The Impact of the Financial ServicesMeltdown on The Global Economy And ThePrivate Equity IndustryDavid Rubenstein, Co- FounderSuper Return DubaiOctober 15, 20081
How Did This Happen?3
Excesses in The US Housing AndMortgage Markets Are A Root CauseÜSubprime loans accounted for 15% of the USmortgage market in 2006 vs. 3% in 2002Subprime Share of Total Mortgage Market (1)4(1) Source: Danske Bank. March 30, 2008.
Excesses in The US Housing AndMortgage Markets Are A Root CauseÜThe more than 600 billion of subprimemortgages that were issued in the US provedriskier than anticipatedMortgage Arrears Rates: Prime vs. Subprime(1)Subprime Arrearsrate: 20%Prime Arrearsrate: 3.75%5(1) Source: Chicago Fed Letter, August 2007.
Excesses in The US Housing AndMortgage Markets Are A Root CauseÜTo compete with private lenders, Fannie Maeand Freddie Mac lowered lending standards andprovided mortgage loans to subprime borrowersGSE Mortgage Lending: Total Value & % of Market 3,000 bn100%Private mortgagelendingPercent Fannie &Freddie 1,500 bn50%Fannie & Freddie 060%(1) Source: A Primer on t he Mort gage Market & Mort gage Finance, St. Louis Fed. Reserve Bank. February 2008.
Excesses in The US Housing AndMortgage Markets Are A Root CauseÜEasy credit and lax lending standards fueledan unprecedented bubble in house pricesMedian US Home Price Relative to Owner’s Rent7
Mortgages Were Packaged IntoStructured Financial ProductsÜTrillions of dollars of asset backed securitiesand CDOs were distributed throughout thefinancial systemGlobal Issuance of Structured Financial Products(1)( billions)1,000(in B)80060040020011111111111111Q 6Q 7Q 8Q 9Q 0Q 1 Q 2Q 3Q 4Q 5Q 6Q 7 Q 8 Q59999900000000019 19 19 19 1 9 2 0 20 20 20 20 2 0 2 0 20 20Total CDO8(1) Source: Lehman Brothers, April 2008.Total ABS
Financial Institutions DramaticallyIncreased Leverage LevelsÜInvestment banks, hedge funds, and evencommercial banks used borrowed money toinvest in structured financial productsBank & Broker Leverage Levels (Assets/ Equity)9(1) Source: Citigroup. September, 17 2008.
Hedge Funds and Private Equity FirmsIncreased Their Use of LeverageÜHedge funds and private equity firms control 2.5trillion of equity but borrowed several times thisamount to fund their investmentsPrivate Equity Leverage Multiples(1)6.5x6.2x6.0xLeverage5.3x 5.4x5.5x5.0x4.6x4.5x4.0xEstimated Hedge Fund Leverage(2)4.8x4.0x3.5x3.0x2002 2003 2004 2005 2006 200710Sources: (1) Morgan Stanley. September 2008. (2) McKinsey, October 2007.
Sovereign Wealth Funds And CentralBanks Bolstered Global LiquidityÜPetrodollar inflows and exchange rate managementpolicies resulted in massive capital accumulationsthroughout the developing worldTop Five Sovereign Wealth Funds(1)( billions) 875Global Foreign Exchange Reserves(2) billions4,9875,0004,3093,8224,0003,1123,000 330 2502,000 200 1082,4752,0931,0000ADIA11GICKIACICTemasekSources: (1) Monitor. May 12, 2008. (2) McKinsey, October 2007.200120022003200420052006
Rating Agencies Propagated The Illusionof A Low Risk Investment EnvironmentÜÜThey assigned high, investment grade ratings toopaque structured financial products and debtissued by highly leveraged companiesSince the outbreak of the credit crisis, they havedowngraded over 1.9 trillion of mortgage backedsecuritiesRating Agency Downgrades: Mortgage Backed Securities(1)( billions)1,000739800841600400200237850Q3 200712Q4 2007(1) Source: Citigroup. September, 17 2008.Q1 2008Q2 2008
The Bottom Line Is That SystemicLeverage Rose To Unprecedented HeightsÜTotal U.S. Credit Market Debt Has Risen to 350% of GDP%Total Credit Market Debt / U.S. GDP (1)350Today330310290270Great Depression2502302101901701501301925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 200513(1) Source: Ned Davis Research, 2008.
