Bubbles and big numbers –
how could it happen?
Wayne Lonergan
April 2009
1
The main causes







Falling interest rates
Excess liquidity
Under-priced risk
Excessive F. Institutions leverage / growth
Declining prudential standards
Residential property boom
Implicit assumptions
2
Second order causal factors










Government policy
Inadequate regulators
Off B/S finance
Securitisation
Excessive remuneration / moral hazard
Short termism
Accounting issues*
Unexpected double whammy*
Valuation issues*
Academics *
* (Mostly) not yet outed.
3
Causality chain
4
The scale of the problem

$bn
$tn
US$14.3tn
US$5tn
–
–
–
–

US$1.5 - $3.0tn
–

US$1.4tn
–

US$5,000
–



9 zeros
12 zeros
USA GDP 2008
fall in market cap of
banks (2007-09)
estimate of US F.I.
losses
total stimulus etc. package
(10% USA GDP)
per person in USA
Source: Economist
5
$10,000 – in $100 notes
6
$1 million – in $100 notes
7
$100 million – in $100 notes
(fits on a standard pallet)
8
$1 billion – in $100 notes
(10 pallets)
9
$1 trillion – in $100 notes
(10,000 pallets – those below are
double stacked)
10
Just another boom?

Lower interest rates

Increases ability to borrow

Increases asset values

Encourages more leverage

Increases asset values

Declining prudential standards

Increases asset values
+
11
Interest rates fell
USA weighted average mortgage rate
1994 – 1997
9.0%
2000
6.8%
2008
5.2%
USA sub-prime housing loan rate
2004
11.5%
2008
9.1%
Credit spreads were low
Volatility fell significantly
Source: National Economic Accounts
12
Corporate spreads fell
– Global Corporates AAA – Global Corporates AA
– Global Corporates A
– Global Corporates BBB
Source: Bloomberg
13
Inadequate (for a time) credit
spreads
14
Volatility declined – implied
volatility of the S&P 500 and DAX
Source: CBOE and Deutsche Borse
Note: VIX and VDAX are indices of implied volatility for stock option prices on the S&P 500 and DAX respectively
15
Excess liquidity was created –
USA domestic issues
% of
GDP
p.a.
Fall in savings ratio (2000 – 2008)
4.0
Balance of payments deficit (ave)
(2000 – 2008)
4.8
Government deficit (ave) (2002 – 2007)
3.5
2000 +1.6%
2007 – 2.8%
NB! Cumulative impact over 8 years
Source: USA National Economic Accounts
16
Excess liquidity – international
issues




Undervalued currencies created
surpluses recycled to USA (eg China)
Imprudent lending (e.g. large loans to
eastern European countries)
Widespread foreign currency
denominated borrowing (eg Czech)
Reckless lending / expansion (e.g.
Iceland)
17
Risk was underpriced

Corporate bonds spread over govt bonds
(B.PTS)
AA
BBB
Difference
6/05
56
84
28
6/06
53
75
22
6/07
58
88
30
6/08
216
267
51
2/09
248
50
255
Source: RBA
18
Risk was underpriced cont.

Five year credit default swaps
AA
BBB
Difference
6/05
12
49
35
6/06
9
44
35
6/07
5
50
45
6/08
84
142
58
2/09
189
398
209
Source: RBA
19
National debt levels exploded
Source: FSA
20
National debt levels exploded
cont.
Source: FSA
21
Household indebtedness rose
USA
Australia
UK
% of
disposable
income
141
156
177
Source: Prof N. Ferguson (Harvard)
22
Role of financial institutions*








