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After the storm 27 aug 2010

  1. Time for storytelling… After the storm Gaurav Sharma 27 August 2010 1
  2. Global Financial Crisis Consumer Credit Markets Capital Markets Alternate Assets (Private Equity etc Big Shifts Approach 1 2 2 3
  3. Lets get Started 3
  4. Global Financial Crisis -Timeline of Crisis 2007/08…. The recent financial crisis is categorized as the worst since the Great Depression. Some of the major events related to the crisis are mapped to the Dow Jones Industrial Average 4
  5. The turmoil was not merely another turn of the business cycle but a restructuring of the economic order. 5
  6. Causes: US Housing Market Collapse Many expertsbelievethat theglobal crisiswastriggeredbytheUS housingmarket collapse Easyaccessto credit: Falling interest rates and rising availability of mortgages, combined with rising housing prices encouraged consumersto buy homes Relaxed lending standards: To cater to the growing number of mortgage seekers, lenders relaxed standards and issuedalarge number of sub-primeloans Inadequate regulations: Regulations did not keep pace with innovations in US financial products,leading to much higher complexity, poor transparency and greater risk Complex credit derivatives: The invention and use of complex debt derivatives such as CDOs1 madeit difficult to identify and contain the sub-prime lending problem, oncedefault ratesbegan to Rise Market collapse: The property boom led an over-supply of housing and prices could no longer be supported. Just like the self-perpetuating behaviour that led to the rise, the crash was also self- perpetuating. As pricesfell, more foreclosuresstarted taking place, increasing the supply of homeson the market. Lenders started to tighten their standards and fewer consumers could qualify for mortgages and help reducethe supply 6
  7. Growing global financial assets provided increasing liquidity and credit availability at a global level 9 Private debt 10 securities 7 8 19 10 4 3 19 25 26 29 34 38 38 40 13 14 14 17 20 23 23 25 3 12 2 5 18 15 23 65 32 22 93 28 91 23 94 32 30 25 38 34 133 44 35 140 54 2 116 160 Equity securities Govt debt securities Bank deposits +8% +10% 41 3.333. 1.09 1980 95 2000 01 02 03 04 05 2006 CAGR % 95-04 06-08 Global financial assets $, trillions 4 4 Global Fin. assets/GDP, % U.S. Fin. assets/GDP, % Sources: McKinsey Global Institute; Global Financial Stock database 7
  8. Historically low global interest rates after the bursting of the dot- com bubble sparked greater global liquidity… 0 1977 87 Sources: Federal Reserve System; ECB statistics 5 10 15 20 FF ECB Japan 97 00 07 Global interest rates % Global rates hit historic lows in aftermath of dot-com bubble burst 03 Fed and ECB monetary easing created greater liquidity and helped global rebound after the tech-bubble burst 8
  9. A vicious cycle completed to drive further illiquidity Risk aversion of investors Falling asset prices Announce- ment of losses Banks reduce funding to other banks Banks pay inflated price for liquidity Investors avoid lending to banks Banks/ hedge funds need to liquidate positions Rising losses in subprime market 9
  10. Genesis of a Crisis Scant Regulatory Oversight Originate-and- Distribute Model Deterioration of Underwriting Standards Mortgage Securitization Mispricing of Risk Credit Default Swaps Excess Global Liquidity CrisisExcessive Financial Leverage Low Interest Rates Driveto Increase Investment Returns Rising Real EstatePrices 10
  11. Regulatory Balkanization – Failure of Oversight Officeof Thrift Supervision Federal Deposit Insurance Corporation Individual States Department of Labor Officeof the Comptroller of theCurrency Federal Reserve National Credit Union Administration Securitiesand Exchange Commission Commodity Futures Trading Commission Commercial Banks Thrifts Insurance Companies Securities and Exchanges Futures Credit Unions Industrial Loan Companies Bank Holding Companies 11
  12. Global Financial Crisis  Proximatecauses  Sub-prime lending  Originate and distribute model  Financial engineering, derivatives  Credit rating agencies  Lax regulation  Largeglobal imbalances  Fundamental cause  Excessively accommodative monetary policy in the USand other advancedeconomies(2002- 04) 10 8 6 4 2 0 12 Jan-90 Dec-90 Nov-91 Oct-92 Sep-93 Aug-94 Jul-95 Jun-96 May-97 Apr-98 Mar-99 Feb-00 Jan-01 Dec-01 Nov-02 Oct-03 Sep-04 Aug-05 Jul-06 Jun-07 May-08 Percent Effective Federal Fund Rate in the US US Monetary policy too loose during 2002-04; aggregate demand exceeded output; large current a/c deficit; mirrored in large surpluses in China and elsewhere.
