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Day After tomorrow: The Financial Crisis

Day After tomorrow: The Financial Crisis. Stephen Y L CHEUNG Professor (Chair) of Finance Dean, School of Business Hong Kong Baptist University. Contents. Causes of sub-prime crisis Consequences China and India Policy implications Consequences. Origins. Causes of sub-prime crisis

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Day After tomorrow: The Financial Crisis

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  1. Day After tomorrow: The Financial Crisis Stephen Y L CHEUNG Professor (Chair) of Finance Dean, School of Business Hong Kong Baptist University

  2. Contents • Causes of sub-prime crisis • Consequences • China and India • Policy implications • Consequences

  3. Origins • Causes of sub-prime crisis • Consequences • China and India • Policy implications • Financial crisis derives from the US housing market • Housing market in US • An unparalleled boom in 2007 • Negative real interest rates in US • Excess liquidity offered by financial innovation • High leverage

  4. Real interest rate • Causes of sub-prime crisis • Consequences • China and India • Policy implications • Graph

  5. Financial Innovation • Causes of sub-prime crisis • Consequences • China and India • Policy implications • Housing loans offered at back loaded teaser interest rates • Assuming that borrowers could refinance the sub prime loans through gains in home equity • But loan originating banks were smart …

  6. What is Sub-prime loans? • Causes of sub-prime crisis • Consequences • China and India • Policy implications • (1) low credit scores • (2) No 20% down-payment for a home • (3) Disable to fully document their income • No Conventional mortgages • No Best market interest rates 6

  7. What did the banks do? • Causes of sub-prime crisis • Consequences • China and India • Policy implications • Offloaded the sub-prime loans through instruments like Collateralized Debt Obligations • Modus Operandi of banks (loan originators) • Pool together mortgages, including sub prime loans, into CDOs • Get top notch credit ratings for senior tranches • Retain the highly rated senior derivatives through SIVS • Repackage the lower rated derivatives to transform them into synthetic CDOs • Investors : Hedge funds, money market and pension funds

  8. How did the investors buy? • Causes of sub-prime crisis • Consequences • China and India • Policy implications Sharp rise in derivatives CDO and CDS issuance CDO Derivatives Industry 2004 - $25 billion 2002 - $ 103 trillion (3 X Global GDP) 2007 - $186 billion 2007 - $ 450 trillion (9 X Global GDP)

  9. The boom begins to unravel from 2004 • Causes of sub-prime crisis • Consequences • China and India • Policy implications • US Fed reacts to rising consumer and asset prices by monetary tightening from second half of 2004 • Housing prices begin to fall by end of 2006 • Rising interest rates and falling housing prices lead to rise in subprime mortgage delinquencies & foreclosures

  10. Overloading… • Causes of sub-prime crisis • Consequences • China and India • Policy implications

  11. Suffering… • Causes of sub-prime crisis • Consequences • China and India • Policy implications

  12. Causes of sub-prime crisis • Consequences • China and India • Policy implications “Do you know the true balance sheet of US Investment banks?” There are two sides on the balance sheet: the left side and the right side.On the left side, there is nothing right.and on the right side, there is nothing left.

  13. Causes of sub-prime crisis • Consequences • China and India • Policy implications

  14. Causes of sub-prime crisis • Consequences • China and India • Policy implications “Yes, it’s true that the Chinese have been selling us toxic toothpaste, toxic pet food, toys with toxic lead paint —” “but all the while US was selling them toxic investments.”

  15. China and India are the Saver • Causes of sub-prime crisis • Consequences • China and India • Policy implications

  16. Policy implications • Causes of sub-prime crisis • Consequences • China and India • Policy implications • More hazard • A new financial order • Financial innovations • Credit rating agencies • Regulatory framework • Highly leveraged institutions • Regulator quality

  17. Consequences • Liquidity squeeze => Excessive liquidity • Asset bubbles; stock and property prices • Commodity prices up • Inflation? • Loose monetary policy is likely to end • Interest rates up?

  18. Consequences • Economy not recovered yet • Gap between real economy and financial markets • Total exports declining • High interest rates, negative impact on the fragile economy

  19. Day after tomorrow: • Incentive system; how to compensate senior management? • Exit strategy? • Financial markets will be different • Risk management • Corporate governance

  20. The End

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