Powerpoint of lecture - McGill Mini-Biz

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Financial Armageddon:
Myths and Reality
ART DURNEV
McGill 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 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
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
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 2: Complex financial
models are wrong
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
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

Credit markets are frozen
TED SPREAD
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

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 market
 banks
 stock market
 pensions

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 income


Debt as a percent of assets in Canada is
20%


Compared to the 7% peak in the US in 2005
Compared to 26% in the US – 30% less
Canadian subprime mortgages represent
only 5-6% of the market

Compared 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
UK
Hong Kong
Russia
China
Brazil
Turkey
Pakistan
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