MASTER OF BUSINESS ADMINISTRATION

Assignment Mark Sheet

Student ID Number: K0960932 Cohort: December 2009

Assignment: Business & Financial Environment 1

Date Received: 14.12.09 Marker: Alexey Verbetsky

Comments and suggestions for improvement:

Q1: Very good and comprehensive analysis of the crisis development with specific data,
arguments and identification of vulnerable points for various countries. No analytical
frameworks used. Excessive information on the US housing market.

Q2: Again quite comprehensive and focused analysis of the Russian construction sector and
relations with the financial system. In the future, you could try using some analytical
frameworks in your discussion.

Q3: Potentially good but very short discussion – this limited analysis did not give you a chance
to develop any conclusions and/or recommendations.

The overall suggestion is to plan your report structure more accurately and put some supporting
data into Appendices. Either Executive Summary or Conclusions section would benefit your
report. This will also help you to stay within the prescribed word limit – a skill which is very
useful for business report writing!

OVERALL
Question 1 Question 2 Question 3 Question 4
MARK
Mark obtained 32 24 16 72

Marker's signature:

Moderator: F Filippaios (Mark 72)

Please note: The above marks are provisional and subject to ratification by the MBA External Board.

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Assignment: Business & Financial Environment 1
I certify that all the material in this paper which is not my own work has been identified and
acknowledged and that no material is included for which a degree has been previously conferred upon
me.
Please sign:
Student ID Number: K0960932

KINGSTON UNIVERSITY BUSINESS SCHOOL

Business & Financial Environment

Assignment 1

Prepared by:
ID Number
K0960932
Word count:
2350

Moscow, December 2009

Content

Question 1.“In recent years, demand has been sustained at high levels not as a result

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of excess government spending but as a result of the wealth effect of rising asset prices
stocks and residential housing). This has underpinned the bubble economies of current
decade”. Comment on the above statement with reference to: 3

1.1 The factors which have contributed to the turbulence in the global economy
in particular in Russia, the UK, Japan, the US and the Euro zone. 3

1.2 The specific impact of fluctuations in the level of interest rate on an construction
industry. 8

1.3 How LSR Group (construction sector) has developed strategies in order to maintain
profits in the face of these fluctuations in the interest rates? 11

Bibliography 12

1.1 The factors, which have contributed to the turbulence in the global economy in
particular in Russia, the UK, Japan, the US and the Euro zone

The main factors, which contributed to the turbulence in the global economy, was an excessive
increase in US housing prices fueled by cheap and easy access to credit. During the boom years

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of 2002 until 2006, the choice of US citizens to buy a home was driven by 'the irrational
exuberance of individual families who saw house prices rising ever higher and higher'
(Krugman, 2009, p 148). During this period the Case Shiller House Price Index, which tracks
price changes of US homes, increased by approximately 71% from 2002 until mid 2006. (Figure
1, S&P/Case-Shiller Composite 20 Price Index). This steady increase of prices led individuals to
believe that there is little risk to buy a house, as prices will continue to rise.

Figure 1: S&P/Case-Shiller Composite 20 Price Index

Source: Bloomberg

The ever-increasing demand was supported by a fundamental change in lending practices

of banks as well as loan originators, which created a steady inflow of liquidity into the housing
market. These financial institutions outsourced the risk of default, by arranging mortgages into
pools. After such a pool was created, banks issued CDOs (Collateralized Debt Obligation),
which offered shares in the payments from these mortgage pools. These shares had different risk
categories characterized by the order of payout from the mortgages. The claims of the senior
tranche were satisfied first and the remaining money would be distributed among less senior
shares. This was supposed to make the senior shares a very save investment and so the rating
agencies were willing to classify them as AAA rated. The classification of the CDO’s by rating
agencies enabled banks and originators to sell them to a wide range of investors, which in turn
guaranteed a steady inflow of liquidity into the housing market to satisfy the increasing demand
of US citizens.

