Financial Armageddon: Myths and Reality

1. Financial Armageddon:Myths and Reality ART DURNEV McGill University

2. 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?

3. Some history • Prime Mortgages • Mortgages for borrowers with good credit, provide a down payment, and document their income • Subprime Mortgages • Mortgages given to the least credit-worthy clients: low credit scores, uncertain income prospects

4. 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

5. 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

6. Mortgage Financial Flows 1990s

7. 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

8. Mortgage financial flows 2000

9. 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

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

11. 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

12. Myth 2: Complex financial models are wrong

13. 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

14. 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

15. US Housing Prices

16. 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

17. 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

18. Credit markets are frozen TED SPREAD

19. The US Government steps in • The US government helps orchestrate a takeover of Bear Sterns by JP Morgan Chase • Freddie Mac and Fannie Mae bailout • They allow Lehman Brothers to go under • They bail out AIG- largely because of its size and interconnection with the financial industry

20. Bailouts (US and British)

21. Myth 3: Bailouts are good

22. 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

23. Myth 4: Canada is immune • Is Canada immune? • housing market • banks • stock market • pensions

28. Exchange rate (CAD/USD)

29. 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

30. Canada vs. US • Canadian net borrowing has reached 6.3% of disposable income • Compared 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 market • Compared to 25% in the US

31. 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

32. 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

33. Toronto Stock Exchange

34. 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.

35. Magna International

36. Bombardier

37. Bank of Montreal

38. Talisman Energy

39. Lundin Mining

40. "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. "

41. 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 Turkey UK Russia Brazil Pakistan