Overview on :

Wall Street Black Sunday :

what lessons can we learn

Yunia.lie@thomsonreuters.com
CDS Basket #4447707. Markit v452&v453 #4450164, v501 #4450174, v510 #4450353.
Agenda

Wall Street’s Black Sunday

Possible Roots of the Problem

Events unfolded … …

Lessons to learn

2 Wall Street Black Sunday – what lessons can we learn ?

Wall Street’s Black Sunday
 1. The burst of US real estate fueled CDO bubble

2. Increased supply of Creative CDO

(CMO/CBO/ABS)
to meet yield-hungry local & global demand
3. Over-supply of Houses,
Falling Property Prices
& Rising Defaults

S&P
New Home Sales financial sector

1. Irresponsible policies, 4. Collapse or Forced-sale 6. Fourteen

Deregulation politics, of Investment Banks Central Banks
Loose lending, Filed for cut rates but
Bankruptcy Protection
Low borrowing rate markets stay
on 15 Sep 2008, Monday
& Rising Property Price fearful.

5. The revised 700 billion bail out package for

Fannie, Freddie & AIG is finally approved by
US Congress on 4 Oct 08

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1.1.1 Irresponsible Policies & Deregulation Politics ?

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1.1.2 Who and What to blame ?
Highly Leverage Investment Banks ?

Politician ?

Regulators? Greed ?
More Commission for the Sale persons ?
Economists or Noble Price winners for Economics
Higher Yield for the Investors ?
on Merits of Deregulation ?
Fat Bonus for the Bankers ?
Revealed half of the equation, how about its Demerits ?

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1.1.3 “The World may come to an End but I still want my Fat Bonus”

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 1.2 Structured Note Investor’s Woes

Policewomen comfort a weeping Lehman Brothers minibond investor outside the Bank of China Tower,
one of the banks which sells the minibonds, in Hong Kong October 8, 2008.
Hong Kong's government has proposed a way to let investors recoup some losses from a reported
$2 billion
8 Wall Street Black
in securities Sunday
linked – what
to failed lessons
Lehman can we
Brothers, learn
urging ?
distributing banks to buy the bonds
back. REUTERS/Bobby Yip (CHINA)
1.3 The Story of Foreclosure Alley
Main points :

3. Seven hundred families lose their homes to foreclosure everyday.

5. People leave behind many valuable material possessions during a foreclosure

because they may no longer be able to pay for them.

8. Original prices for these foreclosed homes just a few short years ago :
$ 399,000. Today, they are worth $180,000 … …

From : http://www.thedigeratilife.com/blog/index.php/category/things-gone-awry/
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1.4.1 Lehman Brothers Investment Bank walked into history

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1.4.2 From Wall Street to Main Street

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1.5.1 Brief Background on Fannie Mae and Freddie Mac

Fannie Mae was created by the government during the Great Depression
Freddie Mac was created in 1970.
They are both what are know as "Quasi-Governmental" agencies
(semi-private companies).
They issue stocks. They report earnings. They have a board of directors, CEO, CFO, etc.
But they are basically controlled by the Federal Government, the OFHEO.

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1.5.2 % of subprime loans ALREADY on Freddie's books that are deliquent

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1.6.1 Warren Buffett on Derivatives

Mar 2003
“Time bomb”

“ Derivatives are financial weapons of mass destruction”

“ Contracts devised by ‘madmen’ “

“ Derivative Business like hell … easy to enter and almost impossible to exit”

“ The rapidly growing trade in derivatives poses a ‘mega-catastrophic risk’ for the economy …”

“Large amount of risk have become concentrated in the hands of relatively few derivatives dealers
… which can trigger serious systemic problems”
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1.6.2 Alan Gleenspan on Credit Crisis

Sep 14, 2008

“US in ‘once-in-a-century’ financial crisis”

Dec 2007 Don't blame me for credit crisis

“Subprime Mortgage Crisis is an ‘accident waiting to happen’
as a period of unprecedented global growth lulled investors into a false sense of security.”

“The root of the current crisis, lies back in the aftermath of the Cold War, when market capitalism
quietly, but rapidly , displaced much of the discredited central planning that was so prevalent in the
Third World”

“Interest rates are, in part, designed to reduce the impact of inflation, which erodes an asset’s value
in real terms.
As the outlook for inflation continued to remain low, so interest rates came down and borrowing
for mortgages and other assets went up.”

