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Financial Armageddon: Myths and Reality

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What are the pros and cons of the proposed bailouts around the world? ... 'Shares on the Topix index, the broadest gauge of Japan's stock market, trade at ... – PowerPoint PPT presentation

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Title: 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 Moodys
    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
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

12
Myth 2 Complex financial models are wrong
13
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

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 RMBSs 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

24
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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
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