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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.

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the main causes
The main causes

Falling interest rates

Excess liquidity

Under-priced risk

Excessive F. Institutions leverage / growth

Declining prudential standards

Residential property boom

Implicit assumptions

second order causal factors
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.

the scale of the problem
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

just another boom
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

+

corporate spreads fell
Corporate spreads fell

– Global Corporates AAA – Global Corporates AA

–Global Corporates A – Global Corporates BBB

Source: Bloomberg

volatility declined implied volatility of the s p 500 and dax
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

excess liquidity international issues
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)

risk was underpriced
Risk was underpriced

Corporate bonds spread over govt bonds (B.PTS)

risk was underpriced cont
Risk was underpriced cont.

Five year credit default swaps

role of financial institutions
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

plus risks not recognised taking risk off b s
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

lending complexity increased participants and roles changed
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

lending complexity increased participants and roles changed cont
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

advanced securitisation
Advanced securitisation

Slice, hive, improve, trade*

*No acronyms please

Credit insce / CDS

CDS2  CDS 3 (etc)

declining prudential standards
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

what s different about usa property loans
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”.

usa residential property boom
USA Residential property boom

Interest rates fell

Incomes rose

LVR increased

Values increased

declining loan quality
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%

implicit assumptions were ill founded as always
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

failure to identify there were two types of risk
Failure to identify there were two types of risk

Quantifiable expected deviation

Unquantifiable unexpected (Fat Tail) deviation

australian property valuation issues
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

australian infrastructure valuation issues
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”

valuation issues other corporates
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

valuation issues australian banks
Valuation issues – Australian banks

Relied on property valuations

Recognise losses only when incurred (AIFRS)

Reliance on offshore debt capital

accounting standard contribution not yet outed
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)

accounting standard contribution not yet outed cont
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

unexpected double whammy
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)

failure of academics
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

summary and conclusion
Summary and conclusion

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

Mao Tse-Tung (Zedong)

1956

recommended reading
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)