Panel Detail:Wednesday, April 30, :50 AM - 12:05 PM Financial Innovations: Complexity Isn't Innovation, Leverage Isn't Credit

Transcription

1 Panel Detail:Wednesday, April 30, :50 AM - 12:05 PM Financial Innovations: Complexity Isn't Innovation, Leverage Isn't Credit Speakers: Michael Milken, Chairman, Milken Institute; Chairman, FasterCures / The Center for Accelerating Medical Solutions Lewis Ranieri, Prime Originator and Founder, Hyperion Private Equity Funds; Chairman, CEO and President, Ranieri & Co. Inc. Richard Sandor, Chairman and CEO, Chicago Climate Exchange; Senior Fellow, Milken Institute Myron Scholes, Nobel Laureate, 1997; Chairman, Platinum Grove Asset Management Moderator: Andrew Rosenfield, Managing Partner, Guggenheim Partners LLC; Chairman, Guggenheim Investment Advisors

2 Credit from Latin, meaning "trust" Credit was first used in Assyria, Babylon and Egypt 3000 years ago.

3 Merriam-Webster dictionary Credit(n.): reliance on the truth or reality of something the balance in a person's favor in an account an amount or sum placed at a person's disposal by a bank the provision of money, goods, or services with the expectation of future payment an entry on the right-hand side of an account constituting an addition to a revenue, net worth, or liability account any one of or the sum of the items entered on the right-hand side of an account a deduction from an amount otherwise due

4 Merriam-Webster dictionary Leverage (n.): The use of credit to enhance one's speculative capacity

5 Financial innovation and complexity Innovation is a hallmark of our capital markets. Securitization of credit is one example of an innovation that has made more, more flexible and lower-cost capital available to consumers and companies, and stimulated competition. Secretary Henry M. Paulson March 13, 2008

6 Financial innovation and complexity Financial innovation has also brought, inevitably, the challenge of complexity. Excessive complexity is the enemy of transparency and market efficiency. Investor sentiment has swung hard to risk aversion, and now markets are punishing not only complex, but non-complex products as well. Secretary Henry M. Paulson March 13, 2008

7 Financial innovation and complexity [An] element in the constellation of vulnerabilities was the greater complexity of interlinkages both within and across financial systems. Testimony of this evolution are the speed and degree of complexity of today s capital flows; the relative variety, obscurity and interrelationship of many classes of financial instruments often with large levels of embedded leverage; and the intertwined relationship of a growing variety of financial institutions. Jean-Claude Trichet President of the European Central Bank April 15, 2008

8 Structured credit finance products ABS Credit derivatives RMBS MBS CDS CMBS CDOs ABS: Asset-backed securities MBS: Mortgage-backed securities RMBS: Residential MBS CDS: Credit default swap CMBS: Commercial MBS CDOs: Collateralized debt obligations Source: International Monetary Fund.

9 When is a AAA not a AAA? Multi-layered structured credit products Mortgage loans Mortgage bonds High-grade structured-finance CDO Senior AAA 88% Junior AAA AA A BBB Unrated 5% 3% 2% 1% 1% AAA 80% AA 11% A 4% BBB 3% BB-Unrated 2% Source: International Monetary Fund. Mezzanine structuredfinance CDO Senior AAA Junior AAA AA A BBB Unrated 62% 14% 8% 6% 6% 4% CDO-Squared Senior AAA Junior AAA AA A BBB Unrated 60% 27% 4% 3% 3% 2%

10 Venezuela sovereign debt rating Moody s rating Aaa Aa Ba3 B2 Caa Source: Moody s.

11 Venezuela sovereign debt rating S&P rating AAA AA BB B+ BB- CCC Source: Bloomberg and S&P. SD

12 Leverage of various institutions 2007 Government sponsored enterprises 24.7 Brokers and hedge funds 31.6 Credit unions 8.4 Savings institutions 8.4 Commercial banks Asset/Capital Source: David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin, 2008

13 Diffusion of financial innovation Transaction costs Transparency Pricing Perception vs reality Regulations Liquidity / market participants

14 Global financial structure 2006 World Euro area United States Japan Asia Latin America Middle East Africa Europe Stock market capitalization Bond outstanding Share of total financial assets Emerging markets Bank assets Bonds, equities and bank assets US$ billions 194,463 54,130 56,822 20,110 19,210 4,580 1,755 1,603 3,837 (percent of GDP) Sources: World Federation of Exchanges; Bank for International Settlements; International Monetary Fund.