  13. • Lowinterest rates • Excessivefinancial leverage • Complexity of financial products • Lack of effective risk managementat largeinstitutions • Inadequateappreciation/regulation of derivatives risk • Conflicts of interest at rating agencies • Mark-to-market accounting • Lackof accessto liquidity • Poor corporate governancepractices How Did We Get in the crisis? 13
  14. Differences Between Financial Crisis in US/Europe and India What hasnot happenedhere  No subprime  No toxic derivatives  No bank lossesthreatening capital  No bank credit crunch  No mistrust between banks Our Problems  Reduction in capital flows • Pressure on BoP • Stock markets • Monetary and liquidity impact • Temporary impact on MFs/NBFCs(Sept-Oct) • Reduction in flow from non-banks • Perceptionsof credit crunch 14
  15. But do we really understand the real reason for crisis ? The conventional wisdom used to be that the basic cause of the crisis was bad incentives in the mortgage industry , while it’s tempting to blame what happened on just a few greedy bankers who took irrational risks But isthat the real reason.... The largeglobal impact of the crisissuggeststhat the problems with subprimemortgageswere asymptom rather than the cause The main causesare: -Flawed global financial order in which the incentives to take on risk are incrediblyout of step with thedangersthoseriskspose. -System where growing inequality and thin social safety net createstremendous political pressure to encourage easy credit and keep job creation robust, no matter what the consequencesto theeconomy’slong-term health -Unequal access to education and health care in the united states and other countries (includingIndia) puts everyone in deeper financial peril. 15
  16. So far…. 16
  17. Global banking trends after the crisis The near-term prospects for US and European banks are decidedly grim. The global financial crisis will bring about the most significant changes to their operating framework banks have seen in decades. There will be fundamental re-regulation of the industry, ownership structures are shifting towards heavier state involvement and investor scrutiny is rising strongly. Equity ratios will be substantially higher. As a result, growth and profitabilityof thebanking sector asawhole arelikely to decline. Lean years lie ahead for US banks. Performanceimprovementsduring thelast 15 yearshaveoften been due to strong lending growth and low credit losses. As private households reduce their indebtedness, revenue growth in some European countries but especially the US may remain depressed for several years. With weak loan growth and a return of higher loan losses as well as a fundamentally diminished importance of trading income and modern capital market activitiessuchassecuritisation,banksmaybelacking major growth drivers. Consolidation to continue but with a different focus. Whiletherewill still be aconsiderable number of deals, transaction volumes are likely to decline and restructuring stories rather than strategic M&A may dominate.Theprobability of domesticdealshasincreased,while that of cross-bordermergershasdeclined. Internationalisation of banks likely to slow. Uncertainty about the future prospects especially of foreign markets and strictly national banking sector stabilisation programmes are triggering a re-orientation towards domestic markets. This is more relevant for European banks that have greatly expanded into other European countries recently, whileAmericanbanksoverall maycontinueto target thenational market ratherthangoing abroad. 17
  18. expanding price-to-earnings multiples during the long economic expansion. Over the past decade, PE rode a credit bubble inflated by low interest rates to record deal values. That boom, of course, came to an abrupt end with the mortgage-led debt crisis that froze credit markets in 2008 and triggered a global recession affecting nearly every industry. Private Equity is a cyclical business Global Private Equity From private equity’s heyday a few years ago when deal makers were riding high, to the gut- wrenching drop in deal making through last year’s recession, this industry knows what it’s like to ride the roller coaster. Private equity has always been a cyclical industry, and signs of a nascent rebound in 2010 underscore that fact. Since it emerged as a major asset class in the 1980s, PE has experienced three major booms. In the 1980s, the PE industry capitalised on the sale of many poorly run public companies and corporate divestitures available at low cost and largely financed with junk bonds. During the 1990s, debt financing prominent role. PE industry returns mainly by gross domestic product played a less were driven growth and 18
