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					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               –   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


                                                        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)                        4.8
 (2000 – 2008)
 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
                               % of
                          disposable
                             income
USA                              141
Australia                        156
UK                               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)
                      Total         Total    Mkt Cap
                     assets    assets end   Oct 2008     Lev ratio     Lev ratio
Bank                June 08            07    (Billion)    June 08        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.
                             Total    Total     Mkt Cap
                            assets   assets    Oct 2008     Lev ratio     Lev ratio
Bank                       June 08   end 07     (Billion)    June 08        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                                      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




                                                                   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                 AAA
            BB        Credit
             B        insce
                                AA
                      / CDS
          Equity                 A
                                BBB
                                BB      CDS2  CDS 3 (etc)
*No acronyms please
                               Equity
                                                             31
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          +90%
repayment
                               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
                                                  % of
                                      US$bn   increase
Annual housing loan service cost
– 2000                                  497
Income increase                         174        38
Interest rates fell                     113        26    Cyclical

LVR increased (78% - 88%)               128        28
                                                          36%
Other (low doc, step up rates, etc)      37         8
Annual housing loan service cost
– 2008                                  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
                                  US$tn
2000                               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                          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


                                                                   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.       Y    Y     N
regulation

Large federal deficit      Y    Y     N




                                            46
Government regulators exacerbated /
caused / ignored problems cont.
                                USA    UK   Aust
Ignored problems
Inadequate / no response to      Y     Y     N
debt explosion
Excessive property prices        Y     Y    Some
Excessive dependence on         Some   Y    Some
financial services sector
Basel I K adequacy encouraged    Y     Y     Y
house mortgage lending
Basel II introduced              N     Y     Y




                                                   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

				
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