The Credit CrunchCrisis and Opportunity

Wynn Quon

Oct 9, 2008

How did we get into this mess?

• Real-estate prices normally go up and down like a roller-coaster….but something weird happened beginning in the late 90’s in the U.S.

• Go for a ride: http://www.speculativebubble.com/videos/real-estate-roller-coaster.php

Attack of the NINJA loans!

• “Mike Garner, is a bartender in Nevada turned mortgage broker. Mr. Garner said that Wall Street’s appetite for mortgages, pushed loan standards down: ‘No income, no asset. You don’t have to state anything. Just have a credit score and a pulse.’ ”

--This American Life, NPR, “The Giant Pool of Money” May 9 2008

You can’t make this stuff up

• In one case, mortgages were also granted to 23 dead people in Ohio.

Wall Street Mortgage mania

• Banks float $2.6 trillion of mortgages in 2006 alone. (20% subprime)

• Investment banks issue $45 trillion of mortgage/debt insurance (credit default swaps).

• Use of 30x leverage - $1 down on a $30 loan

• Amount of bad investments >> dot.com bubble

End of illusion

Bad news

• 1000 foreclosures a day in California as real estate prices plunge. Housing prices fall 25-30%+ in Las Vegas, San Francisco, LA, Detroit, Miami, San Diego, Phoenix...

• Lehman Bros, Bear Stearns, Countrywide Financial, Fannie Mae, Freddie Mac, AIG collapse or get taken over. Severe declines in bank shares. Bank failures. ($1 trillion in shareholder losses). Failures ripple through bank sector internationally.

• U.S. stock market falls 20%, wiping out $4 trillion in wealth.

Worse News• Credit crunch - Without banks lending, the economy will

grind to a halt. (car loans, mortgages, business loans e.g. Ford Sept. sales down 35%)

• Default rates increasing on prime mortgages, auto loans, credit cards

• Unemployment in the U.S. growing; 6.1% up from 4.7% a year ago.

• Real-estate bubbles in U.K., Ireland, Spain, China. Stock market crashes in China (-60%), India(-43%)...

• Danger of a decline spiral

What about Canada?

• We’re the tail on the U.S. dog• real-estate bubble in Vancouver, Calgary,

Edmonton• worrying: levels of personal debt are high -

household net borrowing at 6.3% of disposable income, just shy of the peak in the U.S. in 2005.

• the credit crunch is already here - ABCP mess, 5 yr mortgage rates have increased to 7.2%, CIBC troubles, interbank lending has stopped

How bad will things get?

• The longer and bigger the boom, the bigger the crash

• Lack of transparency breeds fear• “rational panic”• Bank crises strike at the core of the global

economy• $850 billion U.S. bailout unlikely to stop recession

Lessons of history

• 5 severe post-war banking/real-estate crises (Japan, Spain, Finland, Norway, Sweden)

• On average, home prices fall 20% from peak, stock prices fall 20%.

• Bear market average length 2 yrs.

• But every crisis is different...

Optimistic case

• An average crisis?

• Stocks have already fallen by more than 20% as have real estate prices in the U.S.

• Bear market has already lasted ~1 yr

• Optimistic case - we’re near the bottom

• What’s the pessimistic case?

Japanese Super Bear market

Japanese Super Bear market

• 13-year bear market

• Stocks lost 78% of their value

• Real-estate prices still down 50% from 1991 peak, down 64% in six largest cities.

Fog of forecasting

• Huge Unknowns:

How much bad debt will there be?

Policy response - competence?

Investor response - confidence?

Investment companies - liquidity?

System feedback loops

• As difficult as hurricane forecasting

Wrong question

• How bad will it get?

Right questions

• What is your risk tolerance?

• What is your time frame?

Most common mistake

• …of investors is to overestimate their risk tolerance.- during bull markets, the downside is completely theoretical

- during bear markets, losses are real. Investors suffer loss aversion.

- fear, regret and panic overwhelm rational decision-making

- therefore, take your assumed risk tolerance and divide by 2. E.g. if you think you can have 70% of your portfolio in stocks, your real tolerance level is actually 35%.

• Use scenarios to test drive your risk tolerance

Hope for the best, prepare for the worst

• If we are hit by the equivalent of a Japanese Super bear scenario:

Dow Jones Ind. Avg would fall to 2800

TSX would fall to 3000.

….prices would begin recovery sometime after 2021. Yikes.

• A $100,000 all-stock portfolio would fall to $20,000.

Impact of a Super Bear

• Assume a $100K portfolio at the market peak. The following is what would happen in a Japanese Super Bear scenario.

• 100% stocks, 0% fixed income - your $100K portfolio would fall to $20K. (Don’t do it!)

• 80% stocks, 20% fixed income - your $100K portfolio would fall to $36K.

• 60% stocks, 40% fixed income - your $100K portfolio would fall to $52K.

• 40% stocks, 60% fixed income - your $100K portfolio would fall to $68K.

• 20% stocks, 80% fixed income - your $100K portfolio would fall to $84K.

Notes: Fixed income = cash, gov’t bonds, GICs. Results ignores dividends.

Which allocation allows you to sleep at night? Ideally, this exercise should be done before a bear market hits. But it’s never too late. Remember also that unemployment rises during recessions. Would you still have the same portfolio allocations if you lost your job?

Is your money safe?

• In a credit crisis, trust is lost.

• E.g. Lehman Bros bonds rated ‘A’ by S&P, Sept. 9th 2008.

Less than one week later the company collapsed. Bonds are worthless.

• This is a good time to check that your deposits/GICs are with CDIC-insured institutions. Gov’t guarantees $100K of deposits. (cdic.ca)

• CIPF protects up to $1M in your brokerage account. All securities you’ve paid for are segregated. (cipf.ca)

• ***www.financeprotection.ca

Not insured

• Money market funds, mutual funds -note: money market funds are now neither ‘low-risk’ or ‘high risk’.

• Principal-protected notes, aka ‘index-linked GICs’

• Foreign currency accounts, etc.

Success in the stock market

• In bull markets investors ignore risk.

• In bear markets investors ignore return.

Bear market buying

• Bear markets are the best time to buy

• But if your portfolio doesn’t match your risk tolerance, you will be too scared to do it. Or buy too soon.

Buying strategies

• Make a plan beforehand!

• Decide how much $ you want to commit

• Divide it into chunks

• Tie your buying decisions to price points or index levels.

• E.g. TSX - 8000, 6000, 4000, 2000…. Or say MCD @ $40, $30, $20….

Stocks to watch• Dividend-payers (e.g. Telus, Enbridge,

Cameco) with relatively low debt in the TSX60

• Avoid for now: financials (banks, insurance companies) unless you know something I don’t;

• Add some gold (Barrick, Goldcorp)

• Pfizer, yield 6.5%+; Analog Devices

Speculations

• Nortel Networks - Common shares @ $2.00; Floating-Rate Preferred Cumulative F shares. $4-$5. Guess the yield!

• BCE. Currently @$33. Upside to $42. Downside to $16. A gamble.

• Gold Fields, currently $7, 3.2% yield.