15 World stock markets Apr 18, 2008 Market capitalization Percent of world Percent of GDP YTD % change World U.S Japan U.K China France Hong Kong Germany Canada Brazil India Source: Bloomberg.

16 Weak U.S. market S&P 500 Materials Energy Consumer staples Consumer discretionary Utilities Industrials Financials Health care Info technology Telecom services YTD (Apr. 15) Source: Datastream Percent

17 Invest $100 on Apr. 15, 2003 As of Apr. 18, 2008, in US$ S&P500 U.K. FTSE 100 Nikkei 225 MSCI World Shanghai A Share Hang Seng Germany DAX 30 MSCI Emerging Market Russia RTS 563 Source: Datastream. India BSE US dollar

18 Invest $100 on Apr. 15, 2003 As of Apr. 18, 2008, in US$ Cotton 122 Natural gas Raw sugar Corn Wheat Gold bullion S&P GSCI Commodity Crude oil Rice Source: Datastream US dollar

19 Invest $100 on Apr. 15, 2003 As of Apr. 18, 2008, in US$ U.S. Treasury U.S. Mortgage U.S. AAA Corporate U.S. BB High Yield U.S. B High Yield U.S. C High Yield Global High Yield and EM Source: Datastream.

20 Volatilities are on the rise Annualized 100-day rolling historical volatility Percent S&P MSCI Emerging Market 0 Apr-94 Apr-96 Apr-98 Apr-00 Apr-02 Apr-04 Apr-06 Apr-08 Source: Datastream.

21 Volatilities are on the rise Annualized 100-day rolling historical volatility Percent MSCI Emerging Market S&P500 0 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08

22 Volatilities are on the rise Annualized 100-day rolling historical volatility Percent Nikkei DAX30 5 FTSE100 0 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08

23 Tightening credit U.S. commercial and industrial loans Credit tightening indicator Loan demand indicator Q Q Q Q Q Q Q Q Q Q3 Credit tightening indicator: percent of respondents reporting that credit standards have tightened... over the previous three months. Loan demand indicator: percent of respondents reporting that demand for loans is stronger minus those reporting demand is weaker over the previous three months. Source: International Monetary Fund.

24 Tightening credit U.S. consumer loans Credit tightening indicator Loan demand indicator Q Q Q Q Q Q Q Q Q Q3 Credit tightening indicator: percent of respondents reporting that credit standards have tightened... over the previous three months. Loan demand indicator: percent of respondents reporting that demand for loans is stronger minus those reporting demand is weaker over the previous three months. Source: International Monetary Fund.

25 Tightening credit U.S. real estate loans Credit tightening indicator Loan demand indicator Q Q Q Q Q Q Q Q Q Q3 Credit tightening indicator: percent of respondents reporting that credit standards have tightened... over the previous three months. Loan demand indicator: percent of respondents reporting that demand for loans is stronger minus those reporting demand is weaker over the previous three months. Source: International Monetary Fund.

26 Widening spreads Percent AAA corporate bond yield month treasury yield 1.0 Jan-03 Oct-03 Jul-04 Apr-05 Jan-06 Oct-06 Jul-07 Apr-08 Source: Datastream.

27 Widening spreads Mortgage-backed and high-yield bond Basis point spread above 10-year treasury bond 1200 ML BBB Mortgage-Backed Securities Index ML High-Yield Bond Index Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Bloomberg.

28 Widening spreads Asset-backed and corporate bond Basis point spread above 10-year treasury bond 250 ML asset-backed securities master index yield spread ML corporate master index yield spread 0 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Bloomberg.

29 Widening spreads Municipal bond Basis point spread over 10-year treasury bond 120 ML municipal master index yield spread Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Bloomberg.

