The Credit Crunch and its Consequences

Howard DaviesDirector, LSE

LSE Alumni Lecture Series – Inaugural Lecture

Wolfson Theatre, New Academic Building

19th February 2009

A Five Act Shakespearian Tragedy

Act One: Subprime

… real estate prices rise

Source: Tano Santos

The growth of securitised credit

Recent ABX BBB Price HistoryPrice

Source: Markit Partners

Resecuritisation

BBB

A

AA

AAA

Residual/Equity

SUPER SENIOR

AAA

AAA

AA

A

BBB

Equity

Capital Structure Containing Subprime Loans

Subprime Mezzanine CDO Containing BBB Subprime Bonds

100%

28%

20%

11%

7%

0%

11%7%

11%

8.6%

7%

100%

40%

0%

CUMULATIVE LOSSES

Act Two: Liquidity

Financial market liquidity

Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill Lynch, Thomson Datastream.

Act Three: Unravelling

-Bear Stearns, Indymac, Wa mu

-HBOS, RBS

-Fortis, Dexia etc.

Act Four: Meltdown

• Lehman’s failure leads to

– indiscriminate sell-off of financial stocks

– seizing-up of many markets

– generalised market panic

Act Five: Pumping

• additional liquidity facilities

• fiscal stimuli

• near-zero interest rates

• quantitative easing

Act One: Subprime

Act Two: Liquidity

Act Three: Unravelling

Act Four: Meltdown

Act Five: Pumping

The Credit Crisis: A Five-Act Tragedy

•global imbalances

•loose monetary policy, leading to•mispricing of risk•credit bubble

•‘excess’ growth of financial sector

•‘excess’ leverage, facilitated by procyclical regulation

But what are the underlying causes?

Global current account balances

China’s Growth LaggardPersonal Consumption as % of GDP

Source: China National Bureau of Statistics and Morgan Stanley

Household debt as a proportion of GDP

Source: FSA, ONS, Federal Reserve, Eurodata, Datastream

UK Saving Rate

Source: ONS; Morgan Stanley Research

The growth of the financial sector

Source: FSA, Oliver Wyman

Major UK banks’ leverage

Source: FSA, Bank of England

“ Bank failures are caused by depositors who don’t deposit enough money to cover the losses due to mismanagement”.

Dan Quayle

“ The owners of capital will stimulate the working class to buy more and more of expensive goods, houses, and mechanical products, pushing them to take more and more expensive credits, until their debt becomes unbearable The unpaid debt will lead to bankruptcy of the banks, which will have to be nationalised, and the state will have to take the road which will eventually lead to communism.”

Das Kapital

So what next?• growth prospects have deteriorated

sharply, across the world

• Europe mired in recession

• long downturn the most likely outcome, and (in the UK) anaemic recovery

Growth Rates: IMF Forecasts

-4

-3

-2

-1

0

1

2

3

4

Germany France US UK

2007

2008

2009

2010

Source: www.ft.com

European Economic Forecast – April 2008

Source: www.ft.com

European Economic Forecast – January 2009

Larger than previous crises

UK recovery options:• V-shaped: sharp contraction, quick

bounce-back• U-shaped: longer trough, delayed but

strong recovery• L-shaped: Japanese style stagnation• Nike swoosh: sharp downturn, weak

recovery

Is London Reykjavik on Thames?• Banks big, but not that big in relation to

GDP

• Fiscal position poor, pre-recession, but stock of debt not excessive

• But needed fiscal tightening will mute the recovery.

Sovereign five-year CDS

Source: Morgan Stanley (as at 21 January 2009)

General government debt rations in OECD countries in 2008

Source: OECD, Economic Outlook No. 84, November 2008

UK gross issuance forecast

Source: Morgan Stanley

Discretionary policy change projected in the PBR

Source: HM Treasury, Pre-Budget Report 2008

The Credit Crunch and its Consequences

Howard DaviesDirector, LSE

LSE Alumni Lecture Series – Inaugural Lecture

Wolfson Theatre, New Academic Building

19th February 2009