1 / 19

Professor Eric Kirzner John H. Watson Chair in Value Investing Rotman School of Management

The 2008 Financial and Economic Crisis : A lethal combination of Greed, stupidity, fraud, And bad luck! Breakfast with the Bulletin speaker series. Professor Eric Kirzner John H. Watson Chair in Value Investing Rotman School of Management University of Toronto November 2008. Introduction.

ellema
Download Presentation

Professor Eric Kirzner John H. Watson Chair in Value Investing Rotman School of Management

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. The 2008 Financial and Economic Crisis :A lethal combination ofGreed, stupidity, fraud, And bad luck!Breakfast with the Bulletin speaker series Professor Eric Kirzner John H. Watson Chair in Value Investing Rotman School of Management University of Toronto November 2008

  2. Introduction • Three Wise Men

  3. ROOTS • From mid 1990s on... • Huge currency inflows to U.S. • Rising housing prices • Low interest rates • Open up housing market to new home buyers; “The American Dream” • Mortgages offered (with specialized terms) to sub-prime borrowers • Homes sold by agents; Mortgages typically sold by mortgage brokers, sometimes the lenders • Borrowers not always qualified; lenders fail to or choose not do due diligence

  4. Typical sub-prime loans • Adjustable Rate Mortgages (ARMs) • Artificially low interest rate (1%, 2%) first two years • No principal or even negative principal (neg. Amortization) • Interest rate resets after two years to market levels • If mortgage reaches 115% LTV, payments shift to 25 year amortization • Payments can go from $800 per month to $3,000 per month • Liar loans (stated income)

  5. Example: The Teaser Mortgage Carpenter, wife two children Annual income $50,000 • $350,000 house in Phoenix, Arizona  • $15,000 down • $335,000 mortgage TERMS • 1% annual interest 30 months • zero amortization • Adjustable rate: • after 30 months interest rate goes to 7% • amortization goes to 10 years

  6. Example: The Teaser Mortgage RESULT: • initial mortgage payments $279.16 per month • after 30 months mortgage payments $3,977.78 per month! • PAYMENT SHOCK!

  7. Example: The Teaser Mortgage • So... • Today $350,000 house in Phoenix worth about $245,000 • Mortgage $335,000 Equity: -$90,000 • Probably a non-recourse loan • Besides no other assets • What is this loan worth in an MBS or CDO? • 70 cents , 60 cents on the dollar?

  8. Next Stages 2004 and on • Meanwhile...Loans sold by mortgage banks to investment banks • bundling/packaging of assets and liabilities: MBSs and CDOs • Packages grossly mis-rated by credit agencies • If misrepresentation: investment bank can put mortgage back to mortgage bank at par

  9. The Causes • Payment shock: teaser loans 2003 and on • Put-back option sales to Wall Street • Slowing and then down-turn in housing prices starting in July 2006 • Now off about 20% on average; 30%+ in Sun Belt

  10. Late 2006 • Housing prices stop rising July 2006 • Mortgage terms change • Refinancing very difficult • Huge mortgage defaults • 2007 defaults subject to foreclosure 1.3 million • MBSs and CDO’s lose value • As default rates increased Wall Street investment banks examined loan detail on delinquent files and put them back to mortgage banks

  11. A lethal combination of Greed, misrepresentation, stupidity, fraud, And bad luck!

  12. Miscalculations and poor forecasts • Housing prices would keep rising! (stopped in July 2006) • $22, 000,000,000,000 asset class! • Modest home price appreciation puts homeowner skin in the game and strong willingness to pay mortgage • As home prices fall, loan to value ratios rise • U.S. appallingly weak regulation re lending practices of financial institutions • LTV’s, capital adequacy , mortgage documentation

  13. Miscalculations and poor forecasts 2.Interest rates would fall: ARMs resets would be at low rates 3. Massive miscalculation re propensity of borrowers to default when loan to value ratios exceed 100%

  14. Miscalculations and poor forecasts 4. Relationship between falling home prices and default rate by region miscalculated 5. Degree of put-backs grossly miscalculated 6. Coincident risk of .. • Teaser loan mortgages resetting, • Interest rates rising • and housing prices falling at same time grossly miscalculated

  15. The result... • Investing is like picking up quarters on a railway track. It works until the train comes. • The train came in... • S&P 500 Sept 10, 2001 close 1092 • S&P 500 today 800 • April 1997 close 813

  16. The Extent of the meltdown • No place to hide: diversification? • Correlations move to 1.0! • Average one –year returns to Nov 21: • World (MSCI) -49% • EAFE -52% • Canada -52% • Countries -38% (Japan) to -74% (Russia) • Sectors -43% (sp. Retail) to -62.2 % internet, catalog

  17. What happened to… • Credit spreads? • Highest on record • Hedge funds: -15% to -20% 2008 YTD • E.g. convertible arbitrage • Acme paper Inc • Buy the convertible bond • Sell short the stock • Stock falls by 60% --hurray! • But cannot sell the bond!

  18. Two schools: Democracy and Dictatorship?…Depends on your point of view Interventionist • Who gets credit, on what terms, • Regulation of… • Lenders • Hedge funds • Complex financial products • Sales agents • Mortgage brokers • Free Market • Caveat emptor • Market will sort it out • Only the strong survive

  19. What’s ahead • More rounds of technical selling • December, January hedge fund redemptions • Year-end tax-loss selling • Further deleveraging • And then?...

More Related