Excessive leverage
Inadequate (no?) review of credit quality
Off B/S structures
Excessive proprietary trading
Short-term focused remuneration incentives
Culture of greed
Reliance on flawed formula
With a few notable exceptions e.g. Allco, B&B
* Not in Oz
23
Average bank and investment
bank leverage became excessive
Reported debt to equity leverage
USA
25 (+)
Eurozone
30 – 60 (+)
UK bank debt
440% of GDP
Source: Centre for European Policy
Studies, Prof N. Ferguson
24
European banks ranked by
total assets (€ million)
Bank
Total
assets
June 08
Total
assets end
07
Mkt Cap
Oct 2008
(Billion)
Lev ratio
June 08
Lev ratio
end 07
HSBC
2,546,678
2,354,266
140.9
20.1
18.4
RBS
2,463,214
2,579,194
37.2
18.8
20.8
Deutsche Bank
1,990,740
2,020,349
24.4
59.1
52.5 *
BNP Paribas
1,817,193
1,694,454
59.1
36.1
31.5
Barclays Bank
1,726,187
1,654,652
37.0
61.3
52.7 *
Credit Agricole
1,464,822
1,414,223
32.3
40.5
34.8
ING Group
1,369,947
1,312,510
33.8
48.8
35.3
UBS
1,292,081
1,370,820
42.1
46.9
63.9 *
Societe Generale
1,075,925
1,071,762
37.5
30.3
39.3
UniCredit
1,059,767
1,021,504
37.7
19.0
17.7
Source: CEPS
25
European banks ranked by
total assets (€ million) cont.
Bank
Total
assets
June 08
Total
assets
end 07
Mkt Cap
Oct 2008
(Billion)
Lev ratio
June 08
Lev ratio
end 07
Fortis
974,343
871,179
12.9
33.3
26.4
Credit Suisse
764,828
820,762
34.6
33.4
31.5
Commerzbank
615,223
616,474
8.5
39.9
38.2
Dexia
613,708
604,564
9.8
64.4
41.6
Intesa Sanpaolo
572,902
572,902
48.2
11.1
11.1
BBZ Argentaria
504,990
502,204
43.4
20.1
18.6
Lloyds TSB
464,876
479,185
19.8
34.1
31.0
Hypo Real Estate Holding
395,422
400,174
1.1
83.0
65.9
KBC
377,351
355,597
21.9
24.4
20.5
Standard Chartered
251,287
224,092
25.1
19.5
15.8
Deutsche Postbank
202,991
202,991
4.8
38.2
38.2
Banco Popular
108,928
107,169
10.3
16.6
17.2
Source: CEPS
26
Plus risks not recognised –
taking risk off B/S

Traditional
Deposits
funds
loans
Loan originator = ultimate funder
Securitised

Securitised
Deposits
funds
loans
Loan originator and packager ≠ ultimate funder
* Shaded = no capital unregulated
27
AAA rated entities / securities
Companies rated as AAA
CDO’s etc rated as AAA in 2007-8
12
62,000*
*One AAA ratings issue every 15 minutes per working day
Source: Goldman Sachs
28
Lending complexity increased,
participants and roles changed

Traditional model


Loan originator (bank) makes loans, funds,
holds to maturity
Securitisation model

Loan originator (broker) makes loans,
investors fund / trade / hold to maturity
29
Lending complexity increased,
participants and roles changed cont.

Advanced securitisation model


Loan originator / broker makes loan
Intermediaries slice, trade, hive off risk and
improve / enhance apparent credit status
with CDS and credit insurance
30
Advanced securitisation

Slice, hive, improve, trade*
AAA
AA
A
BBB
BB
B
Equity
AAA
Credit
insce
/ CDS
AA
A
BBB
*No acronyms please
BB
CDS2  CDS 3 (etc)
Equity
31
The USA residential debt
binge 2000-2008
US residential debt
Disposable income
Ratio residential debt to DI
30 year loan average minimum
repayment
+122%
+47%
+51%
+90%
Source: Freddie Mac
32
Declining prudential standards






Excessive leverage (US FI 30:1, Fannie Mae 70:1,
Credit Insurers 100:1)
Low doc. Loans (sub-prime 35%, ALT – A 71%)
Low / no deposit loans
Blind faith in credit ratings
Misplaced faith in credit insurance / CDS
Credit ratings agencies

Conflicts:


Defence counsel and judge
Paid by issuers
33
What’s different about USA
property loans






Non-recourse
Mostly fixed rate (90% +)(1)
Rate based on LTBR
No / low penalty for early payout(2)
Tax deductible interest for borrowers
Loan initiators distanced from ultimate financiers
Note:
1 Hard to ameliorate debt burden
2 Interest rate risk, either way, for lenders. Also encourages “trading up”.
34
USA Residential property
boom




Interest rates fell
Incomes rose
LVR increased
Values increased
35
Financial impact on USA
residential borrowers
US$bn
% of
increase
Annual housing loan service cost
– 2000
497
Income increase
174
38
Interest rates fell
113
26
LVR increased (78% - 88%)
128
28
37
8
Other (low doc, step up rates, etc)
Annual housing loan service cost
– 2008
Cyclical
36%
949
36
Declining loan quality



Qualitative decline – more loans to lower income
earners (HSG AWE 64%, UG AWE)
Traditional counter cyclical deposit constraint
removed (+ LVR)
Traditional interest constraint payment removed






