Anatomy of a credit crunch

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A worldwide credit crunch tied to U.S. “subprime” mortgages began in August.

The U.S. credit crunch timeline

Year-end 2006: The value of all U.S. homes, excluding rentals, peaks at 153 per cent of GDP, the highest level in at least six decades.

June 22, 2007: New York brokerage Bear Stearns Cos. spooks Wall Street in saying it will bail out one of its hedge funds due to subprime-mortgage losses. On July 18, the firm reports that its two hedge funds that invested heavily in subprimes are essentially worthless, having lost more than 90 per cent of their value, or $1.4 billion (U.S.)

Aug. 9: French bank BNP Paribas SA suspends three of its funds with U.S. subprime exposure.

Aug. 16: Troubled Countrywide Financial Corp., the U.S. No. 1 mortgage lender, draws down $11.5 billion from its credit lines to stave off insolvency.

Aug. 22: Reports show U.S. home foreclosures were up 93 per cent in July 2007 over July 2006. There were 179,599 foreclosure filings in July, up from 92,845 the previous year.

September: The Bank of England injects $55 billion into Northern Rock PLC to rescue Britain's No. 5 mortgage lender. A run on the firm by depositors is the first in memory.

Sept. 30: U.S. house prices begin to drop, a trend certain to continue as unsold homes proliferate and foreclosure rates rise.

Oct. 25: Merrill Lynch & Co. Inc. records an $8.5 billion writedown, mostly on consumer loans including subprime mortgages. CEO Stanley O'Neal is fired days later.

Nov. 5: Citigroup Inc. says subprime mortgages and related securities lost as much as $11 billion of their value in the previous month. CEO Charles Prince is forced out.

Dec. 7: CIBC discloses a whopping $9.8 billion exposure to the U.S. subprime market.

Dec. 12: Five central banks, including the U.S. Federal Reserve, the Bank of Canada and the European Central Bank, agree to inject $40 billion into the global financial system, with an additional $24 billion set aside for European buyers of scarce U.S. dollars.

Who would have thought questionable loans to Sacramento trailer-home buyers could someday trigger a global credit crisis

December 16, 2007

David Olive
Business Columnist

The cavalry rode to the rescue of the global financial system last week. We hope this unprecedented bailout works, because nothing else has since a worldwide credit crunch tied to U.S. "subprime" mortgages began in August.

The U.S. Federal Reserve Board has cut its key federal funds rate three straight times, or a full percentage point. Henry Paulson, the U.S. treasury secretary, is trying to cobble together a superfund to quarantine the big banks' soured loans, and last week unveiled a bailout plan for homeowners who can't make their mortgage payments. Retiring Bank of Canada governor David Dodge has been trying to repair a troubled financial sector – non-bank asset-backed commercial paper (ABCP) in a deal Canadian banks completed Friday. And so-called "sovereign funds," owned by state governments hailing from Dubai and Singapore, have injected capital into ailing Citigroup Inc. and Swiss banking giant UBS AG.

That's not sound and fury signifying nothing, but it might as well be. Restorative efforts to date have failed to arrest the low-grade panic on Wall Street and in other global financial centres, where expectations of further massive losses run high. Banks, brokerages and other major financial institutions bracing for an estimated $400 billion (U.S.) in subprime mortgage losses are so gun-shy they've even stopped lending to each other, and are turning away credit-worthy prospective consumer and commercial borrowers in order to shore up their balance sheets. A sustained credit freeze of this magnitude could steer the U.S. and Canada into a recession, perhaps a severe one, by the first half of next year if the financiers' confidence in their own system isn't promptly restored. Apart from the financial wreckage, an estimated 2 million Americans risk losing their homes in the next year.

"What we are witnessing is essentially the breakdown of our modern-day banking system," Bill Gross, managing director at Pacific Investment Management Co. LLC (Pimco), writes in his latest client note. Pimco manages close to $1 trillion, and the investing acumen of Gross rivals that of Warren Buffett. His latest commentary only added to fears on Wall Street that the worst of the bad-loan reporting isn't over, even after staggering writedowns declared by blue-chip financial houses including UBS, Citigroup and Merrill Lynch & Co. Inc. Last week, Bank of America Corp. and Wachovia Corp., the No. 5 U.S. bank, declared or warned of large subprime-related losses. Canadian banks have so far taken a $1.3 billion hit.