  19. India’s economy has experienced a robust and broad- based recovery from last year’s financial slowdown Fund-raising has been on the rise again, particularly, from the domestic fund houses. While the core infrastructure sector and the telecommunications sector continued to attract PE investment, we are experiencing the revival of the real estate sector. Other sectors like consumer products and retail, financial services and technology are also showing signsof improved deal activity. There were 11 PE-backed IPOs thus far in 2010 — compared to seven total in 2009 — as the companies leveraged the rising stock market to raisecapital. More PE-backed IPOs in the comingmonthsif the stock market remainsfavourable. Lookingahead, valuations are an expected concern, accentuated by the fact that stock markets continue to soar. Top deals see global funds participate; emerging consumer-driven sectors Private Equity - India 19
  20. •Private equity’s ―golden age‖ of low interest rates, abundant leverage, mega-deal making and effortless returns is over, and will not soon return. Global PE investments sank to a level not seen since the last downturn. All regions and industry sectors suffered. •The dynamics underlying the decline differed by region. In North America and Europe, economic uncertainty and frosty debt conditions constrained deal making. In emerging markets, the massive dislocation of value brought about by declining economic growth and tumbling equity markets led to a mismatch of buyer and seller expectations. In both regions, the rapid rebound of equity markets did not give valuation anddeal multiples achanceto reset. •PE firms readjusted their investment focus to the opportunities 2009 presented, favoring carve- outs, growth equity, acquisition finance, balance-sheet restructuringsand distressed debt investments. •Fund-raising declined across all major PE asset classes and was weak in every region. Despite their continued commitment to PE, the ―denominator effect‖ and the paucity of PE distributions squeezed LPs’ liquidity and impaired their ability to commit to new funds. •The downturn forced significant markdowns in portfolio valuations, causing short-term PE returns to declineby double digits; recent vintageswere hit hardest. •Leading PE firms that laid the groundwork during the downturn should be positioned well for market conditionsin 2010 and beyond. Key takeaways from Private Equity Industry 20
  21. Countriesin the fire zonearelikely to facesevereeconomic pressures asthey increasepublic debt to greater than 90% over the next few years, which will in turn stall growth Imagine earning $100 to pay $90-110 rupees as interest on debt…. BIG SHIFTS: Increase in Public debt might trigger another crisis 21
  22. BIG SHIFTS: World Wealth Status- Gradual Shift happening to Asia 22
  23. The spectre of deleveraging has been haunting the global economy since the credit crunch reached crisis proportions in 2008. The fear: an unwinding of unsustainable debt burdens will drag down growth rates for years to come. Sofar, reality hasbeen more benign, with economic growth recovering sooner than expected in some countries, even though the financial sector is still cleaning up its balance sheets and consumer demand remainsweak. The deleveraging process may just be getting under way and is likely to exert a significant drag on GDP What’s more, analysis of deleveraging episodes since 1930 shows that virtually every major financial crisisafter World War II was followed by a prolonged period in which the ratio of total debt to GDP declined significantly. The one exception was Japan, whose bursting asset bubbles in the early 1990stouched off afinancial crisis followed by many years... BIG SHIFTS: Debt and Deleveraging (1/3) 23
