles that never grew to a scale that could threaten the health of the economy […]”.16

His successor, Ben Bernanke, was certainly also aware of the real estate bubble Already in 2005 Bernanke commented that

12 Cf D Satyajit, Traders Guns & Money: Knowns and unknowns in the dazzling world of derivatives, 2006, p.|163.

13 Cf N Ferguson, The Ascent of Money: A Financial History of the World, 2008, pp 164-169.

14 Cf Alan Greenspan, Remarks by Chairman Alan Greenspan At the annual convention of the Independent Community Bankers of America 2003, http://www.federalreserve.gov/newsevents/speech/ 2003speech.htm (retrieved on 3 March 2009).

15 Cf Alan Greenspan, The Age of Turbulence: Adventures in a New World, 2007, p 231.

16 Alan Greenspan, The challenge of central banking in a democratic society Remarks at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research, 1996, http://www.federal- reserve.gov/boarddocs/speeches/19961205.htm (retrieved on 5 March 2009).

“ […] house prices have risen by nearly 25% over the past two years Although speculative activity has increased in some areas, at a national level these price in-creases largely reflect strong economic fundamentals […]”.17

The belief that asset bubbles do not affect the long-term economic development may be based on the strong conviction of the FED, that over time asset prices are mean reverting in nature and do not create serious inflation This may explain why the FED focuses on ‘core inflation’ instead of a wider definition of inflation when measuring the development of the Consumer Prices Index (CPI).18

The availability of cheap debt alone should normally not lead to a housing ble of this magnitude For a long time Americans have been buying houses with borrowed money It is therefore hard to see why anybody should have believed that basic principles of borrowing had been repealed From long experience home buy-ers, mortgage banks and investors should have known that home buyers shouldn’t take on mortgages whose payments they could not afford, and that enough money should be put down to be able to sustain a moderate drop in home-prices while still having positive equity on hand Low interest rates should have reduced the mort-gage payments but not the amount of equity, a homebuyer has to invest when ask-ing for a mortgage.19

bub-The reason for the crisis was a complete negligence of the traditional ples in the credit business To some extent this was driven by the irrational exu-berance of many individuals who saw house prices rising ever higher and decided that they should jump into the market and should not worry about how to cover the debt service This attitude was mainly driven by the change in lending practice: home buyers were offered loans which required little or no down-payment and with monthly repayments that often were well beyond their ability to afford or would be-come unaffordable once an initial low teaser interest rate would reset Much of this dubious lending was labelled ‘subprime’ but the phenomenon was much broader

princi-17 Ben S Bernanke, The Economic Outlook, 20 October 2005, http://www.whitehouse.gov/ cea/econoutlook 0051020.html (retrieved on 5 March 2009).

18 The concept of core inflation tries to measure only inflation that is not peripheral This theory assumes that in particular food and fuel prices are peripheral as they are supposed to be mean-reverting, implying that these prices may go up in the short run but would tend to revert to equilibrium over the medium term What matters are only prices of other products that will not tend to asymptotically move back towards a hypothetical normal but would tend to be sticky in the downward direction and hence all increases could be taken to be of a perma- nent nature.

19 Cf P Krugman, The return of depression economics and the crisis of 2008, 2009, p 148.

than that – it reached into the market for the Alt-A loans and even into the prime market The problem wasn’t restricted to low-income or minority home buyers, many other borrowers were also taking on more debt then they could handle.

So why did lenders relax the credit standards? One reason was the anteed refinancing provided by the GSEs, which – under pressure from politicians – refinanced and took over ever riskier loans from the banks originating the loans

state-guar-To get rid of the exposure they basically invented the securitisation industry already back in the 1930s Later, this business model was copied by investment banks The reinforced competition further accelerated the growth of the credit bubble

Another motivation was that many lenders started to believe in this scheme of ever rising home prices As long as home prices only went up, it didn’t matter much from a lenders point if a borrower could honour his or her payments

Ponzi-If the debt service is too high the borrower could take out a home-equity-loan to get more cash or just sell the home and pay-off the mortgage plus the interest due

As further incitement lenders did not worry about the quality of the loan any more because these were not put on their balance sheet Instead they were sold to investors, who lacked the information and knowledge to understand what kind of credit quality they were buying Investors rather relied on ratings, state guarantees

or other kind of credit insurance

The invention and proliferation of a new form of innovative financial instruments, so-called ‘credit derivatives, provided the necessary toolset for building up the sub-prime credit bubble

