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The Credit Crisis of 2008 “You Fail, We Bail?” Southwest Chapter PLUS Educational Seminar
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Transcript of The Credit Crisis of 2008 “You Fail, We Bail?” Southwest Chapter PLUS Educational Seminar
www.guycarp.com
Seán Mooney, Chief Economist
October 2, 2008
The Credit Crisis of 2008 “You Fail, We Bail?”
Southwest Chapter PLUS Educational Seminar
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Guy Carpenter
It’s about time our team started winning!
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Guy Carpenter
Emergency Economic Stabilization Act of 2008RIP September 29
The Act– Treasury buys troubled loans
– Helps lenders by reducing uncertainty about their balance sheets
– Increases flow of credit in the economy
– Insurance of troubled assets
Impact– Overall result not that different from before
• Bail-outs on a case by case basis• Values still dependent on real estate recovery• Given uncertainties, Act could exacerbate the problem in the near-term
- Lenders hold back until they see how current and/or future Treasury Secretary implements the plan
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Guy Carpenter
Emergency Economic Stabilization Act of 2008Insurance of Troubled Assets
Program to guarantee troubled assets, issued prior to March 14, 2008
Treasury collects premiums, set at actuarial level to meet anticipated claims
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Guy Carpenter
Agenda
Overview of the Financial Market Debacle – how the problems developed, implications for the broader
economy
Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O
Possible regulatory responses impacting our industry
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Guy Carpenter
The Evolution of the Crisis
First phase, 2007: The subprime mortgage fiasco.
The figure of $400 billion from Bernanke still appears about correct. About $300 billion of this has been reported.
Second phase, 2008: The broader credit crisis.
As lenders reshaped their finances to meet regulatory and accounting standards credit dried up in lot of areas, e.g., commercial paper, M & A financing and auto loans. The broader risk of Credit Default Swaps (CDS) emerged.
Third phase, August 2008: The insolvency phase.
Broader still. The first two phases create a world wide financial crisis, which, coupled with oil and food crises, triggered a longer term economic downturn.
In Phase Three, but not heading to a depression
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Guy Carpenter
First Phase Subprime Fiasco: Why?
Housing boom
– Investors cycle from tech stocks to housing, following technical bust of 2000
– “Free” money in first half of current decade
– Price of homes has never declined (current dollars)
– Secondary market creates break in link between debtor and ultimate mortgage holders. (Forget Bedford Falls!)
– Hedge funds seeking outsized returns
– Globalization increases flow of funds to the sector
– A positive force, risk classification, turned into a negative, with no docs and option ARMs
A good word about subprime
– Risk classification from an insurance perspective
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First PhaseSubprime Fiasco…By The Numbers
US unemployment rate: 6.1%
GDP: $13 trillion
Financial Assets: $40 trillion+
Financial impact– 2 million foreclosures @ $200,000 =$ 400 billion
– Reported: $280 billion
Economic impact– Housing construction: 6% of economy
– Wealth Effect: 6% of wealth change. • Drop in housing prices: 10% implies GDP cut by 0.5%
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Long Upward Trend in Home Prices
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Price drops 1.4% in 2007, and 9.5% in 2008
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The Evolution of the Crisis
Second phase: The broader credit crisis.
As lenders reshaped their finances to meet regulatory and accounting standards, credit dried up in lot of areas, e.g., commercial paper, M & A financing and auto loans.
The broader risk of Credit Default Swaps (CDS) emerged.
“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Warren Buffett, Letter to Shareholders, 2002
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Second Phase
Pressures on banks Subprime defaults
Credit Default Swaps: Notional Base of $62 trillion, up from $1 trillion in 2001
Problems at GSEs: Debt of $1.5 trillion
Fair-Value Accounting
Off-balance items to on-balance (SIVs)
Other exposures Consumer debt at record levels: $2.5 trillion, 22% of Personal Income
A credit-quality crisis, not a deflationary policy. The Feds are pushing on a string. Last instance in 1990/91.