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With the deflation of the great U.S. housing boom mid 2006, and the increase in subprime
related losses, a vicious cycle let house prices to plunge and credits to dry up. After the massive
increase in the Case Shiller between 2002 and 2006, (Figure 1, S&P/Case-Shiller Composite 20
Price Index) despite relative easy financing it became difficult for some people to purchase new
homes. The market leveled off, and house prices started to decline. With declining house prices,
houses became hard to sell and default rates started to rise. 'As subprime loans were not, for the
most part, made by banks that held on to the loans' (Krugman, 2009, p 168). But by loan
originators, who packed them into CDOs, restructuring was difficult and foreclosure was the
only possibility left to recuperate the value. As more houses came on the market in a forced sale,
price began to plunge even further, threaten the payments on the junior rated shares of the CDOs
and soon even on the senior tranches. The uncertainty with respect to the security of CDOs
created a liquidity trap in the housing market. Investors were not willing to buy anymore of these
instruments and financing dried up triggering a further fall in prices.
Once it became apparent that losses on CDOs will affect junior as well as senior tranches,
it became clear that lenders as well as investors will suffer significant losses triggering a self-
reinforcing cycle of forced liquidation. Given that a variety of investors and institutions bought
these CDOs, the declining asset values started to damage their balance sheets, forcing further
asset sales in a self-reinforcing process. The uncertainty regarding the losses on the subprime
mortgages triggered a massive bank run and individual institutions stopped lending money to
each other out of fear of further losses and a lack of transparency regarding the ownership and
value of these CDOs. While funding started to dry up among banks, individual institutions
stopped lending to business and stopped giving out consumer credit, effectively chocking off any
further grow in the private sector and throwing the country into a recession.
The spread of the financial fallout into developed markets as well as emerging markets
was due to cross border investments of financial institution. The ownership of CDOs and
subprime mortgage securities was not restricted to U.S investors. A broad range of financial
institutions from pension funds to hedge funds had exposure to this very sector. While the
globalization of the financial system was assumed to decrease systematic risk, the drive of the
globalization force actually 'came from the investments of highly leveraged financials
institutions', (Krugman, 2009, p 177), hence increases the risk. On August 9 th 2008, BNP Paribas
suspended withdrawals from three of its funds, and it became apparent that the crisis had spread
beyond the US. Similar to the US, the uncertainty about the possible exposure of various
institutions to the subprime investments created a liquidity crunch in the European financial
system. In a matter of days the overnight Libor, which is the daily set rate at which banks borrow
from each other, surged 3 fold from 2.14% to 6.43% (Figure 2, Overnight Libor USD). The

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reluctance of banks to borrow to each other triggled down into the real economy, and credit also
dried up to corporate and individuals, effectively chocking off business and growth. The lack of
available credit made it impossible for business to borrow for future investment or to finance
their ongoing investments, which pushed some of these companies into bankruptcy. The risk of
European companies to file for bankruptcy is partly reflected in the ITRAXX index (Figure
3,ITRAXX Crossover Index). The ITRAXX index reflects the cost of Credit Default Swaps
(CDS) and hence the cost for insurance in case a company goes bankrupt. While banks stopped
borrowing to businesses, the increase in the default risk of companies also permitted them to
raise money in the debt market, hence forcing them to lay off people, cut costs and effectively
slowing growth in Europe and the UK.

Figure 2: Overnight Libor USD

Source: Bloomberg

Figure 3: ITRAXX Crossover Index

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Source: Bloomberg

In case of the emerging markets, especially commodity reliant markets like Russia, the special
point of vulnerability was the disappearance of the so-called carry trade. The carry trade involves
borrowing in countries with low interest rates, especially but not only Japan, and lending in place
with high interest rates like Russia. Similar to the credit crunch, which crippled Europe, UK and
the US, capital stopped flowing out of low interest nations. Because capital stopped flowing out
of Japan, the value of the yen soared (Figure 4, JPY USD Exchange rate), and the lack of capital
inflow into Russia led to a sudden devaluation of the ruble (Figure 5, RUB Basket (EURO &
USD)). While the Russian government had accumulated around $560bn of foreign exchange
reserves to fight such crisis, it was mainly the private sector in Russia, which borrowed money in
low interest rate countries. With the lack of capital flow, the plunging of asset values (including
oil) and the resulting depreciation of the ruble, the cost of foreign debt soared for Russian
companies pushing them to the verge of default. The outcome is similar to Europe, UK and US,
the companies had no money anymore to invest and grow, they had to cut costs and/or file for
bankruptcy, hence triggering a sharp drop in growth.

