Page 1 of 6 This research note is a follow-up to a previous fundamental business driver that detailed the recent PIGIS sovereign debt crisis. 1 This ongoing crisis has not only wreaked economic and political havoc in Portugal, Italy, Greece, Ireland, and Spain (PIGIS) but it has also shaken the broader European markets as well. While the PIGIS countries and their Eurozone neighbors have addressed the critical issues of their crisis, the world markets have responded in a fundamentally different manner to this situation compared to the global financial crisis of 2008, which had its origins in the collapse of the U.S. subprime mortgage market. This report summarizes the key differences between the current PIGIS crisis and the global financial crisis two years ago. Systemic vs. Local Implications The 2008 financial debacle was a crisis of epic global portions that negatively impacted the entire banking system and the global economy. Interbank, mortgage, and consumer lending markets froze as banks refused to lend on a commercial and retail basis. Banks began to actively re-engineer their balance sheets through aggressive deleveraging and incurred asset write downs at such a rapid pace that almost all major U.S. and European banks could have become insolvent, save for numerous government rescue packages that helped to re-capitalize and stabilize the banks. The current PIGIS sovereign debt crisis, by contrast, has unfolded as a series of local events with potentially larger regional implications for the rest of Europe. The PIGIS crisis has created significant funding pressures for European financial institutions that hold large amounts of PIGIS sovereign debt, but has not yet created conditions indicative of a systemic crisis. If Europe is unsuccessful in containing the PIGIS crisis from expanding into other countries within the Eurozone, market turmoil could develop into a full regional crisis imperiling other vulnerable economies. To date, the PIGIS crisis has many investors convinced that the sovereign debt of Portugal, Italy, Spain, and Ireland may also be at risk as these countries struggle to stay solvent. Furthermore, the PIGIS crisis has raised concerns that the status of the Euro currency may be jeopardized as a bona fide reserve currency. Frozen vs. Tighter Financing Markets Until the financial crisis of 2008, major banks were overly reliant on both wholesale funding in the interbank markets and overnight financing in the repo markets, with no contingency plans should those markets encounter a shock. The subprime mortgage crisis that peaked with the collapse of Lehman Brothers, the nationalization of Fannie Mae and Freddie Mac, Bank of America s acquisition of Merrill Lynch, and the U.S. government rescue of insurer American International Group in September 2008 provided such a shock. The housing-related market crash and the ensuing financial crisis negatively impacted the value and performance of U.S. bank-held assets by well over $1 trillion in its aftermath. As events unfolded, reliedupon lending markets froze, as many investors, concerned with counterparty bankruptcy risk, refused to lend in short-term funding markets such as commercial paper and repo. Additionally, banks themselves refused to lend to others in the interbank markets, instead opting to leave excess balances at the Federal Reserve, considered one of the few safe places to position cash. The financial crisis of 2008 created enormous upward pressure on the spread between the 3-month London Interbank Offered Rate (LIBOR) and the 3-month Overnight Indexed Swap rate (OIS). As global banks faced a crisis in which repo financing was greatly diminished for much of their U.S. dollar- 1 See "My Big Fat Greek Debt Crisis, May 13, 2010, by John Nyhoff, Director, Financial Research & Product Development.
Page 2 of 6 denominated assets, they turned to the wholesale interbank markets to meet their funding needs. Banks, including contributing LIBOR panel members of the British Bankers Association, found the interbank market for (overseas) U.S. dollars equally frozen as banks did not wish to lend to one another, especially for terms greater than overnight, which drove 3-month LIBOR higher. Simultaneously, the Federal Reserve Bank of New York, acting on the behalf of the Federal Open Market Committee, flushed the federal funds market with available overnight funds, artificially driving the (domestic) fed funds effective rate down, the key component of 3-month OIS. When 3-month LIBOR trades at a large premium over 3- month OIS, it is indicative of counterparty bankruptcy fears. As shown in Exhibit 1, the 3-month LIBOR- OIS spread peaked at 364 basis points between September 15 and December 31, 2008, the apex of the 2008 financial crisis. The financial crisis of 2008 also produced similar pressure on the spread between the 3-month Euro Interbank Offered Rate (Euribor) and the 3-month Euro Overnight Index Average (EONIA), a spread that is a reasonable economic equivalent to the LIBOR-OIS spread. The 3-month Euribor-EONIA spread reflects the difference in lending rates between the European domestic 3-month interbank rate and the European domestic unsecured overnight interbank rate. As shown in Exhibit 2, during the peak period of the 2008 financial crisis, the 3-month Euribor-EONIA spread widened significantly like the 3-month LIBOR-OIS spread, albeit to a lesser degree, topping out at 207 basis points. During the PIGIS debt crisis, however, the interbank and repo markets continued to function even as key interest rates underlying these markets increased. Subsequently, the 3-month LIBOR-OIS spread and the 3-month Euribor-EONIA spread only experienced modest widenings when compared to the 2008 financial crisis. Between May 7 and July 16, 2010, when the PIGIS crisis was at its i worst, the 3-month LIBOR-OIS spread topped out at 34 basis points, a spread level that was approximately 91 percent below the peak spread level that prevailed during the 2008 financial crisis. Likewise, during the May 7 through July 16 period, the 3-month Euribor-EONIA spread topped out at 33 basis points, a spread level that was approximately 84 percent below the peak spread level that was recorded during the 2008 financial crisis. The 3-month LIBOR-OIS spread increased more than the 3-month Euribor-EONIA spread during the PIGIS crisis largely because European banks were experiencing greater funding pressure in U.S. dollars than in euros, due to their large holdings of U.S. dollar-denominated assets. While the 3-month LIBORbanks continue to view OIS spread is now about equal to the 3-month Euribor-EONIA spread, European the U.S. dollar as a safe haven and hedge against continued euro depreciation.