Credit derivatives, which were developed in the 1990s, experienced a quent colossal growth In only ten years the total market for credit derivatives grew

subse-on average by 80.2% p.a from 180 billisubse-on USD in 1996 to 20.2 trillisubse-on USD in 2006 Credit Default Swaps (CDS) – which were originally intended to insure and transfer credit risk – account for 30% to 50% of all traded credit derivative contracts This market exploded from an underlying notional amount of still less than|500|billion USD in 2000 to about 6.6 trillion USD in 2006.20

20 Cf R Barrett / J Ewan, BBA Credit Derivatives Report, British Bankers Association, 2006, n.p http://www.bba org.uk/bba/jsp/polopoly.jsp?d=341&a=7673&view=purchase (retrieved on 10 March 2009).

This growth is expected to go on It is not just the size of the market that has continued to grow but also the diversity of products Among others the expansion

of index trades, and equity-linked products have created an unprecedented

varie-ty of traded products in the credit derivatives market The ‘Times’ estimated that the nominal volume of all traded credit derivatives would reach| 62|trillion USD in

2008.21 By comparison the global GDP for 2008 is also forecasted to reach|62 lion USD

tril-To understand the factors for the subprime crises it is vital to figure out how these instruments work and how these have been used by the banks to transfer risk and synthetically leverage-up on- and off-balance sheet

Credit derivatives are defined as a class of derivative financial contracts whose value derives from the credit risk of an underlying bond, loan or other financial assets In this way, the credit risk is with an underlying entity other than the counter-parties to the transaction itself.22 The underlying entity is known as the ‘reference entity’ This reference entity may be a corporate, a sovereign or any other form of legal entity which has incurred debt Credit derivatives are bilateral contracts be-tween the protection buyer and protection seller (investor) Under a derivative con-tract the seller sells protection against the credit risk of the reference entity and re-ceives a credit margin (‘premium’) from the buyer

The main market participants are banks, hedge funds, insurance companies, pension funds and corporations

Credit default products are the most commonly traded credit derivative ucts Under these contracts the parties will define one or more credit events that trigger a payment from the investor to the protection buyer

prod-The credit event is usually triggered when the reference entity goes into ruptcy, fails to pay or defaults on any of its obligations (such as a bond or loan), faces an acceleration such as an obligation that is declared immediately due and payable following a default, faces a moratorium over its obligations or has to restructure its obligations

bank-In contrast to standardized exchange traded derivatives, contracts where the parties assume credit exposure to a clearing house as the central counterpar-

ty, credit derivative contracts are highly customized and traded directly between

21 Cf P Hosking / M Costello / M Leroux, Dow dives as Federal Reserve lines up $75bn emergency loan for AIG, in: The Times, 2008, p 4

22 Cf D Satyajit, Credit Derivatives: CDOs and Structured Credit Products, 2005, p 6.

two interested parties Therefore the parties to the contract are exposed to each others default risk This type of bilateral contract is also referred to as over-the-counter (OTC-)|contract There is no standardized exchange traded contract and no clearinghouse for credit derivatives at the moment All contracts are traded OTC but normally the counterparties benefit from individually negotiated collateral and margin call agreements that help to reduce their counterparty risk Given the fast growing volume of the credit derivatives market, the size of the associated counter-party exposure clearly has the potential to destroy the financial system The coun-terparty-risk has become the Achilles heel of today’s financial markets Insurance

is worth nothing if the insurer cannot pay up The huge involvement of large vestment banks or of some insurance companies (e.g AIG or a monoline insurer)

in-in the credit-derivatives market is the main-in reason why there is such a public in-est to bail them out A fast and uncontrolled default of one of these counterparties could be sufficient to destabilize the whole financial system The ultimate proof of this hypothesis was the default of Lehman Brothers on 15 September 2008 Leh-man’s bankruptcy caused derangement in the markets because all its innumerable counterparties struggled to calculate their risk exposure and to cover their positions

inter-in the market againter-in This massive re-hedginter-ing of positions created huge price tortions, significantly increased the existing uncertainty in the markets and further contributed to illiquidity

dis-Today, there are several initiatives supported by regulatory bodies to create parent and regulated markets and clearinghouse solutions for the most common-

trans-ly traded credit derivatives Regulators have sought to establish a comprehensive clearinghouse solution for credit derivatives since 2004 These efforts took on new urgency during 2008’s financial turmoil and especially after the default of Lehman Brothers, after which several major banks disclosed that they had several thousand OTC credit derivative contracts with Lehman and suffered significant losses while trying to close out the underlying risk position or to find a new counterparty.23Credit derivatives are fundamentally divided into two categories: funded credit derivatives as CDOs and unfunded credit derivatives such as CDS.24

