BUSINESS

WHEN GREED TURNS TO FEAR

How high-risk mortgages in the U.S. sparked a global financial panic

JASON KIRBY September 3 2007
BUSINESS

WHEN GREED TURNS TO FEAR

How high-risk mortgages in the U.S. sparked a global financial panic

JASON KIRBY September 3 2007

WHEN GREED TURNS TO FEAR

How high-risk mortgages in the U.S. sparked a global financial panic

JASON KIRBY

Ah, the dot-com collapse. No one likes a financial crisis, but at least that was a meltdown folks could wrap their heads around, even as their portfolios tanked. Rampant speculation fuelled a massive stock market bubble, which collapsed under its own weight. How simple was that? By comparison, the current rout in financial markets feels like being trapped in a trigonometry class.

Each day brings more troubling economic news about the liquidity crunch that’s helped drive down stock markets around the world, including Toronto, where all the gains made by the S&P/TSX Composite index so far in 2007 evaporated in just four weeks. Seemingly overnight, a problem that afflicted an obscure niche of the U.S. housing market has ballooned into talk of a worldwide economic slowdown. How did we get here? Why did things fall to pieces so fast? And, more importantly, what now?

Like every other major financial crisis of the past, this latest upheaval is, at its root, all about greed and fear. Think of it as an elaborate game of musical chairs. When things are going well, and everybody is making money, they merrily stroll along with the music. But underneath it all, they’re always a little nervous that the music will stop and they’ll be stuck without a chair. All it takes is for a little bit of extra fear to seep into the game, and pretty soon everybody is diving

for chairs. Even if the music is still playing, the game breaks down.

“It’s always a question of the tipping point,” says Lawrence Booth, professor of finance with the University of Toronto’s Rotman School of Management. “It comes down to a fear of losses that makes people say ‘I’m not buying anymore.’ ” When all the buyers disappear overnight, you get what finance professors call a liquidity crisis. And when such crises spread, you get the kind of panic that took hold of financial markets last week.

The most galling thing about this latest crisis is that, for the vast majority of ordinary investors, it’s somebody else’s greed that has triggered the realization of their fears.

TO UNDERSTAND what’s been going on, you have to go back to those dark days after the technology sector exploded seven years ago. With the American economy tumbling into recession, the U.S. Federal Reserve chopped interest rates in a bid to lift the country out of its funk. Inflation was low, and borrowing money was easy. By the time the Fed was done, rates were down to just one per cent, where they stayed for more than a year. Plenty of observers warned that rates were kept too low, for too long, but shoppers and homebuyers weren’t about to complain.

Low interest rates touched off a housing frenzy. Suddenly everybody could chase the American dream of owning a patch of turf to

call their own, helped along by a mortgage industry eager to dole out cheap loans. No group proved more willing to take on heavy debt loads than so-called “subprime” borrowers. These were folks with abysmal credit ratings who couldn’t scrounge together enough cash to make even the tiniest down payment. But they did have a pulse, which was enough for subprime mortgage lenders. Last year, those lenders doled out more than US$600 billion in loans, up from US$120 billion five years earlier. With house prices soaring, anyone who had trouble making payments on their first mortgage could just get a second one, and so on. This left the sector thoroughly exposed if the housing market ever slowed and interest rates rose.

But to lay all of this at the feet of subprime borrowers is to only tell one piece of the story. So what if some foolish bank wants to give a US$400,000 mortgage to somebody who makes US$30,000 a year?

Well, since the 1990s the world of finance has undergone a huge shift. Globalization and technology have interconnected even the most far-flung markets. Massive pension funds, insurance companies and other institutional investors, in the quest for better returns, took on more risk—often by putting trillions of dollars into the hands of private equity investors and hedge fund managers. Those fund managers, in turn, borrowed vast sums of money on world

markets to fuel their soaring aspirations.

Risk and return have always gone hand in hand—the greater the risk, the higher the potential returns. But with their secretive trading models, made up of arcane algorithms and opaque strategies, hedge funds promised stellar returns with little downside. To achieve that, they set out to invest in new types of products not tied to traditional stock and bond markets. Things like subprime mortgages, for instance.

The idea of packaging up loans and other types of debt and selling them to investors wasn’t new, but hedge funds made it into an art form. They bought billions of dollars worth of mortgages from lending compan-

ies, many of them high-risk, and conjured them into specialty funds to be resold. Along the way, the risk would be sliced and diced, packaged and repackaged with other low-risk investments and spread out over thousands of willing investors. It didn’t work.