Default Rates Started to RiseÜDefault rates on certain types of subprimemortgages had risen to above 20% (vs. 6% at thebeginning of 2005)Mortgage Default Rates(1)15(1) Source: Freddie Mac, March 27,2008.
The Market Prices of Mortgage BackedSecurities Fell PrecipitouslyÜMarket prices of mortgage backed securities hadfallen dramatically by the end of last summerPrice Performance of Asset Backed Security Indexes(1)16(1) Source: BNP Paribas, September 15, 2008.
Investment Banks Couldn’ t SyndicateHigh Yield LBO DebtÜPrivate equity deals started to fall apart as debtmarkets re-priced risk and rejected complexstructuresLarge LBO Failureṡ Sallie Mae ( 25.5 billion)̇ Huntsman ( 10.6 billion)̇ Affiliated Computer Services ( 8.0 billion)̇ Harman International ( 8.2 billion)̇ Alliance Data ( 7.8 billion)̇ Penn National Gaming ( 6.1 billion)̇ United Rentals ( 4.0 billion)̇ Acxiom ( 2.9 billion)17
Investment Funds Lost Billions Bettingon Risky Credit InstrumentsÜTwo of Bear Stearns’ flagship hedge fundscollapsed in July 2007The funds had invested 1.5 billion in subprime CDO’ṡ These failures were followed by the collapse ofSowood Capital, a prominent 3 billion hedge funḋÜStructured Investment Vehicles (SIVs)announced billions of dollars of losses and wereliquidateḋ18They had borrowed heavily in the short-term debtmarkets to fund purchases of CDOs and other longterm, risky debt instruments
Financial Institutions Announced MassiveLosses On Mortgages and Credit InstrumentsÜFinancial institutions have sustained over 500billion dollars of write-downs since the creditcrisis begaṅThe IMF expects that total financial losses will exceedthose of any past crisisIMF Comparison of Losses Across Financial Crises(1) 0US Savings and Loan Japan Banking CrisisCrisis (1986-95)(1990-99)20Asia Banking Crisis(1998-99)(1)International Monetary Fund, “Global Financial Stability Report,” April 2008.Credit Crisis(2007- ? )
Several Systemically ImportantInstitutions Have Failed in the USÜ21Victims of the credit crisis:̇Bear Stearns (investment bank) Saved frombankruptcy by government backed sale to JP MorgaṅLehman Brothers (investment bank)BankrupṫAIG (world’s largest insurance co.)Bailed ouṫWashington Mutual (6th largest US bank*) Assetsseized by the government and sold to JP MorgaṅWachovia (3rd largest US bank*) Sold to Wells Fargoafter an aborted bid by Citigroup* By deposits
A Radical Policy Response Seeks ToPrevent A Systemic CollapseÜUnder the Troubled Asset Relief Plan (TARP), theTreasury Department is:̇̇ÜÜThe FDIC is guaranteeing certain types of bank debtand has increased deposit insurance to 250,000The Federal Reserve has taken extraordinary steps:̇̇̇̇22Purchasing up to 250 billion in equity stakes in US financialinstitutions, including 20-25 billion stakes in Bank of America,Citigroup, and Wells Fargo and 10 billion stakes in GoldmanSachs and Morgan StanleyPurchasing up to 700 billion of financial sector assetsAllowed banks to post unconventional assets as collateralBegun purchasing commercial paper from corporationsExtended a 50Bn credit line to money market fundsBegun paying interest on bank reserves
The Credit Crisis Has Struck EuropeWith A VengeanceÜEurope’s economies are in many ways asvulnerable as America’ṡLeverage levels are high, house prices are inflated,and financial institutions have suffered deep lossesUK Household Debt/ Income (%) (1)Bank Leverage: Europe vs. USA(1)(Assets/ Equity)38x21xEurope24Source: (1) Citibank, “A Downward Spiral.” 17 September 2008.USA
Large European Financial InstitutionsHave Experienced Extreme DistressÜIn the United Kingdoṁ̇̇ÜIn GermanẏÜHypo Real EstateBailed out by the German governmentIn France & Belgiuṁ̇25RBS The British government is recapitalizing Europe’s largestbank by assetsHBOS & Lloyds TSB The UK government is injecting capitalinto both banks (Britain’s 4th & 5th largest), having alreadyengineered their mergerNorthern Rock and Bradford & Bingley Two of the UK’s largestmortgage lenders became insolvent and were nationalizedFortis Europe’s 11th largest bank was sold off piecemeal andpartly nationalizedDexia France and Belgium were forced to recapitalizeEurope’s 16th largest bank
Other Systemically Important EuropeanBanks Are at RiskÜMany of Europe’s largest banks operate at veryhigh leverage levelṡOne reason is that many of them have highlyleveraged investment banking operationsEuropean Banks’ Leverage Ratio Compared With Citigroup(1)Citigroup26Source: (1) Greed & Fear, 09 October 2008.