Figure 4: JPY USD Exchange rate

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Source: Bloomberg

Figure 5: RUB Basket (EURO & USD)

Source: Bloomberg

1.2 The specific impact of fluctuations in the level of interest rate on an construction
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 industry

The liquidity crunch in Russia, which had its roots in its financial systems dependence on
short-term and overseas capital, drove up interest rates to unprecedented levels, making it
impossible for real estate companies to get access to credit. In 2008, the 'Russian corporations
and banks were running up $460 billion in foreign debt' (Krugman, 2009, p 179). Foreign
investors became reluctant to refinance $120 billion falling due in the second half of 2008 and
2009, which pushed companies to use short term funding from local banks (BCG Moscow, The
long-term perspective to beating Russia's liquidity crunch, n.d). However, due to the risk
awareness of domestic banks and their reliance on foreign capital, interest surged to levels of
around 20% in a short period of time (Figure 6, Russian short term interest rates MBOR),
making it impossible for companies to borrow for even the shortest time period. On the one
hand, the high levels of interest rates made it impossible for the real estate sector to finance
future projects, repay interest on current debt obligations and finance their operational activity.
On the other hand, the high level of interest made it impossible for individuals to take mortgage
loans from banks in order to finance their purchases of new apartments.

Figure 6: Russian short term interest rates MBOR

Source: BCG Moscow

Given the global credit crunch and the local liquidity crisis, Russian banks have curtailed
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their relationships with developers. With the onset of the crunch at the end of 2008, Russian
banks stopped lending to the real estate sector for the most part, raising interest rates to record
levels (Figure 7, Overall Lending Growth in Russia). In spring 2008, construction companies
borrowed funds at 10%-14%; by late summer rates increased to 20%-25%, and by October 2008
developers could not borrow for less than 40%-50%, if at all. (UniCredit Research, August
2008). Banks preferred to rollover existing facilities to fund new developments, and generally
supported only those projects that are at least 90% complete, or at the stage just before receiving
state acceptance. The result of the massive increase in interest rates as well as the inavailability
of funds forced developers to freeze their current projects to preserve their cash in order to meet
debt obligations as well as to finance operarional expenditures. In mid 2008, most of the Russian
real estate companies had at least 50% of the debt in short term obligations, which implied a
payback period of no more that 6 month. However, with debt markets as well as equity markets
beeing closed and banks reluctant to lend, the solvency risk of these companies surged, reflected
in massive drops in the bond prices of these companies (Figure 8, LSR RUB bonds)

Figure 7: Overall Lending Growth in Russia

Source: JP Morgan Equity Research, Russia

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Figure 8: LSR RUB bonds

Source: Bloomberg

The massive surge in interest not only affected the real estate developer but also the real
estate buyers and investors as access to mortgage loans became increasingly difficult to obtain.
With respect to Russia, mortgages were historically more common in St. Petersburg compared to
the rest of the country. For example, around 30% of real estate transaction were concluded with
mortgages in St. Petersburg versus 9% in Russia overall (JP Morgan Equity Research, November
2009).With the onset of the crisis, aggregate mortages continued to grow in St. Petersburg,
however the rate of growth significantly started to slow down in January 2008.
Lower mortgage rates had an immediated impact on apartment prices as well as vacany rates,
with the former continuing to drop and the latter continuing to increase. The oversupply of
appartments on the market combined with falling prices permitted the real estate developers to
realize their returns and transform them into physical cashflow. Hence the high interest rates
permitted access to financing for the developers as well as for the buers/investors and triggered a
slump in the market pushing most of the Russian real estate developers into default.

