11

Bubbles and big numbers – how could it happen?

Wayne LonerganApril 2009

2

The main causes Falling interest rates Excess liquidity Under-priced risk Excessive F. Institutions leverage /

growth Declining prudential standards Residential property boom Implicit assumptions

3

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.

4

Causality chain

5

The scale of the problem $bn – 9 zeros $tn – 12 zeros US$14.3tn – USA GDP 2008 US$5tn – fall in market cap of

banks (2007-09) US$1.5 - $3.0tn – estimate of US F.I .

losses US$1.4tn – total stimulus etc.

package (10% USA GDP)

US$5,000 – per person in USA

Source: Economist

6

$10,000 – in $100 notes

7

$1 million – in $100 notes

8

$100 million – in $100 notes (fits on a standard pallet)

9

$1 billion – in $100 notes (10 pallets)

10

$1 trillion – in $100 notes(10,000 pallets – those below are double stacked)

11

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

+

12

Interest rates fellUSA 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

13

Corporate spreads fell

– Global Corporates AAA – Global Corporates AA– Global Corporates A – Global Corporates BBBSource: Bloomberg

14

Inadequate (for a time) credit spreads

15

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

16

Excess liquidity was created – USA domestic issues

% of GDPp.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

17

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)

18

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

19

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

20

National debt levels exploded

Source: FSA

21

National debt levels exploded cont.

Source: FSA

22

Household indebtedness rose

% of disposable

income

USA 141

Australia 156

UK 177

Source: Prof N. Ferguson (Harvard)

23

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

24

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

25

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

*

*

*

26

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 08Lev 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

27

Plus risks not recognised – taking risk off B/S Traditional

Deposits funds loans

Loan originator = ultimate funder

Securitised Deposits funds

loans

Loan originator and packager ≠ ultimate funder

Securitised

* Shaded = no capital unregulated

28

AAA rated entities / securitiesCompanies rated as AAA 12

CDO’s etc rated as AAA in 2007-8 62,000*

*One AAA ratings issue every 15 minutes per working day

Source: Goldman Sachs

29

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

30

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

31

Advanced securitisation Slice, hive, improve, trade*

*No acronyms please

AAA

AA

A

BBB

BB

B

Equity

AAA

AA

A

BBB

BB

Equity

Credit insce / CDS

CDS2 CDS 3 (etc)

32

The USA residential debt binge 2000-2008

US residential debt +122%

Disposable income +47%

Ratio residential debt to DI +51%

30 year loan average minimum repayment

+90%

Source: Freddie Mac

33

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

34

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 burden2 Interest rate risk, either way, for lenders. Also encourages “trading up”.

35

USA Residential property boom

Interest rates fell Incomes rose LVR increased Values increased

36

Financial impact on USA residential borrowers

US$bn

% of increas

e

Annual housing loan service cost – 2000 497

Income increase 174 38

Interest rates fell 113 26

LVR increased (78% - 88%) 128 28

Other (low doc, step up rates, etc) 37 8

Annual housing loan service cost– 2008 949

36%

Cyclical

37

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%

38

Total US home mortgage loans lending boomed

US$tn

2000 5,500

2008 12,200

122%

Source: National Economic Accounts

39

Increasing leverage ratio on housing

40

Loan originations by type

41

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 57%

Fall in residential house values 3Q 2006 to 4Q 2008 16.8%

Freddie Mac / Fannie Mae

– Total debt $5tn

– Total US government debt $9.5tn

42

Home ownership rate

43

Case-shiller home price index

44

Source of funds for Freddie Mac’s MBS’s

45

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

46

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

47

Government regulators exacerbated / caused / ignored problems cont.

USA UK Aust

Ignored problems

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

48

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/MLSource: Economist

49

Failure to identify there were two types of risk

Quantifiable expected deviation Unquantifiable unexpected (Fat

Tail) deviation

50

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

51

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”

52

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

53

Valuation issues – Australian banks

Relied on property valuations Recognise losses only when

incurred (AIFRS) Reliance on offshore debt capital

54

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)

55

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

56

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)

57

Not just a USA/UK problem

58

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

59

Summary and conclusion

“The United States owes debts everywhere … it is nothing but a paper Tiger”

Mao Tse-Tung (Zedong)

1956

60

Recommended readingAvailable from leading book

stores orAllen & 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)