He believes that there was little the Federal Reserve could have done to prevent credit markets
from seizing up in August : “After more than half a century observing price bubbles evolve and
deflate, I have reluctantly concluded that bubbles cannot be safely defused by Monetary Policy or
other Policy Initiatives before the speculative fever breaks on its own.”

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1.6.3 Free Market or Flee from Market ?

Dow Jones Industry Average Index Nasdaq 100

Nikkei 225 FTSE

Hang Seng Index Straits Time Index

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1.6.4 Watch out for G.O.D

Gold Price

US Dollar Index (=USD) provides a general indication

of the international value of the USD.
(Trade-weighted geometric average of 6 currencies)

Crude Oil Futures US Dollar Index

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1.6.5 Why USD index rose ?
Possible Reason :
US companies are selling Assets overseas to paying back debts in USD to stay afloat.

GBP=

Money flows EUR=

AUD=
Money flows

18 Wall Street Black Sunday – what lessons can we learn ? NZD=

1.7.1 Possible Roots of the Problem

Instead of problems in economy pulls down the financial markets, businesses have
troubles repaying their loans, now we have the reverse,
and these are some of the possible reasons :

1. Private greeds, ignorance and recklessness,

(as greed exceeds fear, trouble follows)

2. Public regulatory negligence,

Wall Streeters did not have to worry about regulations
nor risk as it was supposedly hedged away with credit derivatives.
(Investment Banks are not bounded by Basel II)

3. Alan Greenspan’s low interest rate environment.

(cheap money and low cost of funding)

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1.7.2 Possible Roots of the Problem

4. Property Bubbles
(hardly any fear of buying a house with nothing down as property prices
would be going up,
hardly any fear of making mortgage loans as the price appreciated property
would increase the value of collateral if borrowers could not or would not pay.)

5. Flawed Practices at Ratings Firms

(Report confirms agencies considered own profits when rating securities)

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1.7.3 Possible Roots of the Problem

6. High Leverage : double-edged sword

(Lehman borrowed huge sums relative to its size, its debt were about 34 times
its capital,
Unfunded CMO or CDO structure further increase the leverage factor and risk)

7. Sophisticated Products that are not meant for Retail Investors

(Try to ask them to price a MBS or CMO or CDO or CDO2)

8. Inverted Pyramid credit derivatives

Provide credit protection on
$42.6 trillion in debt in Jun 2007
(from BIS)

$5 trillion outstanding in
global corporate bonds

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1.7.4 Possible Roots of the Problem

9. Distortion in the Credit Market

(The fact that so much money was flooding into the CDO market,
CDS sellers were being forced to accept less and less money for the
credit protection they were providing.

Example
European bondholders could now protect EUR 10 million of bonds for
five years at a record-low cost of EUR 189,000 in 2007.
That was down 58% from the EUR 450,000 that protection cost in 2005.

This raises the whole issue of counterparty risk.

A CDS contract is not worth the paper it is printed on if the guy who sold you
the protection gets vaporized in a credit crisis.

Question to ask :
Are CDS sellers really collecting enough money to put them in a position to
make bondholders whole in the event of a default ?

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1.7.5 Possible Roots of the Problem

9. Financial Engineers or Quants that failed to factor in the Counterparty Risk

when pricing the CDS or Credit Derivatives.

“Credit Derivatives are supposedly a way to hedge risk,

I’m sure their predictive models were right as far as the risk of the things
they were insuring against.
But what they didn’t factor in was the the risk that the sellers of this
protection wouldn’t pay … That’s what we’re seeing now.”

says Ellen Brown, the author of the book “Web of Debt.”

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1.7.6 Review on “Flawed Practices at Ratings Firms”

CRASS …
“let’s hope we will all be wealthy and retired by the time this house of cards falters”
An analyst, in a candid assessment, emailed to a colleague in December 2006, of
certain investments linked to subprime mortgages.

CARELESS …
“It could be structured by cows and we would rate it.”
An analyst, in a note written in April 2007, revealing that analysts, faced with less
time to perform the due diligence expected of them, began cutting corners.

CONNIVING …
“I am trying to ascertain whether we can determine, at this point, if we will suffer
any loss of business because of our decision and, if so, by how much ?”
An analyst, in a November 2004 email, pegging his rating to his firm’s revenue.

From New York Times, reprint in The Straits Times on July 10, 2008.