"Credit contraction, with its inevitable companion of asset destruction," Gross writes, "is spreading with the speed of an infectious disease."

To halt the contagion, five central banks – the U.S. Fed, the Bank of Canada, the Bank of England, the European Central Bank (ECB) and the Swiss National Bank – joined Wednesday to inject as much as $64 billion of liquidity into the world financial system.

The funds will be distributed in four auctions, beginning tomorrow and stretching into January. Twenty-four billion dollars of the amount represents greenbacks the Fed is making available to the ECB and the Swiss National Bank for European clients who've coped most of this year with a scarcity of U.S. dollars. It's the biggest central-bank intervention in the global system since the aftermath of the attacks of Sept. 11, 2001, and is described by one U.S. analyst as "revolutionary" for the impressive degree of co-operation among the central banks.

"As always with central banking, the most important message is in the signal that central banks are sending," Bruce Kasman, an analyst at JPMorgan Chase & Co. wrote in his blog Wednesday. "They are telling us they are now prepared to take an aggressive and co-ordinated approach to dealing with this issue."

To get the banks lending again, the U.S. Fed-led initiative will lend money to banks at discount rates and, in an unorthodox move, accept as collateral a wide range of assets including securities not backed by government entities. "More than lowering rates in the economy, just having this banking system liquefied will make a huge difference," Wachovia CEO Ken Thompson said in a Wednesday conference. Financiers "are still fearful of each other, and everybody is worried about counter-party risk and so [banks] are hoarding their balance sheets, and this will help that."

Financiers have had ample grounds for fear. Write-down announcements by the world's biggest financial institutions have been a bad penny for months. UBS has alarmed the market more than once with fresh revelations of soured mortgage-related loans on its books. Banks thought to be free of the contagion, including London-based giant HSBC Holding PLC, have dismayed rivals with news of subprime-infected balance sheets. Canadian Imperial Bank of Commerce stunned Bay Street on Dec. 7 by revealing its $9.8 billion exposure to the U.S. subprime market.

The deep-seated problem is that no one knows exactly where the debt is, in what amount, and in what state of repair. Since the U.S. housing bubble began to inflate in 2004, something like $2 trillion worth of mortgages have been granted, in many cases to "ninjas" (no income, no job, no assets). In the case of low-income borrowers with spotty credit histories, mortgages were sold at "teaser" rates as low as 7 per cent that would eventually "reset" at as much as 13 per cent.

Foreclosures are now mounting, as the dubious mortgages begin to reset. The toxic loans, which should have been labeled "junk mortgages" yet inexplicably bore Triple-A ratings from credulous credit-rating agencies, were bundled into packages of $100 million or more and labeled ABCP and "collateralized debt obligations" (CBOs). They were then swapped and re-swapped among global banks, brokerages, hedge funds and other investors who each garnered a fee as the hot potatoes made their way around the globe.

The outcome has been one of the biggest fiascos in the financial system in modern times. "What is happening in credit markets today is a huge blow to the credibility of the Anglo-Saxon model of transactions-oriented financial capitalism," veteran money-market observer Martin Wolf wrote last week in the U.K. Financial Times. "A mixture of crony capitalism and gross incompetence has been on display in the core financial markets of New York and London."

The system itself appears long ago to have grasped the enormity of its troubles, and thus failed to react positively to the remedial actions preceding last week's dramatic central-banks bailout scheme. As recently as the day it was announced, Wall Street initially jumped for joy, pushing the Dow Jones Industrial Average up 270 points, before coming to its senses and closing the day up just 41 points, or 0.3 per cent.

The jolt has had some salutary effects, in the realm of central-bank practices. The stigma of the Fed's "discount window" has kept banks from borrowing there for fear of appearing desperate. Under last week's bailout scheme, banks are encouraged to borrow at discount rates knowing their identities won't be revealed.