Page 3 of 6 Deleveraging vs. De-risking During the 2008 global financial crisis, with underperforming assets dropping in value by over $1 trillion as they were marked-to-market, banks had to drastically reduce overall levels of leverage to bring their assets-to-liabilities ratio not only back in line, but ensuingly lower. In order to stay solvent, surviving banks received capital infusions from their home governments, and later were required to raise capital to fill the void left by the toxic asset write-downs. This resulted in massive deleveraging on a global scale as banks shrank their balance sheets and related use of derivatives. CME Group, like many markets worldwide, experienced sudden and large decreases in volume and open interestt as market participants scaled back their trading activities or went out of business. 2 Throughout the 2008 financial crisis, CME Group sustained double digit percentage declines in volume and open interest on a year-over-year basis in both Treasury and Eurodollar futures, its two key core interest rate product franchises. As Exhibits 3 and 4 illustrate, CME Group experienced sharp declines in volume and open interest, hitting bottom between December 2008 and March 2009. As 2009 progressed, these declines became smaller in scope as deleveraging leveled off. Throughout the financial crisis, banks participated in numerous government programs established to temporarily provide U.S. dollar wholesale funding and repo financing necessary to stay solvent, including the Term Auction Facility (TAF), a liquidity program that provided repo financing. In addition, the Federal Reserve System joined forces with major central banks around the globe by establishing reciprocal currency arrangements (i.e., swap lines) that were designed to improve liquidity conditions in global financial markets and to mitigate the difficulties of obtaining U.S. dollar funding in fundamentally sound and well managed economies. In contrast to today s PIGIS debt crisis, major banks now have largely reduced their leverage ratios to appropriate levels and completed raising necessary capital. These measures have left banks in a stronger position to weather higher levels of volatility. Also, major banks are not as reliant upon interbank or repo markets, having already secured longer term financing via bond issuance (Exhibit 5). The PIGIS crisis, however, has resulted in increased risk management activities to de-risk portfolios, as market participants have meaningfully begun to re-establish hedges in derivatives markets in response to the 2 See "Hedge Fund Update, March 18, 2010, by John Labuszewski, Managingg Director, Equity, Foreign Exchange, and Alternative Instrument Research & Product Development; Tina Lemieux, Managing Director, Hedge Fund and Broker Services; and Kelly Brown, Director, Hedge Fund and Broker Services.
Page 4 of 6 volatility brought about by the current PIGIS situation. Accordingly, open interest in CME Group interest rate products increased in May 2010 by 22 percent compared to the end of 2009. Exhibit 5: 2008 Global Financial Crisis v. 2010 PIGIS Debt Crisis Comparison 2008 Global Financial Crisis 2010 PIGIS Debt Crisis Market Conditions: Banks overly reliant upon overnight financing. Banks assets became toxic; values plummet. Toxic assets no longer acceptable collateral. Banks solvency called into question. Cash lenders pulled back on credit concerns: Repo markets freeze. Wholesale funding freeze. Results: Trillions in write-downs. Market Conditions: Banks less reliant upon overnight financing. Toxic assets written down; values stable. Euro debt on balance sheets a concern. No Change. Fewer bank solvency concerns. Commercial paper issuance declined. Treasury repo market strong. Some pullback in wholesale funding. Results: Write-downs continue to much less extent. $1 trillion in capital infusions necessary. Capital positions of banks stable. Leverage collapsed. Government lending and repo programs introduced and supplanted private market. Underlying markets froze and slowly became functional again (e.g., Treasury repo, exchange volumes and open interest). 3-month LIBOR-OIS spread spiked by 294 basis points to 364 bps. Higher mix of longer-term financing with less reliance on overnight and wholesale funding. Deleveraging vastly complete. Re-introduction of some programs. Underlying markets performing strongly. 3-month LIBOR-OIS spread rose by 24 basis points to 32 bps. Longer-term financing in place; reduced critical need for overnight or wholesale funding. Aftermath of PIGIS Crisis On May 2, 2010, Greece, its Eurozone neighbors, and the International Monetary Fund reached an accord on a loan agreement and austerity measures. The Eurozone countries and the IMF will loan Greece 45 billion in 2010 to bridge Greece s immediate funding needs and will make additional funds available later if required. Greece, in turn, agreed to impose a final round of austerity measures aimed at reducing public expenditures and debt. Greece s sovereign debt rating has been downgraded to high yield, or junk, status with negative credit watch implications. With the exception of Italy, Spain, Portugal, and Ireland have suffered downgrades in their sovereign debt ratings in the wake of the PIGIS crisis. Sovereign 5-year credit default swap spreads for Greece and the other at risk European countries, after peaking in early May, continue to be elevated above spreads levels prevailing before the PIGIS crisis (Exhibit 6).