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 1.3 How LSR Group(construction sector) has developed strategies
in order to maintain profits in the face of these fluctuations in the interest rates?

The massive increase of interest rates and the inability of domestic real estate companies
to borrow money from banks made it necessary to revise the companies’ strategies in order to
survive and remain profitable. In the 1h of 2008, LSR Group achieved a net profit of $124m
USD and was able to remain profitable in the 1h of 2009, posting a net profit of $45m (Deatsche
Bank Global Market research, October 2009). The achievement to stay solvent and to remain
profitable was mainly based on a three pillar crisis strategy, which included focus on government
contracts, re-directing its construction materials business from the residential property market
towards infrastructure programs and focus on meeting outstanding debt obligations to guarantee
future access to debt and equity markets.
During the crisis of 2008/2009, LSR was offering deep discounts for governmental
projects in St. Petersburg, which enabled the company to generate additional construction
volume and additional sales in its construction materials business. The projects mainly included
developments of mass-market housing for the Ministry of Defense and the Government of St.
Petersburg, which amounted to a total volume of 664,000 sqm. Even though, the contracts have
been offered at a significant discount to the current market price, the volumes ensure a revenue
generation of RUB 21.5bn until end 2011 (Deatsche Bank Global Market research, October
2009). The tender for these projects has been particularly important for LSR’s strategy as it
enabled the company to continue to operate its construction materials business, which ensured
continued cash flow to meet operating expenses and debt obligations. While the construction
materials business was designed to mainly support LSR’s own housing projects pre-crisis, the
company was also able to diversify its stream of revenues by selling construction materials to
ongoing infrastructure projects in the St. Petersburg area, which secured continued free cash
flow.
The final important pillar in LSR’s crisis strategy was the company’s focus to meet current debt
obligations in a timely manner, in order to maintain ability to borrow in the future at reasonable
rates. “LSR’s strategy is to refinance bonds that have near-term maturities with longer term bank
loans. For example, in November a 5 year $100mn credit line was obtained from
Rosselkhozbank, which should provide funds for a RUB 2bn bond repayment in December 2009
(JP Morgan Equity Research, November 2009). In fact, the RUB bond payment (RUB 2bn) has
been redeemed on the 9th December 2009 (Figure 8, LSR RUB bonds) This will enable the
company to continue to tab credit markets in the future as well as potentially raise equity in an
SPO in 2010 in order to finance further projects.

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Bibliography

1. Archbold, Stuart, Ashley Carreras, Robin Jarvis, Robin Matthews and Kent Springdal
(2004), Business and Financial Environment (1), Kingston University Business School
2. Assessing risks to global financial stability, the IMF, 2008,Global financial stability
report, retrieved December 2, 2009 from
http://www.imf.org/external/Pubs/FT/GFSR/2007/02/pdf/chap1.pdf
3. BCG Moscow, The long-term perspective to beating Russia's liquidity crunch, retrived
December 1, 2009 from http://www.bcg.ru/documents/file21388.pdf
4. Collateralizeddebt obligation, retrievedDecember 2, 2009
fromhttp://en.wikipedia.org/wiki/Collateralized_debt_obligation
5. Credit default swaps, retrieved December 2, 2009 from
http://en.wikipedia.org/wiki/Credit_default_swaps
6. Gordeeva J, Deatsche Bank Global Market research, October 2009, LSR Group 1h 2009
results review, Moscow
7. McConnell C.R., Brue S.L., Economics, 11st edition. McGraw-Hill Publishing Company,
1993
8. Krugman Paul, 2009, The return of depressioneconomics and the crisis of 2008, W.W.
Norton &Company, Inc, New York
9. Kochkina A, UniCredit Real Estate Research, August 2008, Turn around in Russian real
estate, Moscow
10. Journova E, JP Morgan Equity Research, November 2009, LSR Group, Moscow

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