23 Recognizing the huge business opportunity several leading derivatives exchanges and clearinghouses are about

to fierce competition to establish a trading and clearing platform for standardized credit derivatives contracts based on the most commonly traded underlying reference entities Atlanta-based Intercontinental Exchange (ICE) created, via its ICE Clear Europe unit, a European-regulated central counterparty for CDS transactions NYSE Euronext and LCH Clearnet as well as LSE, Eurex and others are also working hard to get into the market.

24 Cf R Barrett / J Ewan, BBA Credit Derivatives Report, British Bankers Association, 2006, n.p., http://www.bba org.uk/bba/jsp/polopoly.jsp?d=341&a=7673&view=purchase (retrieved on 10 March 2009)

An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract itself without recourse to other assets, i.e credit spreads and payments of cash or phy-sical settlement amounts The seller is not obliged to make any upfront payment to provide collateral or fund an underlying bond, loan, loan-portfolio or credit index Under an unfunded credit derivative, the protection seller is only obliged to make

a payment if the credit event occurs or other conditions to settle the contract are met If the contract parties fail to stipulate a collateral agreement or margin calls, the buyer has full credit risk on whether the seller will be able to honour its obliga-tion and provide the defined cash or physical settlement amount when the credit event is happening With the introduction of unfunded products, credit derivatives have separated funding from credit This has made the credit markets more acces-sible to players with relatively high funding costs (e.g hedge funds) and made it cheaper to leverage credit risk.25

The most important unfunded credit derivative product is the single name CDS, which is set up as a bilateral contract that enables an investor to buy protection against the risk of default of a single asset issued by a specified reference entity Following a defined credit event, the buyer of protection receives a payment in-tended to compensate the loss of the investment In return, the protection buyer pays a fee.26

Other unfunded credit derivative products include: Total Return Swap, CDS on Asset Backed Securities (ABS), CDS on portfolios or indices (like the iTraxx index based on a portfolio of single name CDS), Credit Default Swaption, Credit Spread Option, Constant Maturity CDS (CMCDS), First to Default CDS

On the other hand funded credit derivatives are transactions where the creditderivative is fully or partially embedded in a bond or loan structure.27 A funded credit derivative therefore involves the protection seller making an initial payment (i.e the purchase price of a CDO) which is used to settle any potential credit event The advantage of this structure for the protection buyer as the seller of the CDO is,

25 Cf D O’Kane, Credit Derivatives Explained: Market, Products, and Regulations, 2001, p.|3

http://www.investinginbonds.com/assets/files/LehmanCredDerivs.pdf (10 January 2009).

26 Cf ibid., p.|25.

27 Cf Edmund Parker, Credit Derivatives, in: PLCFinance, 2008, p.|4

http://www.mayerbrown.com/london/article.asp?id=4234&nid=1575 (retrieved on 22 March 2009).

not being exposed to the credit risk of the protection seller Thereby the party credit risk is to some extent collateralized At the same time the investor pro-vides the funding for the underlying bond, loan or loan portfolio as well.

counter-Funded credit derivative products include the following products: Collateralized Debt Obligation (CDO), Synthetic Collateralized Debt Obligation (Synthetic CDO), Collateralized Debt Obligation squared (CDO2), Credit Linked Note (CLN), Constant Proportion Debt Obligation (CPDO), Synthetic Constant Proportion Portfolio Insur-ance (Synthetic CPPI)

So how did this new breed of derivative instruments foster the subprime crisis? Focusing on a bank which wants to enhance the return on its loan portfolio and free

up some balance sheet by securitizing a certain portfolio of mortgage loans Firstlythe bank repackaged the loan-portfolio by selling it to a Special Purpose Vehicle (SPV).28 In a second step the SPV’s loan portfolio was then sliced into tranches

of different seniority (first loss tranche, second loss tranche and different CDOs are assigned to each tranche) Finally the different CDO tranches were rated by at least one of the three major rating agencies and sold to yield hungry investors In-terest and principal payments are made in order of seniority The so-called ‘super senior tranche’ or ‘senior tranche’ used to have a AAA+ or AAA rating and hence were considered to be the safest securities The (super) senior tranches normally accounted for about 88% to 91% of the SPV’s total liabilities The senior tranches

of a CDO were often at times followed by so-called ‘mezzanine tranches’, which were subordinated to the senior tranches and therefore used to carry a lower but still high investment grade rating such as AA or BBB Mezzanine tranches typically accounted for 4%-5% of the total financing volume

Finally there were the so-called ‘junior tranches’ or ‘equity tranches’ which were meant to absorb any first losses Consequently these tranches used to have the lowest or even no-rating and therefore had to offer much higher returns (higher coupon payments or lower prices) to compensate for the significantly higher risk

of default A specific equity tranche would account for only between 3% and 7%

of the total liabilities

28 An SPV is a limited liability company created for the single purpose of holding and refinancing the loans outside the balance sheet.