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1.8 Fixed Income View : Search for Distressed Debts

1. Choose relevant Job role

2. Click Distressed Debt

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1.9 Credit View : Recovery Rate for Lehman’s CDS

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1.10 CDS Chart

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1.10.1 CDS Chart : CDS premium widens

Lehman Brothers Screen shot

AI captured on
Merrill Lynch 21st Sep 2008
Morgan Stanley

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Apr 2008 Sep 2008
1.10.2 CDS premium as lead indicator of falling Equity Prices

5Y CDS premium of Lehman Brothers Inverse Equity Price of Lehman Brothers

5Y CDS premium of AIG Screen shot

Inverse Equity Price of AIG captured on
21st Sep 2008

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1.11.1 Review on Commercial Banks & Investment Banks

Investment Banks
(full grown vine)

Commercial Banks
(boring trees)

Everyone is willing
to lend money to
a profitable investment bank

30 Wall Street
In good Black everyone
times, Sunday – what lessons
wants canan
to join weInvestment
learn ? Bank
1.11.2 In challenging times …

Commercial Banks Investment Banks

with cost of fundings that are unable to borrow money
fully backed by public deposits to fund their operations
(trees with deep roots) (dried vine)

Credit Crunch

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1.11.3 Case Study on Lehman Brothers Investment Bank
Balance Sheet of an Balance Sheet of an Balance Sheet of an
Investment Banks Investment Banks Investment Banks
in good times in bad times in crisis

Positive Equity reduce MV(Asset)

reduce Equity MV(Asset) < PV(Liability)
but not PV(Liability) => Negative Equity

Present Value
Market Value Market Value Present Value Mar
of Liability ket
of Assets of Assets of Liability of A Valu
sset e
s Pres
ent
CMO/CBO/CLO of Li Valu
Cash Mark-to-market abili e
ABS/CLN ty
Bonds Mark-to-model
Structured Notes
CDS Equity
Mini-Bonds
Equities
Others

Equity

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1.11.4 Last Line-up for Staffs in Lehman Brothers (12 Sep 08)

Picture shot by Kevin Coombs, senior editor in charge for Reuters Pictures,
in 4th floor newsroom at Canary Wharf,
an office directly across from the Lehman offices.

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1.12.1 Events Unfolded … More Regulation
1. Private greeds, ignorance and recklessness,
(Contained the greed through Regulation and Supervision)

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1.12.2 Events Unfolded … IB walked into History

2. Public regulatory negligence,

Wall Streeters did not have to worry about regulations
nor risk as it was supposedly hedged away with credit derivatives.
(Investment Banks had gone into History, the surviving ones will be converted
to Commercial Bank-equivalent or be acquired by Commercial Banks)

News on 22 Sep 2008

“Morgan Stanley and Goldman Sachs have received Federal Reserve approval to
become bank holding companies.

The last two giant investment banks on Wall Street concluded that they would
have more flexibility and opportunities if they submitted to supervision by the
Federal Reserve.

They will have access to the Federal Reserve Bank Discount Window and
expanded opportunities for funding, which may allow them to avoid the fate
of their former rivals Bear Stearns, Lehman Brothers and Merrill Lynch.

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1.12.3 Events Unfolded … All eyes on Ben Bernanke
3. Ben Bernanke’s future interest rate policy
(future FED target rate will have more factors to consider)

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 1.12.4 Events Unfolded … Nomura’s acquisition of Lehman

Japan’s
37 Nomura
Wall Holdings
Street bought
Black Sunday the lessons
– what Asian operations of? Lehman.
can we learn
It later also acquires its European Investment Banking Operations.
1.12.5 Events Unfolded … AIG to sell businesses

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1.12.6 Events Unfolded … A more responsible ratings agencies

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1.13 Question on Responsibility & Accountability

The teenage girl is pregnant,

the teenage boy and girl may be held responsible,

but

should their parents (tax-payers) be accountable ?

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1.14.1 Summary : why is this happening ?

In a nutshell,

• Borrowers who stretched out too far,

2. Mortgage brokers who pocketed big commissions on loans they knew were bad,

7. Wall Street banks that packaged those bad loans, applied a little “sweetener”
and sold them to investors,

10. Investors who did not bother to check the “label” carefully what they were
purchasing and relied on rating agencies who gave their unfounded blessing on
the investments.

……

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1.14.2 Summary : we should learn how to write “R”

1. Regulation and Reshaping

for Banks and hedge funds.

4. Risk Management :
focusing on Credit Risk,
on Market Risk,
on Operation Risk,
on Liquidly Risk,
on Counterparty Risk.

9. Rating Supervision :
for Ratings Agencies

4. Re-education :
to un-learn and to re-learn,
financial text books should and will be re-written.

……

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 Questions
&
Answers

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