THE FIRST DOMINO began to wobble late last year. Subprime mortgage lenders reported increased delinquency rates among their customers. No surprise there. Rising inflation had forced the U.S. Federal Reserve to hike interest rates to 5.25 per cent, while house prices began to falter. Up to their eyeballs in debt, subprime borrowers began walking away from their payments. Since then, more than 120 mortgage lenders in the U.S. have imploded. In June, the defaults caught up with Wall Street. Complicated strategies meant to limit risk failed spectacularly. Two massive hedge funds run by investment bank Bear Stearns, that invested in products tied to subprime mortgages, wiped out US$1.6 billion of investors’ money. Soon other funds on the Street and as far away as Germany and Australia were in trouble. (Canadian Imperial Bank of Commerce had to fend off rumours it had billions at stake in the subprime sector. Last week the bank said its exposure now stands at US$1 billion.)

To observers like Donald Coxe, global portfolio strategist, BMO Financial Group, so much of the hedge funds’ supposed financial wizardry has been exposed as third-rate par-

lour tricks. “This is a full-blown financial crisis which was created because we have an excess of Ph.D.s in mathematics, who had an excess of hubris,” he says.

Before long, it wasn’t just propeller-heads at hedge funds who were suffering. As fear about the level of risk in everybody’s portfolio spread, investors began bailing out, driving down markets such as stocks and bonds. “This is no longer an issue about subprime mortgages,” wrote Richard Kelly, a senior economist with TD Bank, in a report. “This is a crisis of confidence in the financial system.”

When a crisis breaks out in the business world, the response is much the same as if it were a viral outbreak among humans. Health

‘This is a full-blown financial crisis which was created because we have too many Ph.D.s in math, with an excess of hubris’

officials isolate the sick from the rest of the population and treat them. Some may die, but at least the virus is contained. Since the credit crunch first hit, banking officials have tried the same tactic, but it’s too early to say whether it’ll be successful.

Central bankers in Europe, Asia and North America have made hundreds of billions of dollars of one-day loans available to financial markets to keep them from seizing up. On Friday, the Federal Reserve surprised investors by cutting its discount rate on short-term loans to banks, a move a few steps below actually cutting interest rates, but one that was still welcomed by the markets.

But the credit crunch has already seeped

out and infected other sectors. In both Canada and the U.S., short-term loans that companies use to fund their operations have come under pressure. Last week Coventree Capital Group, a Toronto finance firm that packages together car loans, mortgages and credit card debt to sell to investors, hit a wall when it failed to find investors for $250 million worth of loans. A coalition of Canadian financial firms came to the rescue of Coventree and other similar companies, no doubt realizing that if the credit crunch spreads in Canada, the domino effect could hurt them.

Still, the dominoes keep toppling. Merger mania has driven stock markets higher this year, but the sudden panic has thrown many expected deals into doubt. Take the TSX for instance. In the first half of this year, $61 billion worth of buyout deals were announced on the Canadian market, including the blockbuster BCE takeover, nearly five times more than the value of all deals done in 2006. BCE’s buyers have said they remain committed to the deal, but if hopes for other buyouts, financed as they often are with piles of debt, suddenly dry up, a lot of stocks are going to look overvalued, and ripe for a fall.

But the real fear is that we’re seeing the early stages of a global economic slowdown. Consumers have kept the U.S. economy in high gear, and the slowdown in housing, tighter credit and a weak stock market are taking their toll. One consumer sentiment survey for August showed the mood of American shoppers is at its lowest level in a year. Canada’s Finance Minister Jim Flaherty has assured Canadians the economy can handle this credit crunch, but that may not be the case if consumers stop spending and if the U.S. suddenly doesn’t need our exports.

For now, all eyes are on U.S. Federal Reserve Board chairman Ben Bernanke. He’s under intense pressure to simply slash interest rates and relieve the pressure. Others, though, believe the root problems run much deeper than a rate cut alone can solve. There will be calls for tougher regulation of hedge funds, and when the dust settles, some ambitious state attorney general will no doubt launch an investigation into the subprime lending sector. But as long as financial wizards believe that risk can be made to disappear through financial sleight of hand, there’s the very real risk this crisis will only get worse. M