Financial Armageddon: Myths and Reality

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Financial ArmageddonMyths and Reality

• ART DURNEV
• McGill University

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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?

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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

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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

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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

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Mortgage Financial Flows 1990s
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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

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Mortgage financial flows 2000
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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

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Myth 1 Whom to blame? U.S. and Greedy Wall
Street
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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 holidaysat least for a
  while

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Myth 2 Complex financial models are wrong
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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

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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

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US Housing Prices
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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

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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

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Credit markets are frozen
TED SPREAD
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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

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Bailouts (US and British)
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Myth 3 Bailouts are good
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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

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Myth 4 Canada is immune

• Is Canada immune?
• housing market
• banks
• stock market
• pensions

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Exchange rate (CAD/USD)
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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

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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

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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

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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

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Toronto Stock Exchange
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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.
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Magna International
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Bombardier
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Bank of Montreal
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Talisman Energy
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Lundin Mining
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"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.
"
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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