Financial Armageddon: Myths and Reality ART DURNEV McGill University
Dec 21, 2015
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