30 Reduced yield correlation between Treasuries and BBB corporate bonds 200-day rolling correlation coefficient U.S. Corporation AAA yield and 1-3 Month Treasury yield -0.2 U.S. corporation BBB yield and 1-3 month Treasury yield Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Sources: DataStream and MI staff calculation.

31 Moving to the opposite direction Yield correlation between Treasuries and CMBS 200-day rolling correlation coefficient U.S. CMBS AAA yield and 1-3 month Treasury yield U.S. CMBS BBB yield and 1-3 month Treasury yield -1.0 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Sources: DataStream and MI staff calculation.

32 Increased bank holding of commercial and industrial loans US$ billions 1,500 1,400 Commercial and Industrial Loans of Commercial Banks 1,300 1,200 1,100 1,000 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Federal Reserve.

33 Expanding consumer loans by commercial banks US$ billions Consumer (Individual) loans of all commercial Banks Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Source: Federal Reserve.

34 Some CD rates are above LIBOR Apr. 4, 2008 APY 3-month LIBOR Rate 2.68 GMAC Bank 3-month CD 3.50 Bank of America 4-month CD 3.10 Sources: Datastream and Bankrates.com.

35 Steepened yield curve Percent 6 5 April 15, April 15, Sources: Federal Reserves. Month to maturity

36 Capital raised by stock issues Monthly global IPO and PO US$ billions Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Source: World Federation of Exchanges.

37 Corporate bond issuance in the U.S. US$ billions 1,100 1,000 Speculative grade share of total issuance (R) Percent Total issuance (L) Source: International Monetary Fund.

38 Tightened standards for real estate loans Net percentage of domestic respondents tightening standards for Percent commercial real estate loans 100 The end of S&L crisis Subprime 80 LTCM Dotcom Mar-90 Mar-93 Mar-96 Mar-99 Mar-02 Mar-05 Mar-08 Source: Federal Reserve.

39 Default rate of all U.S. corporate bonds Percent, Issuer-weighted 6 Recessions Sources: Moody's Investors Service and NBER.

40 Default rate of U.S. corp. speculative-grade bonds Percent Recessions

41 Black-Scholes Black-Scholes gives me a better method of valuation than I would otherwise have, but it s not God s truth. Myron Scholes

42 Global over-the-counter derivatives markets June 2007 Foreign exchange Interest rate Equity-linked Commodity Credit default swaps Unallocated Total OTC derivatives Notional amounts 48, ,937 9,202 7,567 42,580 61, ,407 Gross market values 1,343 6,057 1, ,233 11,140 Source: Bank for International Settlements.

43 Interest rate derivatives Notional amount US$ 347 trillion, June 2007 By counterparty By remaining maturity By major currency With other reporting dealers With other financial institutions With nonfinancial customers Up to one year One to five years Over five years U.S. dollar Euro Japanese yen Pound sterling Other Percent of total Source: Bank for International Settlements.

44 Participants in credit derivative market, 2006 Protection Purchased Protection sold Insurance 6% Corp. 2% Mutual funds 2% Other 1% Corp. 1% Mutual funds 3% Other 1% Pension funds 2% Hedge funds 28% Source: International Monetary Fund. urance 17% Banks 59% Pension funds 4% Hedge funds 31% Banks 43%

45 Emerging market bond index global yield spreads Basis points Argentina Russia Ecuador Côte d Ivoire Venezuela Brazil Ukraine Pakistan Uruguay Dominican Republic Source: International Monetary Fund. End of , All-Time High 7,222 7,063 4,764 3,609 2,658 2,451 2,314 2,225 1,982 1,750

46 Estimated potential losses From unsecuritized loans Subprime Alt-A Prime March 2008 US$ billions Commercial real estate Consumer loans Corporate loans Leveraged loans Total for loans Outstanding US$ billions ,800 2,400 1,400 3, ,370 Estimated loss Source: International Monetary Fund.

47 Estimated potential losses From selected securities ABS ABS CDOs Prime MBS CMBS Consumer ABS High-grade corporate debt High-yield corporate debt CLOs March 2008 US$ billions Total for securities Outstanding 1, , , ,840 Estimated mark-to-market loss Source: International Monetary Fund.