Regional lenders far smaller than the New York-based "money-centre" banks will be urged to deal directly with the Fed for the first time, bypassing intermediaries. A humbled Fed is adopting tools used by the European Central Bank and the Reserve Bank of Australia, which include lending to a much wider variety of institutions and accepting a more diverse range of collateral.

Both the Fed and the Bank of Canada have hinted strongly that assistance will continue beyond January if necessary. That's not enough to satisfy Gross, who says a federal funds rate cut to 3 per cent from the current 4.25 per cent is required to head off a recession. And when the system is able finally to exhale, there will be a need to debate regulatory and other reforms – including more transparency about the quality of assets on bankers' books.

The current calamity arises from a systemic failure over, of all things, home mortgages – one of the most dead-simple financial transactions in existence. When the housing bubble was gaining altitude, lenders, regulators, debt-rating agencies, buyers of bundled mortgages and central bankers couldn't imagine that questionable loans to Sacramento trailer-home buyers could someday trigger a global credit crisis.

Even those relatively few optimists about last week's dramatic bailout efforts are counseling patience about recovering from a catastrophic blunder that has come close to crippling the global financial system.

"The big, big picture is that a bunch of people basically accepted much more debt than their balance sheets could afford," Jeff Bronchick, chief investment officer at Reed Conner Birdwell, a Los Angeles money management firm, told the Wall Street Journal last week.

"That has to be cured and it can only be cured with time."

ABCP pact sets stage for trading

Market signals mixed

RTGAM

Ahead of a shortened pre-Christmas trading session, global signals are mixed for North American stock markets while the Canadian dollar has climbed above $1.01 (U.S.).

The loonie opened at $1.0108, up about one-third of a U.S. cent from Friday's close.
Stock markets will close early Monday, at 1 p.m. ET.
U.S. futures suggested a mixed open after strong gains Friday. Light sweet crude oil fell 25 cents to $93.06 in pre-market electronic trading on the New York Mercantile Exchange.
Stock markets in Japan are closed for Christmas. Britain's FTSE 100 rose 0.44 per cent and France's CAC-40 rose 0.06 per cent.
On Sunday, a group of investors working to solve the problems of asset-backed commercial paper said an agreement in principle to rescue about $33-billion (Canadian) worth of short-term debt in Canada has been reached.
The committee said the deal covers 20 of 22 member trusts with investments that were devastated by the credit crunch that followed the collapse of the U.S. subprime mortgage market.
On Friday, the Toronto stock market logged a solid triple-digit gain, ahead of the Christmas holiday week, as results from Research In Motion and higher gold prices overshadowed negative developments in the financial sector.
Toronto's S&P/TSX composite index moved up about 189 points to 13,596 in the last full-day trading session until Dec. 27.
On Wall Street, the Dow Jones industrial average rose about 205 points to 13,450. The Nasdaq composite index was up 51 points to 2,691.99 while the S&P 500 index rose 24 points to 1,484.46. Canadian Press


Copyright 2001 The Globe and Mail

ABCP pact sets stage for trading

Purdy Crawford's committee unveils agreement as impatient investors threaten lawsuits

TARA PERKINS

FINANCIAL SERVICES REPORTER

December 24, 2007

An agreement reached yesterday to salvage the frozen $33-billion market for troubled commercial paper will give investors a chance to recoup much of their money after the debt begins trading this spring.

"I am confident that this plan will provide most holders of outstanding commercial paper with the opportunity to receive the full repayment of principal by holding restructured notes to maturity," stated Purdy Crawford, the lawyer who chairs the committee that worked for months on the restructuring agreement.

Some investors had been ready to launch lawsuits in a bid to recoup their money if a timely agreement hadn't been reached.

The plan unveiled yesterday divides the debt pool into three parts, in an effort to ensure that investors in each area can recoup the highest amount possible.

Print Edition - Section Front

There's a $3-billion portion of traditional, securitized assets; a $26-billion portion of mixed synthetic and traditional assets; and then the $3-billion portion that's tied to the U.S. subprime market.