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Banking: Tier 1 Risk-Based Capital Ratio (%), Second Quarter 2008
8.8%9.1%9.3%
10.2%10.8%
11.6%
12.4%
8.7%8.3% 8.0%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
MS UBS GS CS DBK JPM HSBC Citi BofA Wach
US standard at 5%. Merrill at 7.6%
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Second Phase:Recent Capital Market Crises
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Duration in Quarters Severity in Quarters
1987
1990
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1997-99
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Phase Three: The insolvency phase
Muddle Through
-2.00%
-1.00%
0.00%
1.00%
2.00%
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5.00%19
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2009
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Recession
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Worst case scenarios
Depression– Not likely because:
• Bernanke wrote the book on causes of the Great Depression. • Among most free market economists, the key cause of the great
depression was a failure of monetary policy. Following the stock market crash of 1929, banks were threatened by runs. The Federal Reserve was limited in the loans it could make to member banks, partly by philosophy, but also because the law required partial gold backing of its credits to member banks. 9,000 banks failed (one third). This theory is supported by Bernanke, including a major academic article published in 1995.
• Other factors: Cheap credit that fueled excess capacity for consumer goods, trade decline, dust bowl, and the Smoot Hawley tariff act. (June 1930). These factors are all well understood by policy makers so the probability of repeating is low.
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Deflation Japanese style
• Japan in 1990s: Economic growth at 1.3%, inflation at 0.2%• The causes of deflation include:
- Aging of the population- By 2020, Japanese working age population will be 10
percent smaller, ours will be 30 % larger.- Young people needed for economic growth.
- Cheap goods from China and other South East Asian nations.
- Deflation as a self fulfilling prophecy (money in mattresses rather than in the bank.)
- Bailout of banks and corporations- Need to rationalize Japanese banking system.
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Oil DemandMillion Barrels Per Day
2002 2008
OECD 48.1 49.8
Non-OECD 29.8 37.7
Total 77.9 87.5
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Agenda
Overview of the Financial Market Debacle – how the problems developed, implications for the broader
economy
Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O
Possible regulatory responses impacting our industry
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Guy Carpenter
Impacts on Insurance
Direct relationships– Credit enhancers ($3,300 billion)– D & O and E & O
Economic relationships– Driving & auto insurance– Employment and WC– Recession and Fraud– Housing bust and arson (?)
Indirect relationships– Stock Market and Surplus– Interest rates and pricing (long tail)
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Subprime Impact on Insurer Capital
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Miles Traveled Down in 2007 and 2008
Annual VMT
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350019
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Bill
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Commercial LinesCompetition is heating up!
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Rate Decreases Continue for Commercial Lines
Source: Council of Insurance Agents & Brokers 2nd Qtr. 2008 Survey - Chart: Lehman Brothers Equity Research
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Pressures on pricing
Reduced supply
Higher catastrophes in 2008
Reduced investment income, as stock markets weaken
Write-downs for problem assets reduce capital
These pressures may be offset to some extent by concerns of counter party credit quality and by possible increased
move to self-insurance by well capitalized players
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Guy Carpenter
Agenda
Overview of the Financial Market Debacle – how the problems developed, implications for the broader
economy
Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O
Possible regulatory responses impacting our industry
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Guy Carpenter
Regulatory response
Federal regulation– Knee jerk response (Senators Sununo and Johnson)
– New York State action on CDS
Higher capital ratios– Raise costs of doing business
– Disproportionate impact on newer more thinly capitalized ventures, such as Bermuda start-ups
– Search for “Black Swans” • Earthquakes• Liability (Nano, Climate change)
– Pressure on reserves
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The Future
“Fasten your seat belts, it’s going to be a bumpy ride.”
www.guycarp.com
Seán Mooney, Chief Economist
October 2, 2008
Subprime Plus
Southwest Chapter:PLUS
Educational Seminar