48 Debt dependence Leverage ratios at biggest investment banks Total assets to total shareholder equity Bear Stearns Morgan Stanley Lehman Bros. 17 Goldman Sachs Merrill Lynch 15 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Sources: Bloomberg.

49 Debt dependence Leverage ratios at biggest investment banks Total assets to total shareholder equity 40 March March Bear Stearns Morgan Stanley Merrill Lynch Lehman Bros.* Goldman Sachs Note: * the latest figure is as of December 2007 Sources: Bloomberg.

50 Debt dependence Leverage ratios at bank holding companies Total assets to total shareholder equity 21 March 2001 December March Citigroup JP Morgan Chase Bank of America Sources: Bloomberg.

51 Declining leverage at all U.S. commercial banks Total assets to total shareholder equity Sources: FDIC

52 Australia Austria Belgium Canada Denmark Finland France Germany Ireland Italy Japan Netherlands Mortgage debt outstanding Percent of GDP Norway Spain Sweden United Kingdom United States

53 U.S. households have increased leverage materially since 1980 Percent Household debts as % of disposable personal income Sources: Federal Reserve and U.S. Census.

54 U.S. asset-backed securities outstanding 1980, Total = $114 billion 2007 Q3, total = $12.2 trillion Mortgage ABSs (GSEguaranteed) 100% Corporate & foreign ABSs 29% Mortgage ABSs (GSEguaranteed) 35% Assetbacked commercial paper 6% Source: Federal Reserve. Credit card & consumer loan ABSs 6% Mortgage ABSs (private label) 24%

55 Homes for sale Existing and new single family homes, Millions Millions Existing Homes (Left Axis) New Homes (Right Axis) Source: Moody s 0.0

56 Home mortgage share of household liabilities reaches a new high Percent Source: Federal Reserve.

57 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul day delinquency rates on the rise 25% 20% 15% 10% 5% 0% Source: First American Corelogic and LoanPerformance databases. Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Subprime Alt A Jumbo prime

58 The history of credit The 14th century: The bill of exchange - the forerunner of banknotes - was established. Debts were settled by one-third cash and twothirds bill of exchange. The 17th century: Paper money was used. 1730: The first advertisement for credit was placed by Christopher Thornton, who offered furniture that could be paid off weekly.

59 Credit cards are relatively new In 1950, Diners Club and American Express launched their charge cards in the USA, the first "plastic money". In 1951, Diners Club issued the first credit card to 200 customers.

60 Others: Demographics, Education, Water

61 Number of 65+ Americans Millions of people Year (as of July 1) Source: U.S. Census Bureau.

62 Marital status of 65+ Americans 2006 Percent of total Women Married Widowed Divorced or separated/ spouse absent Men Single (never married) Source: U.S. Census Bureau.

63 Burden on working age population Forecast dependency ratio Percent of Working Age (15-64) Japan 70 United States Source: United Nations

64 Aging population in developed countries, Forecast dependency ratio Percent of working age (15-64) Aged 0-14 Aged Source: United Nations

65 Aging population in developing countries, Forecast dependency ratio Percent of working age (15-64) Aged 0-14 Aged Source: United Nations

66 Dependency burden Forecast dependency ratio Percent of working age (15-64) Developing countries Developed countries Source: United Nations

67 Of every 10 people in the world roughly 5 have a connection to a piped water supply at home 3 make use of some other sort of improved water supply, such as a protected well or public standpipe 2 are unserved In addition, 4 out of every 10 people live without improved sanitation. Source: World Business Council for Sustainable Development.

68 Water scarcity 2025 Projected Physical water scarcity Economic water scarcity Source: International Water Management Institute. Little or no water scarcity Not estimated

69 Chicago Climate Exchange, Inc. Financial Innovation: the Use of Markets to Solve Environmental Problems Richard L. Sandor, Ph.D. Chairman and CEO Milken Institute Global Conference April 30, 2008

70 Wealth creation in the U.S. since WW II Manufacturing 1970 s Inflation 1980 s Commoditization of interest rates, asset liability mgmt., commoditization of mortgages and bank debt (junk bonds) 1990 s Commoditization of information: High tech, Telecom 2000 s Commoditization of air and water

71 Impact of trading on SO 2 pollution Annual Mean Ambient SO 2 Concentration The US Acid Rain Program s annual benefits in the year 2010 are expected to be $122 billion (Yr $) - Based on EPA s latest air quality trends data the national composite average of SO2 annual mean ambient concentrations decreased 48 percent between 1990 and 2005.