Traditional assets are those such as mortgages, while synthetics are complex instruments - such as collateralized debt obligations - that are put together using pools of traditional assets that are sliced and diced and divided up in different ways.

Corporations, organizations, government bodies and pension plans across Canada have found themselves stuck holding this paper since August.

That's when the market's fear of U.S. subprime mortgages caused investors to bail out of a slew of complex investment products, including third-party asset-backed commercial paper (ABCP). The market has a small exposure to subprime.

In a bid to buy some time to hammer out a solution, a group of financial institutions that were key players in the market banded together in August and put together a standstill agreement that effectively froze the sector.

Mr. Crawford was eventually put in charge of the committee that's been trying to reach a restructuring proposal. It missed its self-imposed deadline earlier this month, and had set a new deadline of Jan. 31. But Mr. Crawford wanted a deal by Christmas.

"Everybody worked very hard," he said in an interview yesterday. "Thank goodness for modern technology, you can communicate so quickly," he added, as the committee was dealing with people from London to New York. Mr. Crawford held some meetings in his Toronto law office, but much of the work was done remotely.

"This time it was the chairman's turn to play a bit of Santa," said Huston Loke, of credit-rating agency DBRS Ltd.

He added that "the deal was being negotiated in some of the most volatile conditions in the credit markets globally."

Mr. Crawford said that in some cases - mostly the subprime - investors might have to take losses, but it's too early to say by how much. It will depend on the market at the time that the restructuring's complete, he said. For the majority of ABCP, the agreement should give investors a reasonable expectation of receiving the full par value of the investment over time, he said.

All of the ABCP will be exchanged for longer-dated notes that will be more closely matched with the maturity of the underlying assets. Maturity for many of the new notes is expected to be seven years on average. The committee expects most of the new notes to receive investment grade ratings of triple-A.

Before the agreement could be implemented there will have to be approval from the holders of two-thirds of the value of each of the ABCP trusts, as well as certain approvals from government, regulators and the courts. The committee hopes the restructuring will be finished in March.

Mr. Crawford said that each of the big Canadian banks other than Toronto-Dominion Bank has indicated some interest in providing some type of credit facilities to support the restructuring. Negotiations with the banks are ongoing. And TD, not involved in this market, has not definitely said no, Mr. Crawford said.

As part of the deal, two big investors in the paper, the Caisse de dépôt et placement du Québec and Groupe Desjardins - along with several other institutions - have agreed to commit an amount to fund margin calls. A margin facility of about $14-billion will be established, and certain players have agreed to "self-insurance" of almost $8-billion.

The Caisse issued a statement yesterday saying it was "very satisfied" with the agreement.

Aside from Skeena Capital Trust, which was already dealt with, yesterday's agreement does not cover Devonshire Trust, which is worth roughly $700-million. The committee is still working on alternatives for that trust.

"I cannot overstate the complexity of the restructuring, reflecting the value and complex nature of the underlying assets and the involvement of a number of parties with competing interests," Mr. Crawford said.

ABCP - A backgrounder

The freeze

Canada's $33-billion market for asset-backed commercial paper sold by non-bank dealers ground to a halt in August after Coventree Inc. and other trusts failed to renew maturing debt because investors were concerned about ties to high-risk U.S. mortgages. Banks refused to provide backup financing, freezing the market and putting funds at risk of collapsing, even though just 9 per cent of the assets were linked to subprime loans.

The jitters

Stock markets went on a roller-coaster ride in the summer and early fall as nervous investors began selling stocks to free up cash made scarce as banks ceased lending. And worries about who was holding bad U.S. home mortgages tainted even sound investments.

The Montreal meeting

A group of foreign banks, Canadian lenders and pension funds led by Caisse de dépôt et placement du Québec negotiated the so-called Montreal Proposal on Aug. 16 and agreed to convert the short-term debt into longer-term notes with higher interest rates.

The new deal

Based on the advice of financial adviser JP Morgan Chase & Co., most of the restructured notes will receive a triple-A rating, according to the statement. The group didn't say how much investors will receive on the dollar, according to spokesman Mark Boutet.

Bloomberg News, staff