European Governments Have BeenForced To Take Radical Action27ÜEuropean governments have pledged a total of 2.5 trillion to guarantee bank debt and purchaseequity stakes in financial institutionsÜEurozone governments have agreed to guaranteeall new bank debt issuance through 2009ÜIreland, Germany, and Denmark have guaranteedall consumer bank depositsÜEuropean central banks are offering unlimiteddollar funding to banks in order to uncloginterbank lending
European Governments Have BeenForced To Take Radical ActionÜ28Specific national policies include:̇The UK Government is guaranteeing bank debt andinjecting 50 billion into banks including RBS, HBOS, andLloyds TSḂGermany is guaranteeing up to 544 billion of bank debtand plans to buy equity stakes worth up to 109 billioṅFrance is creating a state fund to buy stakes in financialinstitutions and has guaranteed 435 billion of bank debṫSpain is guaranteeing up to 136 billion of new bank debt,has set up a facility to purchase equity stakes, and plans tobuy up to 68 billion of bank assetṡIceland has nationalized its entire banking system and mayborrow billions of dollars from Russia and the IMFSource: Wall Street Journal, 14 October 2008.
Emerging Markets Have Posted SteepStock Market LossesÜHeightened risk aversion, capital flight, anddeteriorating economic growth prospects haveproduced dramatic equity price declinesYTD Performance of EM Equity Markets(1)120100S&P 500:(38.8%)India:(48.1%)80Asia:(52.2%)6030MSCI Latin AmericaMSCI Eastern EuropeIndia (SENSEX)US (S&P 500)Source: (1) Bloomberg, 10 October 2008.MSCI Emerging Feb-08Jan-08Jan-0840Jan-08Lat. America:(60.9%)E. Europe:(62.2%)
The Credit Crisis Has Disrupted CapitalMarkets and Exposed Fiscal WeaknessesÜRegions and countries with major fiscalimbalances have been hit harḋ̇̇Ü31Many emerging markets rely on foreign capitalinflows to finance large current account deficitsThey have funded domestic credit growth withforeign borrowingSome developing economies are heavilycommodity dependant and will weaken ascommodity prices fallCapital flight is a major risk for theseeconomies
Certain Emerging Markets Are VulnerableÜÜEmerging markets with high current accountdeficits and tight banking sector liquidity couldexperience full-blown financial crisesRegions/Countries at risk include:Central & Eastern Europe The Baltic states, Bulgaria,Romania, Ukraine, and Hungary have large currentaccount deficits and have experienced unrestrainedcredit growtḣ Latin AmericaCountries including Brazil, Peru,Argentina, and Venezuela could see their fiscal positionsdeteriorate if commodity prices fall furtheṙ PakistanThe country’s credit ratings have been cutdue to its deteriorating external liquidity situation anddwindling foreign reserveṡ32
Certain Emerging Markets Are VulnerableÜEastern European current account deficits and LatinAmerican commodity dependency are keyvulnerabilitiesCertain CEE countries will experience credit contractions,reduced investment, and slower growtḣ Latin American governments may have to raise taxes or cutspending as commodity related revenues fall̇CEE Current Account .0%-18.2%-22.0%Bulgaria332007 Actual2007 Pro-forma1.1%1.7%-13.7%-20%-25%-5.3%Lat. Am. Fiscal Balances Pro-Formafor Commodity Prices at 10 Yr Avg. (2)Baltic Romania Hungary urces: (1) Economist Intelligence Unit, 13 October 2008; (2) Morgan Stanley, 30 September 2008.Peru
What About India?ÜIndia has benefited from rapidly increasing capitalinflows since 2000, but these are set to fall̇Capital inflows funded investment and boosted GDP growthabove its long-term sustainable rateCapital Inflows Received by India(1) billions981005039102102000-2 Avg. 2003-5 Avg.Ü2007But India should prove relatively resilient due togrowing domestic demand low reliance on exportṡ342006Growth is likely to moderate to a more sustainable rate of 6-7% (from a 3-year average of 9.3% as of March 2008)Sources: (1) Morgan Stanley, 30 September 2008; (2) Carlyle Analysis.