With CDOs banks could create massive leverage for investors, or even selves A 2% first-loss or equity-tranche of a CDO has a leverage of 50 times com-pared to the leverage ratios of ten to twelve times of a typical commercial bank.29Equity tranches used to be bought by hedge funds which are yield avaricious and therefore seek to build-up massive leverage.

them-With the proliferation of credit derivatives and the possibility to securitize and sell loan portfolios investment banks were enabled to provide ever increasing amounts

of mortgage loans to homeowners (as well as leveraged loans to corporates or vate equity firms) without having to keep the loans on their balance sheet and/|or having to bear the connected credit risk

pri-To extend further loans banks did not need to raise funding via deposits from tail or institutional investors or the inter-bank market any longer Instead of keeping the loans on their balance sheet they securitized them and sold the newly created fi-nancial assets to different investors The most junior first-loss or equity-tranche was often bought by hedge funds while the AAA rated senior tranches were bought by pension funds and insurance companies Hence the credit risk of the loan portfolio ultimately ended up with institutional investors or other banks In this new business model the balance sheet was only needed for the comparatively short time interval from originating the loans until they were sold on The balance sheets and there-fore the minimum equity which was needed to satisfy regulatory requirements de-creased while the return on equity was pushed up by the disproportionate high fee income from the securitization and sale of the structured securities (funded credit derivatives)

re-More and more investment banks adapted this lucrative business model and the

‘raw-material’ gradually became a scarce resource Therefore, banks were easing their own lending standards to generate more mortgage or consumer loans Invest-ment banks even started to look externally for ‘supply’ and finally found themselves

in competition against each other to buy mortgage or consumer loan portfolios of retail banks In return these retail banks were incentivised to relax their credit stand-ards and started to accept lower credit qualities knowing that they could offload any newly originated credit exposure Some investment banks even started to take over smaller mortgage or retail banks, to ensure access to further loans that could

be securitized

29 Cf D Satyajit, Traders Guns & Money: Knowns and unknowns in the dazzling world of derivatives, 2006, p.|291.

The invention of ‘synthetic CDOs’ brought the solution to this supply problem Instead of a portfolio of loans, a synthetic CDO is based on a portfolio of CDS Therefore, this new instrument allowed banks to synthetically create fixed income assets independent from the underlying demand for or availability of loans Hence the financial industry was able to meet investors demand for higher yielding fixed income assets The result was a higher demand for the underlying CDSs which drove the prices for these kinds of credit guarantees down The result was that CDS spreads were too low and did not properly reflect the inherent default risk of the un-derlying anymore.

In theory, CDS could be created up to an unlimited amount When selling a thetic CDO, managers simply entered into even more CDS This excessive demand for credit risk via CDS puts pressure on the risk premiums in terms of reduced CDS market spreads After the real risk having become visible in 2007 – due to a widerrecognition of the US subprime in the financial markets and effective default of the first CDO tranches – the demand for new CDOs dried up very fast and the second-ary market for CDOs became totally illiquid Thereby an important source of de-mand for new credit risk trickled away After all, it is only logical that, with the likeli-hood of a recession and bond default rates increasing, more investors would rather buy insurance against such events while becoming more and more reluctant to take over additional risks by buying further CDOs (or alternatively by writing more CDS)

syn-More importantly, however, a CDS has become the product of choice for those investing in credit as an asset class Five to ten years ago, the corporate-bond mar-ket was a lot less active In most bonds there was little trading because they were often locked up in the portfolios of pension funds or insurance companies