Page 5 of 6 How Flight-to-Quality Benefits CME Group If the PIGIS situation leads to further at-risk European countries becoming vulnerable, a wide scale credit and currency meltdown could ensue as a result of a full-blown regional crisis that would facilitate increased investor movement out of Europe. With the U.S. economy and financial markets stabilizing, investors are likely to seek a safe haven, such as U.S. asset classes in general and U.S. Treasuries in particular. If the situation in Europe were to worsen, it could produce positive headwinds for CME Group markets as a direct result of flight-to-quality issues sues and the U.S. dollar s strong position as the global reserve currency. Since we are not witnessing the underlying market malfunctions that were a hallmark of the 2008 global financial crisis indeed, the cash government securities, financing, and exchangelisted derivatives markets have all been performing strongly in 2010 CME Group Treasury and Eurodollar markets should be well positioned to benefit from flight-to-quality inflows as investors manage their interest rate risk with these products. With the European situation driving market de-risking and CME Group open interest experiencing strong growth in 2010, one might draw the conclusion that as market participants de-risk, they establish hedges (additional open interest) in the derivatives markets to help insulate them from downside risk.
Page 6 of 6 Exhibit 7: Flight-to-Quality and Major Market Events 3 Date Market Event Treasury Futures Eurodollar Futures ADV YoY MEOI YoY ADV YoY MEOI YoY October 1987 DJIA -508.00 points 66% 61% 115% 66% August 1990 First Gulf War -8% -4% -18% 4% September 1992 Soros breaks Bank of England 27% 41% 46% 74% December 1994 Mexican debt crisis 12% 12% 76% 21% January 1995 Mexican debt crisis 9% 9% 77% 13% July 1997 Asian debt crisis 10% 24% 3% 6% October 1997 DJIA -554.26 points 49% 50% 33% 16% August 1998 LTCM debacle, Russian debt crisis, DJIA -512.62 points 25% 65% -4% 15% April 2000 DJIA -617.77 points -2% 3% 27% 7% September 2001 9/11, DJIA -684.81 19% 16% 96% 46% October 2001 T-Bond suspension 15% 22% 87% 47% March 2003 Second Gulf War 41% 20% -15% -7% September 2007 LIBOR-OIS spread +95 basis points 51% 20% 42% 9% December 2007 LIBOR-OIS spread +106 basis points 30% 18% 8% 4% March 2008 Bear Stearns collapses 21% 15% 25% 3% September 2008 Lehman Brothers debacle, DJIA -777.68-17% -18% -17% -15% October 2008 LIBOR-OIS spread +364 basis points, 4 major DJIA declines -20% -22% -22% -17% December 2008 ZIRP begins, LIBOR-OIS +191 basis points, DJIA -679.95-50% -41% -35% -26% March 2010 PIGIS debt crisis 53% 29% 27% 16% April 2010 PIGIS debt crisis 61% 39% 45% 21% May 2010 PIGIS debt crisis 56% 44% 53% 21% June 2010 PIGIS debt crisis 69% 46% 27% 19% July 2010 PIGIS debt crisis 45% 42% -3% 16% 3 All figures in this exhibit are based on year-over-year comparisons. As an example, for the October 1987 Dow Jones Industrial Average market decline of 508 points, Treasury futures average daily volume and month-end open interest for October 1987 were up +66% and +61%, respectively, from Treasury futures ADV and MEOI for October 1986 on a year-over-year basis. Likewise, Eurodollar futures ADV and MEOI for October 1987 were up +115% and +66%, respectively, from October 1986 Eurodollar futures ADV and MEOI on a year-over-year basis. For more information, please contact: James Boudreault, Associate Director, Financial Research and Product Development, CME Group (312) 930-3247, james.boudreault@cmegroup.com Daniel Grombacher, Director Financial Research and Product Development, CME Group (312) 634-1583, daniel.grombacher@cmegroup.com