What About China?ÜOf the world’s major economies, China’s is bestpositioned to weather the stormKey reasons include:1.China has amassed 1.8 trillion of foreign currencyreserves as a result of its persistently high currentaccount surpluses2.The economy benefits from a very low level of leverageand low external debt debt levels for households andthe government are only 13% and 33% of GDP,respectively3.Domestic banks remain awash with liquidity as a resultof deposit growth and reserve accumulation4.The banking system in China operates on a conservativebasis with low leverage levels and withoutsecuritization35Sources: (1) Morgan Stanley, 07 October 2008; (2) Carlyle Analysis.
Recession in The West Will AffectChinese Growth ProspectsTransmission mechanisms include:ÜTradėÜInvestmenṫÜWestern investors have supplied much of the capitalthat has been used to grow China’s companiesOpportunities for International Expansioṅ36Western economies are key consumers of ChineseexportsMany of China’s most successful companies – such asLenovo and Bank of China – are expanding abroad
But China Will Continue to Grow RapidlyÜ24%Domestic growth will offset weaker external demanḋAn increasing proportion of GDP derives from domestic demanḋChina’s growing middle class has rapidly increased itsconsumption of items like cars and electronicṡAbating inflationary pressures will allow China’s central bankto further loosen monetary policyChinese Retail Sales (% Change YoY) (1)22%20%18%16%14%Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug08080808080808070708070707070737(1) Source: China Statistics Bureau, August 2007.
The Middle East38
The Middle East Is Likely To ProveResilientÜThe credit crisis is affecting the Middle East but notas much as other regionṡÜÜNevertheless, the credit crisis in the West hasprecipitated a regional liquidity contractioṅForeign banks in the region have stopped lending moneẏRegional stock markets have posted dramatic declineṡLocal banks are generally healthyThis cloud has a silver lininġ39The IMF forecasts only a slight moderation of GDP growth to6.0% in 2009 (vs. 6.5% in 2008)The credit down-cycle and falling food and energy pricesare moderating inflationary pressuresSources: IMF World Economic Outlook, October 2008; Emerging Markets Monitor, 6 October 2008
Oil Price Declines Are Significant But NotDisastrousÜEconomic growth is being sustained mainly by non-oilsectors including construction, retail, transportation,and financial servicesMiddle Eastern GDP Growth: Oil vs. Non- Oil Sectors (1)%40Source: IMF World Economic Outlook, October 2008
Oil Price Declines Are Significant But NotDisastrousÜMost government budgets and investment programsin the Middle East will remain intact unless oil fallsbelow 50/barrel̇Ü41A prolonged drop below 50 is highly unlikely becauseglobal demand for oil continues to rise while supply islargely staticMiddle Eastern governments have amassed hugereserve funds which they could deploy to supportregional growth if the outlook darkenṡMiddle Eastern government saved 70% of their surplus oilrevenues over the past five yearṡSovereign wealth funds in the MENA region have over 1.5trillion at their disposalSources: Monitor Group, “Sovereign Wealth Funds and the MENA Region,” 12 May 2008; Carlyle research & analysis.
