Financial Armageddon:Myths and Reality

ART DURNEVMcGill University

Questions

Why did it happen?What was the role of complex financial

instruments?What are the pros and cons of the

proposed bailouts around the world?How is the crisis spreading to other

countries?How can it boomerang back?

Some history

Prime MortgagesMortgages for borrowers with good credit,

provide a down payment, and document their income

Subprime MortgagesMortgages given to the least credit-worthy

clients: low credit scores, uncertain income prospects

Boom in Non-prime mortgages

In 2001 the sub and near prime mortgages accounted for 9% of newly issued mortgage securities

In 2006 these mortgages accounted for 40% of newly issued mortgage securities

This boom was caused by practices that made getting a loan easier Little to no proof of income, little to no down

payment

Mortgage Financial Flows

Traditionally, banks made prime mortgages funded with savers’ deposits

By the 1990s mortgage lenders had created new ways for funds to flow to prime borrowers: Government Sponsored Enterprises (GSE) (e.g. Freddie Mac) who guaranteed the loans and sold them off to investors as Residential Mortgage Backed Securities (RMBS) Most of the GSE sponsored RMBS were Prime

quality Since these institutions were government

chartered investors perceived them as having an implicit government guarantee

Mortgage Financial Flows 1990s

Mortgage Financial Flows

RMBS that are not issued by the GSEs had to pay investors a high premium to compensate them for the higher default risk Without financial innovations, the cost for the

mortgage takers would have been too high for the target borrowers

Quantitative models were developed to predict the likelihood of default for the various levels

These models allowed a market for securities backed by non prime loans

Mortgage financial flows 2000

Non Prime Boom Unravels

Investors realized that they had purchases non prime RMBS with overly optimistic expectations about default risk

Credit rating agencies such as Moody’s contributed to these overly optimistic expectations by giving A level ratings

Firms also felt they could diversify away risk by entering into Credit Default Swap transactions

Myth 1: Whom to blame? U.S. and Greedy Wall Street

Wall Street sells what international investors want to buy

Enormous demand for financial assets Changing demographics Wealth creation in China, Russia, Brazil The World was requesting much safer assets. Wonderful business while things were going well Similar to demand for parking spaces. US did not have

enough secure parking spaces Finance theories are on holidays…at least for a while

Myth 1: Whom to blame? U.S. and Greedy Wall Street

Myth 2: Complex financial models are wrong

Two Ls: leverage and liquidity. Issue claims and separate claims Can mix them and have them insured by AIG. Money markets started investing in those

securities, those with AAA ratings Investors all over the world could invest in

them thinking they were safe and because of that they could leverage, that is spending more than they initially had.

As long as underlying asset price does not swing a lot, it all looked very safe

Myth 2: Complex financial models are wrong

Reasons behind the unraveling

House prices had been rapidly appreciating so subprime borrowers could borrow against their home value, or could sell them homes to settle debt

Interest rates declined in the early 2000s House prices began to fall in mid 2006

and interest rates began to rise

US Housing Prices

Borrowing requirements increase

The past due rate for outstanding subprime mortgages rose significantly, especially in adjustable rate mortgages

Lenders responded by tightening credit standards

The stricter standards meant that fewer people could afford to purchase homes, and the increasing rate of foreclosures caused the prices of houses to fall starting in mid 2006 Larger mortgage payments and lower house values

increased exacerbated the problems

Questions about valuation

Downgrading of RMBS’s credit ratings led to a dramatic thinning of trade for credit instruments

Aug 14th 2007 three investments funds stopped redemptions because they could not accurately calculated their values

This called into question financial firms’ values, exacerbated by the high leverage the financial firms had taken on

TED SPREAD

Credit markets are frozen

The US Government steps in

The US government helps orchestrate a takeover of Bear Sterns by JP Morgan Chase

Freddie Mac and Fannie Mae bailoutThey allow Lehman Brothers to go underThey bail out AIG- largely because of its

size and interconnection with the financial industry

Bailouts (US and British)

Myth 3: Bailouts are good

Myth 2: Bailouts are good

The scale of nationalization around the world is hard to assess

Especially in Emerging Economies Even in developed countries some companies resist

hard

Russian rescue plan for Iceland is being blocked

Myth 4: Canada is immune

Is Canada immune?housing marketbanksstock marketpensions

Exchange rate (CAD/USD)

Will the crisis spread to Canada?

The Canadian market could face a similar situation according to Robert Shiller - especially in Vancouver or Calgary Psychological factors are often the driver of bubbles Canada embarked on a house buying spree similar

to that of the US

David Wolf from Merrill Lynch Canada predicts that “it is only a matter of time” before the Canadian market tanks

Canada vs. US

Canadian net borrowing has reached 6.3% of disposable incomeCompared to the 7% peak in the US in 2005

Debt as a percent of assets in Canada is 20%Compared to 26% in the US – 30% less

Canadian subprime mortgages represent only 5-6% of the marketCompared to 25% in the US

Canada vs. US

Less than a quarter of Canadian mortgages are securitized The majority of the liabilities remain on the

individual balance sheets – meaning that defaults will affect the bank that issued them

However, real estate prices are falling The benchmark price for houses in Vancouver has

declined 5.8% since May Property sales fell 43% in Vancouver in Sept 2008

A Canadian Bailout? (1)

The Bank of Canada was forced to make cash available for intra-bank lending to keep the overnight lending rate at 3%

Stephen Harper has reiterated that he does not intend to introduce major tax or spending initiatives as the economy slows

"The deterioration of global credit markets is beginning to squeeze the ability of even the strongest of financial institutions to raise longer-term funds, which could limit the provision of longer-term credit in Canada to businesses and households,'' – Jim Flaherty

Toronto Stock Exchange

Russian companies are buying off Canada

May 10 (Bloomberg) -- Magna International Inc., the Canadian auto-parts maker bidding for Chrysler, said Russian billionaire Oleg Deripaska will buy a stake in the company to help Magna expand in eastern Europe and Russia. The shares had their biggest gain in 30 months. Deripaska's Basic Element will purchase 20 million Magna Class A shares worth $1.54 billion, the two companies said today in a statement. The Aurora, Ontario-based partsmaker also said first-quarter profit rose 2.8 percent on record sales.

Magna International

Bombardier

Bank of Montreal

Talisman Energy

Lundin Mining

"Shares on the Topix index, the broadest gauge of Japan's stock market, trade at 0.89 times book value, the first time the average has been below 1, according to Mizuho Securities Co. That means the companies would be worth more if liquidated. "

Myth 5: The Crisis is almost over

Most likely it will boomerang back through other markets

Europe Faces `Huge Threat' as Emerging-Market Partners Slide

Japan Hong Kong China

UK Russia Brazil

Turkey

Pakistan