GLOBAL FINANCIAL MELTDOWN: MYTHS AND REALITY

1
GLOBAL FINANCIAL MELTDOWNMYTHS AND REALITY
ART DURNEV IPMX Global Management Program
2
(No Transcript)
3
What Happened in 1 Slide

• Tremendous misallocation of funds by US banks and
  financial firms to real estate sector
• issuance of exotic financial products
• financed by short-term debt
• New financial instruments entered banks balance
  sheets
• Both CEOs and lower-level employees are rewarded
  for high-return/high risk
• earnings pressure
• bad hedging decisions

4
MYTHS

• Myth 1 Whom to Blame? U.S. and Greedy Wall
  Street
• Myth 2 Complex Financial Models Are Wrong
• Myth 3 Bailouts Will Work
• Myth 4 Canada Is Immune
• Myth 5 The Crisis Is Almost Over

5
MYTHS
Myth 6 The Market Cannot Drop Too Low Myth 7
Emerging Markets Currencies Collapse Because
Governments Make Poor Decisions Myth 8 The
Recovery Is Going to Be Painful But Well All
Make It, Just Like Before
6
Myth 1 Whom to Blame? U.S. and Greedy Wall
Street
7
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?

8
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

9
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
• overbuilding
• low interest rates post 9/11

10
(No Transcript)
11
Mortgage Financial Flows
12
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

13
Myth 2 Complex Financial Models Are Wrong
14
Myth 2 Complex Financial Models Are Wrong

• Even their abbreviations can make you dizzy
• ABS CDO
• asset backed subprime collateralized debt
  obligations
• BB- mezz ABS CDO3
• real toxic waste! do not touch

15
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

16
Reasons Behind the Unraveling

• House prices had been rapidly appreciating so
  subprime borrowers could borrow against their
  home value, or could sell their 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

17
US Housing Prices
18
(No Transcript)
19
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

20
(No Transcript)
21
Credit Markets Got Frozen
TED SPREAD
22
CBOE Volatility Index
23
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

24
Bailouts (US and British)
25
Myth 3 Bailouts Will Work
26
(No Transcript)
27
(No Transcript)
28
Myth 3 Bailouts Will Work

• 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

29
Myth 3 Bailouts Will Work

• The benefits of our success stretch far outside
  the company, Goodwin, 50, wrote in RBSs 2006
  corporate responsibility report. We continued to
  be the largest corporate taxpayer in the U.K.,
  he wrote. That helped in supporting the
  government in the provision of public services
  such as schools, hospitals and state pensions.
• As Goodwins RBS contract expires next week,
  after more than a decade at the bank, the 20
  billion-pound (28 billion) cost of bailing out
  the bank surpasses the corporate taxes paid by
  the Edinburgh-based lender during his tenure.

30
Myth 4 Canada Is Immune

• It was silly to assume that Canada would be
  immune
• housing market
• banks
• stock market
• pensions

31
(No Transcript)
32
(No Transcript)
33
(No Transcript)
34
(No Transcript)
35
CAD/USD
36
Nortel Collapse
37
Caisse de Depot

• 40bn loss
• 26 of its total value
• ?higher fees and contributions to the Quebec
  pension plan and the auto insurance program

38
Housing Market in 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

39
vs.

• 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

40
vs.

• Less than a quarter of Canadian mortgages are
  securitized
• the majority of the liabilities remain on the
  individual balance sheets
• 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

41
vs.
42
No One Is Immune
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.
43
Magna International
44
Bombardier
45
Bank of Montreal





46
Talisman Energy
47
Lundin Mining
48
(No Transcript)
49
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
50
Why do we care at all?Foreign currency reserves
Bill Gates III is worth 50bn
11/10/2009
Art Durnev
50
51
Myth 5 The Crisis Is Almost Over

• Not until
• the risk of large institutions collapsing is
  small
• borrowing in the short term is restored
• clean up bank balance sheets
• when the likelihood of financial assets being
  dumped on thin markets is small
• leverage only increases with collapsing asset
  prices
• set up new and functioning audit institutions

52
Myth 6 The Market Cannot Drop Too Low
"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.
"
53
Myth 7 Emerging Markets Currencies Collapse
Because Governments Make Poor Decisions

• Not reallynot a rocket science
• weve known carry trade for centuries
• take a loan in Rubles 28
• convert to
• wait for depreciation of Rubles gt28
• repay your loan
• pocket your money
• depreciation - loan
• what will happen to Rb/ rate?
• this is how bailout money flows

54
Russian Ruble
55
Ukrainian Ghryvna
56
Japanese Yen
57
Indian Ruppe
58
Myth 8 The Recovery Is Going to Be Painful But
Well All Make It, Just Like Before

• Let me cite the Nobel here, Paul Krugman
• the human cost of a slump that severe would be
  enormous
• we're probably looking at a real-world
  unemployment rate of around 15 percent more
  than 20 million Americans frustrated in their
  efforts to find work
• IMF The global economy will slow close to a halt
  this year as more than 2 trillion of bad assets
  from the U.S. help sink economies from Russia to
  the U.K.

59
Reinhart and Rogoff (2008)
Housing Prices Are -28 in US
60
Reinhart and Rogoff (2008)
61
Reinhart and Rogoff (2008)
62
What to do?

• Since it is hard to figure out whom to blame it
  is even harder to say what to do
• Everyone wants to know the answer

63
Ugly consequences we have not realized yet

• There are a lot of Madoffs
• Loss of faith in capitalism
• Enormous shrinkage of wealth of middle class
• Political instability
• especially in emerging markets
• weak or nonexistent social insurance system
• Financial architecture reforms
• easy to say, hard to implement
• expand G20
• permanence of IMF board

64
(No Transcript)
65
(No Transcript)
66
(No Transcript)
67
(No Transcript)
68
(No Transcript)
69
(No Transcript)
70
(No Transcript)
71
(No Transcript)
72
(No Transcript)
73
Ugly consequences we have not realized yet

• The FED needs to expand money supply to buy
  troubled assets
• deflation is bad!
• recall that corporate and personal indebtness
  increases as assets values drop
• Purchases of Treasuries and corporate bonds
• Read print more money
• China is very worried about the value of dollar

74
Time to curb credit-ratings shopping

• Credit rating agencies play a key role in the
  functioning of a stable, fair financial system
• Financial engineers create a product to sell to
  investors, but investors wont buy it without a
  gauge of its risk.
• So the financial engineers then approach a credit
  rating agency and submit the product to be rated.
  
• The engineers pay for this service, and they want
  the highest rating possible.
• This gives them an incentive to ratings shop
  among the rating agencies, which compete for
  issuers business.
• Such a system inherently gives rise to conflicts
  of interest.

75
(No Transcript)
76
(No Transcript)
77
(No Transcript)
78
(No Transcript)
79
Time to curb credit-ratings shopping

• We recommend that the administration incorporate
  the recommendations that the Presidents Working
  Group on Financial Markets proposed last year as
  a first step to reducing ratings shopping.
• It recommended that underwriters (our financial
  engineers) be required to publicly disclose when
  they choose not to publish all of the preliminary
  ratings their products have received as final
  ratings.