The Current Situation42
Central Banks Have Responded WithCoordinated Global Rate CutsÜOn October 8th, 21 countries around the worldsimultaneously cut interest rateṡThe Federal Reserve cut the federal funds rate by 50basis points to 1.50%October 8 th: Key Interest Rate Cuts(1)43Source: (1) Financial Times, 08 October 2008.
Credit Market Stress Remains AtUnprecedented LevelsÜBut global interest rate cuts have done not hingto encourage private sector lendinġThe spread between US Treasuries and the interbanklending rate remains at all time highsTED Spread: 3 month LIBOR – 3 month T- Bill(1)44Source: (1) BNP Paribas, 10 October 2008.
Global Equity Markets Have CrashedÜGlobal stock markets are testing multi-year lowṡThe MSCI World index has fallen by over 40% since its2007 highMSCI AC World Index(1)45Source: (1) Greed & Fear, 09 October 2008.
Commodity Prices Have RetreatedÜThe price of oil has fallen by 40% since its peakin July 2008Oil Price/ Barrel Since January 1 eb-08Mar-08Mar-08Apr-08Apr-08May -08May -08Jun-08Jun-08Jul-08Jul-08Aug -08Aug -08Aug -08Sep -08Sep -08Oct-088046Source: (1) Bloomberg, 10 October 2008.
Consumer Access to Credit Is DwindlingÜUS Consumer credit fell by a record 7.9 billionin AugusṫThis was the first drop since 1998 and the largestmonthly decline in hist oryMonthly Net Increase in Consumer Credit Outstanding(1)47Source: (1) Greed & Fear, 09 October 2008.
The United States Is Falling Into RecessionÜUnemployment rose to 6.1% in August from 5.7% in JulẏÜRetail sales fell by 0.3% in August and were down 0.7%excluding automobile salesÜThe main index of US manufacturing activity fell 13% inSeptembeṙÜThe current level has only been seen before during full-blownrecessionsUS GDP growth is slowing significantly, and outrightcontraction is likelẏ48The 1.1% surge in the unemployment rate over the past 4months is the fastest in 22 yearsGoldman Sachs forecasts US GDP growth of 1.5% in 2008 and-0.2% in 2009 (vs. 2.0% in 2007)
Much of the Rest of the World MayFollow in America’ s FootstepsÜEconomists are ratcheting down global growthestimatesKey factors likely to suppress growth:̇ Decreased global liquiditẏ Lower capital flows to emerging marketṡ Reduced G-7 demand for importṡ Lower demand for commoditiesÜ49Key 2009 GDP growth d 1.9%Brazil3.3%5.6%5.4%* Goldman Sachs, 10 October 2008.
What ’ s Next?50
Markets Will Recover From Recent LowsInvestor panic had driven valuations to levelswhich were not warranted by fundamentalsÜ Monday’s rally may mark the beginning of amedium term rallyÜ̇ÜBut this does not mean that equity marketswon’t touch recent lows again in the futurė51It marked the largest ever one-day point gain for theDow Jones Industrial Average and the largestpercentage increase since 1933Volatility may return as the deleveraging cyclecontinues and as a consumer recession sinks in
A Broader Recession Will EnsueÜ85%Tighter credit and lower house prices will severelydepress consumptionHome Price % Changevs. Previous Cycle (1)70%% of US Banks TighteningConsumer Credit %1996-062007PresentCredit cardsOther consumer loansSources: (1) Zellman and Associates. September 2007; (2) The Federal Reserve Bank Officer Lending Survey, July 2008
The Deleveraging Process Will BeUnpleasant And Will Take TimeÜDebt levels need to become more sustainable before aneconomic recovery can ensue%Total Credit Market Debt / U.S. GDP (1)3503303102902702502302101901701501301925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 200553(1) Source: Ned Davis Research, 20
provided mortgage loans to subprime borrowers GSE Mortgage Lending: Total Value & % of Market (1) Source: A Primer on the Mortgage Market & Mortgage Finance, St. Louis Fed. Reserve Bank. February 2008. 100% 0% 50% 3,000 bn 1,500 bn 0 Percent Fannie & Fred