  24. BIG SHIFTS: Debt and Deleveraging (2/3) 24
  25. BIG SHIFTS: Debt and Deleveraging (3/3) 25
  26. China Hong Kong India Indonesia Philippines Korea Malaysia Thailand Singapore Taiwan 0 2,000 4,000 11,000 13,000 19,000 22,000 * Assessment including key product penetration (credit card, life insurance), openness to foreign banks, market consolidation, financial stock per€capita ** Financial stock includes bank deposits, government and corporate debt and equity Sources: MGI; WMM; maturity* GDP per capita, 2009 Medium Low Vietnam Mature market with high penetration of banking and insurance products different Size of 2009 financial stock** Degree of market High Emerging fast-growing markets with under-developedbanking sectors; growth driven by product penetration and increase of bankable population Transition markets with fast maturingmarket structure and fast growth Asia is not a homogeneous region; it consists of markets at stages of development Consumer Credit Markets- ASIA 26
  27. 27 Asia’s population(Some countries) is aging rapidly … 200 1 202 1 205 1 10 working adults* support 1 retiree** 6 working adults* support 1 retiree** 3 working adults* support 1 retiree** * Working adults are adults from 15 to 64 years old ** Retirees are adults 65 years old and above Sources: Data up to 2021 from Asian Demographics; data for 2051 from Firm estimates Population over 65 years old % 20 16 7 20 15 7 14 5 9 10 14 20 2021E2001 Singapore Need for retirement investment increases with time Hong Kong India Taiwan Korea China which will create pension-related wealth management opportunities
  28. Important banking trends for Asia (1/2) 1. Asia is fragmented, and markets have distinct characteristics: Asia is not one homogeneous market, but rather afragmented region of independent markets at different stagesof development. 2. The bulk of Asia’s growth will come from a few large markets, though selected smaller markets have high growth rates: China, India, Korea, and Taiwan account for 80% of the financial assets in Asia (excluding Japan) and will be key growth drivers. However, smaller markets such as Vietnam and Indonesia areexpected to grow rapidly. 3. Consolidation is happening at varying paces across the region: Malaysia, Korea, and Thailand have madegood progressin banking consolidation, while countries likeTaiwan arestill highly fragmented. 4. Persistent boom-bust cycles have been observed in the capital markets: Historically, the growth of Asia’scapital markets hasnot been linear; the region islikely to faceboom-bust cycles in the future. 5. Large and profitable pan-Asian foreign franchises have emerged: Citibank, HSBC, Standard Chartered, and GE Capital have created material Asian franchiseswith a median share of 1.7% in active Asian markets and 40%-50% PBT marginsin 2009. 6. New local “empowered” players are seeking regional and global growth: Many local market leaders aregoing beyond their homemarkets (e.g., DBS,ICBC, CCB, Chinatrust, Kookmin, CIMB, OCBC). 7. Rapid influx of new bankable customers in large markets (China, Indonesia, and India): Approximately 600mn new―bankable‖ customerswill enter the market in the next 5-10 years. 28
  29. Important banking trends for Asia (1/2) 8. Extremely high wealth concentration: Lessthan 1.5% ofAsianhouseholdscontrol about 50% of personal financial assets (PFA); this privileged segment is growing rapidly, and its wealth could match that of thesegment’s Continental Europeancounterpartsby 2010. 9. “Flipped” risk-return perception of financial investments: 40%-60% of AsianPFA is still held in low-interest-earning deposits dueto ―flipped‖ risk-return perception; this perception isdriven by afear of investment risk, perpetuated by poor historical performance of theunderlying capital markets. Asa result, consumersarestuck at theawarenessstageof thesalesfunnel for most investment products. 10.Many billion-dollar product marketshaveemerged: Significant revenue and profit pools acrossmany markets havecreated anopportunity for selective players to createlargeand profitable nichebusinesses. 11.Demand hasincreased for borrowing among consumers; consumer financeis still highly underpenetratedin Asian markets (except for Taiwanand Korea): The younger generation is more open to borrowing and believesthat borrowing can improvelifestyle. This belief, coupled with existing low penetration of credit products, suggests that consumercreditwill experienceexponential growth in theAsianbanking sector. 12. Rapidly aging populations haveincreasing retirement needs: Asia’spopulations areaging rapidly. Concerns about meeting retirement needswill drive thedevelopment of innovative pension products,subject to conducive regulatory environments. 29
