Bubbles and big numbers – how could it happen?

1. Bubbles and big numbers – how could it happen? Wayne Lonergan April 2009 1

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 fell

13. Corporate spreads fell – Global Corporates AAA – Global Corporates AA –Global Corporates A – Global Corporates BBB Source: 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

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)

19. Risk was underpriced cont. Five year credit default swaps

20. National debt levels exploded Source: FSA

21. National debt levels exploded cont. Source: FSA

22. Household indebtedness rose

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

25. European banks ranked by total assets (€ million) * * *

26. European banks ranked by total assets (€ million) cont.

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 / securities

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 Credit insce / CDS CDS2  CDS 3 (etc)

32. The USA residential debt binge 2000-2008

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 burden 2 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 Cyclical 36%

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

39. Increasing leverage ratio on housing

40. Loan originations by type

41. Some Freddie Mac statistics (3/09)

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

47. Government regulators exacerbated / caused / ignored problems cont.

48. Excessive remuneration / short termism Excessive focus on STI

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