72 Pre-1992 SO 2 allowance price forecasted vs. actual $2,500 $2,000 $2000 Fine Level Price per ton $1,500 $1,000 $500 $0 $981 United Mine Workers $785 Ohio Coal Office $688 Electric Power Research Institute $446 Sierra Club $392 American Electric Power $309 Resource Data $275 - average auction price, "Phase 1 Middle" prices, 1 Journal, March $1500 EPA Emergency Supply Source: Hahn and May, The Electricity.

73 Benefits of SO 2 emissions reductions Costs to the U.S. economy of the Acid Rain Program: $ 1-2 billion Nominal electricity rates are lower today than in 1990 Current benefits associated with reduced medical expenses associated with lung disease ~ $40-70 billion Future benefits (estimated by EPA) expected to grow to $100 billion annually in 2010 with the same annual costs.

74 CCX & CCFE CFI quarterly volume Volume (Million MT) CCFE CFI Options CCFE CFI Futures CCX CFI Q1 05 Q3 05 Q1 06 Q3 06 Q1 07 Q3 07 Q1 08

75 CCX CFI prices US$ CCX Historical Price (Vintage 2003) February 5, 2008 Super Tuesday /12/03 6/12/04 12/12/04 6/12/05 12/12/05 6/12/06 12/12/06 6/12/07 12/12/07

76 CCFE SO 2 futures & options quarterly volume Millions Q1 05 Q3 05 Q1 06 Q3 06 Q1 07 Q3 07 Q1 08

77 CCFE SO 2 historical prices US$ 1,800 1,600 1,400 1,200 1, /9/98 6/9/00 12/9/01 6/9/03 12/9/04 6/9/06 12/9/07

78 CCFE IFEX futures March 27, 2008 Daily Summary

79 Additional Slides

80 Households Cash Balance Percent Cash to total financial assets Cash to total net worth Cash to total assets

81 23-Apr May Jun Jul Aug Sep Oct Nov-07 DJIA Y/Y almost unchanged down 131 points or 1 percent Dow Jones Industrial Average Index 14,500 14,000 13,500 13,000 12,500 12,000 11,500 11, Dec Jan Feb Mar Apr-08

82 23-Apr May Jun Jul Aug Sep Oct Nov-07 S&P Y/Y almost unchanged down 95 points or 6 percent S&P 500 Index 1,600 1,550 1,500 1,450 1,400 1,350 1,300 1,250 1, Dec Jan Feb Mar Apr-08

83 A history of home price 1890= Current Boom World War I Great Depression World War II 1970 s Boom 1980 s Boom Source: Robert J. Shiller, 2006.

84 History repeats itself YOY change in home price in 100+ years Percentage change, year ago 40% 30% World War I Great World DepressionWar II 1970 s Boom 1980 s Boom Current Boom 20% 10% 0% -10% -20% Source: Robert J. Shiller, 2006.

85 Volatility of U.S. Government Bond Price Quarterly, Q Q % change in price US$ billions, change in market value 15% 10% U.S.Treasury Bond 8 7/8% 08/17 $14 billion Market value (right axis) 4 3 5% 0% -5% -10% -15% -20% Q Q Q Source: Bloomberg. US$ 3.5 billion loss in a quarter. Q Q Q Q Q Q Q Q Q Q Percent change in price (left axis) Q Q Q Q Q Q Q Q

86 High Prices Cause Food Shortage

87 The Growth of World Population and Some Major Events in the History of Technology Source: Fogel, Robert W., The Escape from Hunger and Premature Death, , Europe, America, and the Third World, Figure 2.1, p. 22, Cambridge University Press, 2004.

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