  30. Technology reshaping the landscape – Mobile and Internet Adoption rates 30
  31. Key take away from this session The Global Financial System is still not out of the woods (European crisis, consumer credit, public debt etc ): the hidden fractures still threaten the world economy… theFAULT LINESare to be fixed. Global Debt and leverage reduction will result in slow growth. TheEconomic Wealth shift happeningto East Private equity’s “golden age” of low interest rates, abundant leverage, mega-deal making and effortlessreturnsisover, and will not soonreturn.  Technology (Internet and Mobile) isreshaping theworld of financial services. The Asian financial marketsare projected to grow very fast. 31
  32. ANNEXURES 32
  33. How Did We Get Here? Federal Reserve underAlanGreenspan (EasyMoney) Fannie Mae, FreddieMac& Congress: GSEssupporting affordable housing – increased demand for subprimeandAlt-A loans Borrowers at best wereuninformed; at worse, lied about their financial condition Mortgage Brokers,Appraisers, Realtors: Overvalued propertiesand pushed borrowers into gimmick or complex mortgages Rating Agenciesmisrepresented security/asset values LargeCommercial and Investment Banks demonstrated poor risk management practices Regulators (Banking & SEC) allowed excessiveleverageand failed to criticize the large institutions’businessmodels; no regulation of derivatives Separation of Ownership from Origination: Securitization allowed loan originatorsto carelessabout the quality of the loansthey originated  Mark-to-Market Accounting forcedunreasonable valuations of securitieswhen there wasno liquidity 33
  34. How the story unraveled… • In theaftermath of the dot-com bubble burst, growth of liquidity and easy credit availabilities, combined with novel structuring of financial assets droveadramatic expansion of structured credit; investors chased yield and bet on real asset performance in residential real estateand didn’t properly understand true credit risk • Even whiletheeconomy remained strong, housing pricesceased to rise, and many subprimeborrowers began to struggle to service their debt • Default ratesof RMBSand CDO began to risedramatically, and financial asset valuations were strongly impacted by market reaction against in-transparencyand complexity in theinstruments, and afailure of trust in their credit ranges • Downgradesin financial asset valueshelped spur areduction in market liquidity. A reinforcing cycle, based on lossof confidenceand transparency, drovefurther deterioration in financial asset value as well asacrisisin funding liquidities • The devaluation of financial asset values, combined with afunding liquidity crisis, hit thecapital market participants in various ways. Many players exited themarkets • Central banksinjected capital to secure theavailability of funding liquidity, and held or reduced interest ratesto support thecapital market. The side effect wasto exposethereal economyloop to therisk of inflation • Regardlessof thescenario, there will besome winners and manylosers asthecycle continuesto unravel. 34
  35. What caused the bubble? The monetary policies of central banks particularly the US Federal Reserve and the ECB in some countries were too loose – they focused too much on consumer price inflation and ignored asset priceinflation Global imbalances – the Asian crisis of 1997 and the policies of the IMF led to a desire among Asian governments to savefunds 35
  36. Growing Importance of Finance Note: Financial services and insurance accounted for 7.8% of U.S. GDP in 2009. 36
  37. Housing Prices 37
  38. Leverage 38
  39. Growth of a complex market.. 39