The invention of the CDS increased the liquidity of the market and, crucially, abled investors to take a ‘short’ position on a bond issuer Traditionally, he is likely

en-to buy a corporate bond, e.g at 95%, and expecting the best en-to get the interest bursed and the bond being repaid at par At worst, the issuer could default and the buyer could be left with nothing Nowadays, an investor who believes that credit conditions for a particular company will deteriorate has the option to buy a CDS on the bond, whether he owns the bond or not The value of the CDS will rise if default becomes more likely

dis-In this regard, the dominating credit index family iTraxx Europe deserves tioning, which was created in 2004 by the merger of the DJ TRAC-X Europe 100 and iBoxx Diversified (iBoxx) indices.30 The creation of credit index products like the iTRAXX and the respective derivative contracts on this reference or underlying al-lows investors to bet on or hedge against the rise or fall of a standardized market portfolio of corporate bonds (or a certain segments of the market such as invest-ment grade or high yield).31 As a result, CDS contracts have become such a useful instrument for hedge funds and trading desks of investment banks that it seems to

men-be inconceivable that they will disappear again Just as the future on the S&P 500 index is a key part of the equity market, the CDS on the iTRAXX has become cen-tral subject to the credit market

During a banking crisis, when the credit risk – on which CDS were written – materializes, many of these unfunded credit derivatives will need to be settled

If the counterparties, who wrote the CDS, cannot perform on their liabilities, this could have severe consequences, meaning after the initial default it is implied that the respective CDS buyers, who bought these instruments to insure against cred-

it events, would be left without insurance and consequently would have to suffer further losses Such losses could then drive these buyers into bankruptcy as well The alarming conclusion is that the 62|trillion|USD CDS market might conceivably provide for an even bigger problem to come Governments, central banks and reg-ulators recognized this tremendous risk and – in order to prevent this from happen-ing – already bailed out several ‘system critical’ large banks and other institutions world wide One of the most prominent and probably the costliest institution which had to be saved with a total of 144 billion USD of tax-payers money was American International Group (AIG)

30 Cf ibid pp 210-214.

31 iTraxx is the brand name for the family of credit default swap index products covering Europe, Japan and the rest of Asia They form a large sector of the overall credit derivative markets The indices are constructed on a set of rules with the overriding criterion, being that of liquidity of the underlying CDS The iTraxx index family is owned, managed, compiled and published by the International Index Company (IIC), which also licenses market makers CDS indices allow investors and portfolio managers to invest in or hedge against credit risk in a more efficient manner than by just using groups of single CDSs They are standardised contracts and referenced to a fixed number of obligors

2.1.4 The Case of AIG

With total assets of more than 1 trillion USD and revenues of 113 billion USD

as per 2006, AIG used to be the worlds’ largest insurance company (by assets) and number ten on the Fortune 500 list of the largest US companies

In the 1990s AIG’s Financial Products unit in London entered into the market for credit derivatives Because the underlying debt securities – mostly corporate is-sues and some mortgage securities – carried investment grade ratings, AIG was happy to book income in exchange for providing insurance After all, the manage-ment apparently assumed that they would never have to pay any claims By 2008, AIG had insured 513 billion USD in debt via CDS contracts including 78 billion USD mortgage related CDOs Industry practice permits firms with very high credit rat-ings to enter into OTC derivatives contracts with limited or no collateral or margin payments Since AIG itself used to be a highly rated company, it did not have to post collateral to its CDS counterparties This made the contracts all the more prof-itable.32

On 16 September 2008, AIG suffered a serious liquidity crisis following the downgrade of its credit rating by at least two notches by the three top global ratingagencies, who at the same time warned that more downgrades could follow Moody’s Investors Service cut AIG’s rating from Aa3 to A2, a two-notch down-grade Standard & Poor’s Ratings Services even lowered the rating to A-minus from AA-minus, a three notch reduction while Fitch Ratings reduced its credit standing also by two notches from AA-minus to A This triple strike hit the insurer in a situa-tion when it was struggling to find new sources of funding at a time of global finan-cial turmoil which has brought two of the biggest investment banks to their knees After this rigorous downgrade of its creditworthiness the company was contractu-ally obliged to provide collateral to its trading counterparties, which led to a severe liquidity crisis

The London unit of AIG sold credit protection by writing CDS on CDOs that had declined in value To prevent the company from collapsing, and in order for AIG to meet its obligations to post additional collateral to CDS trading partners, the FED announced the creation of a secured credit facility of up to 85 billion USD The credit facility was secured by the assets of AIG subsidiaries In addition the FED re-ceived warrants for a 79.9% equity stake and the right to suspend dividends to all

32 Cf G Morgensen, Behind Insurer’s Crisis, Blind Eye to a Web of Risk, in: New York Times, 2008, p.|A1.