Deferred interest step ups
(2004) initial rate 7.3%, full rate 11.5%
Low doc / no deposit loans
Loans initiators distanced from borrowers
LVR 78% to 88% (ave)
Some LVR 105% - 110%
37
Total US home mortgage
loans lending boomed
2000
US$tn
5,500
2008
12,200
122%
Source: National Economic Accounts
38
Increasing leverage ratio on
housing
39
Loan originations by type
40
Some Freddie Mac statistics
(3/09)
% of loans
Freddie Mac portfolio (ave) Ltv
– 2005
56%
– 2008
72%
Freddie Mac portfolio ($2.2tn)
– LTV 90% - 100%
10%
– LTV 100% (+)
13%
– sub-prime % of portfolio
34%
USA residential debt
– 2009
$12.4tn
– 2015 forecast
$19.7tn
USA residential debt / house value
Fall in residential house values 3Q 2006 to 4Q 2008
57%
16.8%
Freddie Mac / Fannie Mae
– Total debt
– Total US government debt
$5tn
$9.5tn
41
Home ownership rate
42
Case-shiller home price index
43
Source of funds for Freddie
Mac’s MBS’s
44
Implicit assumptions were ill
founded (as always)









A new paradigm
AAA means AAA
Houses are a safe investment
Credit insurers could cover losses
Financial instruments reduce systemic risk
Lenders will roll over on maturity
No double whammy (assets fall, liabilities rise)
Different states = diversification
Recent low bad debt experience would continue
45
Government regulators exacerbated /
caused / ignored problems
USA
UK
Aust
Caused / exacerbated problems
Home lending encouraged
Y
Y
Y
Inadequate bank F.I.
regulation
Y
Y
N
Large federal deficit
Y
Y
N
46
Government regulators exacerbated /
caused / ignored problems cont.
USA
UK
Aust
Inadequate / no response to
debt explosion
Y
Y
N
Excessive property prices
Y
Y
Some
Excessive dependence on
financial services sector
Some
Y
Some
Basel I K adequacy encouraged
house mortgage lending
Y
Y
Y
Basel II introduced
N
Y
Y
Ignored problems
47
Excessive remuneration /
short termism

Excessive focus on STI
Bonuses
US$bn
Hedge fund management fees
33.0
Wall St bonuses
3 years total*
35.0(+)
Bear Stern
11.3
Lehman Brothers
21.6
Merrill Lynch
45.0
Ave p.a.
26.0
* Seems very low c.f. BS/LB/ML
Source: Economist
48
Failure to identify there were
two types of risk


Quantifiable expected deviation
Unquantifiable unexpected (Fat Tail)
deviation
49
Australian property valuation
issues






Property valuers look backward
No conceptual framework in property
DCF rare
Excessive leverage
“Hedged” borrowings
Cheap trust capital used for
development risks
50
Australian infrastructure
valuation issues






Imputation credits reduce Ke
Capital / loan distributions viewed as
“income”
Excessive leverage
Declining interest rates created illusion
of value creation
“Tame” valuers
Inter entity “sales”
51
Valuation issues – other
corporates






Values depended largely on IA
Widespread “in house” ownership
meant no back up capital
Non-recurring (in house) fees
capitalised as if recurring
Pyramid structures
Mainly “I” entities Allco, B&B, etc
Reliance on offshore debt capital
52
Valuation issues – Australian
banks



Relied on property valuations
Recognise losses only when incurred
(AIFRS)
Reliance on offshore debt capital
53
Accounting standard
contribution (not yet “outed”)






Off B/S finance allowed
Market price confused with market value
Pro-cyclical reporting (K transactions / MTM
in headline profits)
Hedge accounting (asset value fall plus hedge
liabilities rise)
Bad debts not recognised until “incurred”
Recycled profits on first time adoption
(developers)
54
Accounting standard contribution
(not yet “outed”) cont.






Permitting VIU
Not explaining VIU
Allowing CGU’s to change
Not amortising goodwill (preservation of
capital, discouraged takeovers)
Allowing mining co to show ore
reserves as goodwill
Short 5 year PV horizon for impairment
55
Unexpected double whammy



Asset values fell
Liability values rose
Impact of low Rf rate on liability values
not yet widely recognised (govt,
insurers, PB super, etc)
56
Not just a USA/UK problem
57
Failure of academics








To emphasise business fundamentals (LTA with LTD,
liquidity, leverage limits)
To demonise VIU
Belief in VAR
Belief in “rational” markets
Belief in EMH
Modigliani / Miller (D/E curve become exponential)
Li formula (priced CDO by correlation metric)
Belief Gamma factor reduces c of k and + value
58
Summary and conclusion
“The United States owes debts everywhere … it
is nothing but a paper Tiger”
Mao Tse-Tung (Zedong)
1956
59
Recommended reading
Available from leading book stores or
Allen & Unwin
www.allenandunwin.com
Available from leading book stores or
Sydney University Press
www.sup.usyd.edu.au
(Alternatively contact Lonergan Edwards on 02 8235 7500)
60