Debt Capital Markets - An Introduction

					The Liquidity Crunch
Causes and Consequences

10 June 2008

Martyn Hoccom
Lloyds TSB
How did we get here?

  “They were impelled to it by the seminal lunacy which has always seized people

    with the notion they can become very rich. There were many Wall Street

    insiders who fostered this insanity…”

                                            The Great Crash 1929 – JK Galbraith

The Liquidity storm of 2007

  “When the music stops in terms of liquidity things will be complicated. But as long
    as the music is playing , you’ve got to get up and dance. We’re still dancing”
                                               Chuck Prince Citigroup, July 9th 2007

 “This was obviously a very disappointing quarter for us”

                                          Chuck Prince Citigroup, October 1st 2007

  4 November 2007 - Chuck Prince resigns

Size of the global securities market
Source :Bank of England Stability review

Markit iTraxx Index

                              Markit iTraxx Europe Crossover Index (series 8)

         Source : Bloomberg

Credit Pricing

                 1 Year Bond Spread over UK Gilts by Rating: 2003 to 2008

UK Macro – Market Background

               UK – Sterling Liquid Assets relative to total asset holdings of UK banking sector

 Source : Bank of England
UK Macro – Market Background

    UK-resident banks' and building societies' net sterling lending to UK households and non-
                                      financial companies

        Source : Bank of England

        It is the difference between household's and PNFCs' M4 lending and M4
        M4 Lending is the lending made by banks and building societies to the personal sector

Days of August 2007

    Sub prime mortgages were the trigger – amongst the underlying causes

       – Take away the modern terminology and you have something very old fashioned -
         Banks lost money on fuelling a speculative asset boom -
       – In a period of remarkable stability and low credit spreads a “search for yield” – this is
         why mortgages originated in Paris Texas ended up on the balance sheet of banks in
         Paris France
       – Weakened Credit Standards as a result of dislocation between originators and
       – Increasing Sophistication of products whose “ model to market” became very
         misaligned from “mark to market” under stress
       – The herd mentality and extreme difficulty to stand against the crowd

The Market Story

ABCP Market

              US asset-backed commercial paper outstanding - $ Trillions

ABCP Market

                   Asset Backed commercial paper spreads
              One-month top-tier ABCP versus one-month Libor (basis points)

CDS Spreads

What has the Liquidity Crisis Changed ?

                        Short answer – Everything !!

                           – Originate and Distribute Model
                           – Conduit Vehicles
                           – Liquid asset definition
                           – Cost of funding
                           – Basel 2 and ratings
                           – Transfer pricing
                           – Balance sheet structure
                           – Value of Retail Deposits
                           – SIVS
                           – CP Markets……etc etc

Risk Appetite Design

   Clear Articulation and measurement system so Board can know under stress how
    institution is performing

   Governance linkage from Board approved limits to operational activities

   Resolution of potential conflicts of interest over treating liquidity management as a cost
    resource versus a profit centre

   Measurement and allocation mechanism of costs of liquidity

   Operational risk tolerance – problems very visible in “ real time” world of settlements

   Consistency across measures and clear definition

What is Liquidity Management ?

    A profit centre ?

    Fully costed and allocated operation with cost recognised and allocated across business
     lines ?

    Something treasury and the money markets desk do ?

    Integrated part of financial plan ?

    Driving strategy

What is a Liquid asset ?

    Not an issue greatly discussed prior to August 2007 !!

    AAA securities ??

    Secured Repo- Issuer / Collateral / Haircuts/Relationship

    Eligible at central Bank in normal operations-back to the 1980’s ?

    New arrangements with Bank , Fed , ECB – how enduring-how act in a future market

Stress Testing

             Stresses are low-frequency , but extreme severity , events that are not
   “ Liquidity
      well understood”

                                                                  FSA Section 3.5 DP07

   “ Stress tests and contingency funding plans funding plans have not generally
      assessed impact of simultaneous disruption to securitisation and interbank
      markets “
                                                            Bank of England - April 2008

Stress Testing

    Well defined and granular stress testing against a range of events

    A continual process not a one off piece of analysis as markets and business
     profile changes

    Flexible and interactive so scenarios can be rapidly changed and updated

    Comprehensive across the institutions on and off balance sheet exposures

    Judgement ; business sense-not spitting out dozens of unchecked data sheets

Stress Testing

   Retail                 Liquidity Commitments      Money Markets
   Off Balance Sheet      Conduits                   Medium Term Market

   Time & Speed           Nature of Stress           Market Capacity
   Rollover Vector        Central bank actions       Behavioural Assumptions


Secured Funding under Stress

Assesses the amount of secured funding that could be lost in a crisis

Source : Lehman Brothers

Contingency Planning

      Asset Inventory                                  Reputational / Market signalling Impact
      Use/Availability of Central Bank Facilities      Backup Liquidity Lines
      Depth of Repo/Funding Market                     Funding Relationships
      Assessment of Collateral

Pricing for Liquidity

    “ Off balance sheet contingent liquidity exposures appear not to have been priced
     adequately into internal models at firms ”
                                                                     Bank of England April 2008

    Pricing of on balance sheet lending need to address impact on bank costs of the credit

    Credit Crunch has put more focus on ability to fund growth

    Value of long term deposits

    Market characterised by increased focus on aligning internal funds transfer pricing for
     Liquidity premia with external market conditions

Pricing for liquidity

     The “nice decade “ is over

     Asset led income targeted planning assuming an limitless supply of close to Libor
      wholesale funding is over

     Not aligning the true market costs of funding to assets may lead to excessive non value
      generating activity

     Words are easy-establishing the Governance, MI and culture to live the story of economic
      value is a challenge

Commitments/ Liquidity facilities

    Effectively liquidity options written to clients

    Charging often “bundled” into overall product offering

    Credit crunch, Mono line rating issues etc have highlighted risks

    Pricing needs to reflect risks of draw - a function of market spread movements ; drawn
     margins , collateralisation etc …

Valuation of Deposits

      Deposit gathering the non-glamorous / non sexy

      The value of strong deposits are now much more widely appreciated

      More focus going forward on the value of the “Funding Franchise” too often
       neglected in the recent asset boom.

Closing thought

      “ The squall became a hurricane…plain folk will ask. Why should
      we trust anyone?”
                                     Philip Stephens FT - 21 September 2007