The Credit Crunch or What happened to my investments?

The Credit Crunch

or

What happened to my investments?

Today, you will learn... Why what most people thought happened in mortgages was a fairy tale Lots of exciting “technical terms” like CDO Why Moral Hazard isn't a Jane Austen character What might happen next if we're lucky... ... and if we're not

Why what most people thought happened in mortgages was a fairy tale

Lots of exciting “technical terms” like CDO

Why Moral Hazard isn't a Jane Austen character

What might happen next if we're lucky... ... and if we're not

Once upon a time

Here's how it's meant to work Low interest rate X Higher interest rate Y Y – X = Gross Profit (ie – before other costs like staff)

Let's look at incentives... Wants to lend to a stable bank, but actually the Government will pick up most of the risk of bank collapse Only wants to lend to buyers who will make payments each month. Wants to get money back if they have to repossess

... and risks A few customers might default, but negotiation, or repossession kept things working (plus, the profit was enough anyway)

OK, so far? Well, what about the nasty risk hidden there...

OK, so far?

Well, what about the nasty risk hidden there...

Timing... Depositors want to be able to get at their cash at any time Want to repay their mortgage over a long period (25 years)

WARNING The previous slides contained big, fat, oversimplifications...

WARNING

The previous slides contained big, fat, oversimplifications...

Money in = Money available to lend Piffle

Money available to lend

The Problem With Magic as a basis for the global financial system “ Do not meddle in the affairs of Wizards, for they are subtle and quick to anger.” - Tolkein, TLOTR OK, that wasn't really relevant, but it's a great quote, and the whole “financial wizardry” thing is kind of critical here...

The Problem With Magic

as a basis for the global financial system

“ Do not meddle in the affairs of Wizards, for they are subtle and quick to anger.”

- Tolkein, TLOTR

OK, that wasn't really relevant, but it's a great quote, and the whole “financial wizardry” thing is kind of critical here...

How to structure the finance industry for fun and profit (Part 1)

Acronym Soup SPV – Special Pupose Vehicle Bank sets of new company, transfers mortgages into it, and sells it off... the risk is now with the owners of the new company, not the bank, which continues to get a “processing fee” MBS – Mortgage Backed Securities Securities is American for “Shares” MBSs are basically shares in SPVs

SPV – Special Pupose Vehicle

Bank sets of new company, transfers mortgages into it, and sells it off... the risk is now with the owners of the new company, not the bank, which continues to get a “processing fee”

MBS – Mortgage Backed Securities

Securities is American for “Shares”

MBSs are basically shares in SPVs

Sitting comfortably, because we've only just got started

Sitting comfortably, because we've only just got started

How to structure the finance industry for fun and profit (Part 2)

What's a CDO? Collateralised Debt Obligation ?

Collateralised Debt Obligation

If a borrower defaults, who loses and who gains? aka “Moral Hazard for Dummies”

Underpinnings..... As long as the markets carrying on going up, everyone makes money Move to ARMs (variable rate mortgages) in US Those responsible for making lending decisions still make money even if the wheels fall off Everyone believes that the Governments will bail out, well, everyone if things go pear-shaped Because of the dot com bust, interest rates are low “to prevent recession” TBTF theory

As long as the markets carrying on going up, everyone makes money

Move to ARMs (variable rate mortgages) in US

Those responsible for making lending decisions still make money even if the wheels fall off

Everyone believes that the Governments will bail out, well, everyone if things go pear-shaped

Because of the dot com bust, interest rates are low “to prevent recession”

TBTF theory

Consequences... More money continually available to support this Buyers / remortgagers encouraged to borrow more, irrespective of their ability to pay the loans Prices go up, up and away and everyone lived happily ever after...

More money continually available to support this

Buyers / remortgagers encouraged to borrow more, irrespective of their ability to pay the loans

Prices go up, up and away and everyone lived happily ever after...

Then.... About November / December 2007, the big investors in CDOs realised that they might not have quite enough money, and stopped buying for about 3 months Actually, it turned out that many of them had had enough money, but it took a while to work this out, and in the meantime...

About November / December 2007, the big investors in CDOs realised that they might not have quite enough money, and stopped buying for about 3 months

Actually, it turned out that many of them had had enough money, but it took a while to work this out, and in the meantime...

No more CDO buyers... No more CDO buyers, leads to No more SPV / MBS buyers, leads to No more magic funding for mortgages, leads to Fewer mortgages issued, leads to Buyers don't have lots of mortgage companies beating down their doors, leads to Buyers have to pay higher rates, leads to Buyers offer less

No more CDO buyers, leads to

No more SPV / MBS buyers, leads to

No more magic funding for mortgages, leads to

Fewer mortgages issued, leads to

Buyers don't have lots of mortgage companies beating down their doors, leads to

Buyers have to pay higher rates, leads to

Buyers offer less

Buyers Offer Less, leads to... Markets no longer going up, plus... ... fixed rate periods start coming to an end... Buyers' ability to pay interest suddenly an issue Repossessions start, so Market goes down further If Mr. BMV is the only buyer in town, he's setting MV

Markets no longer going up, plus...

... fixed rate periods start coming to an end...

Buyers' ability to pay interest suddenly an issue

Repossessions start, so

Market goes down further

If Mr. BMV is the only buyer in town, he's setting MV

... and, for the banks... Please sir, I sold all these mortgages, but now no-one wants to buy my MBSs Perception of trouble leads to run on banks... ... governments have to step in to lend cash Other banks assets turn out to be mainly made of property, which isn't worth what it used to be Share prices (a reflection of what the banks are worth) collapse, as fears that the banks will be caught short

Please sir, I sold all these mortgages, but now no-one wants to buy my MBSs

Perception of trouble leads to run on banks... ... governments have to step in to lend cash

Other banks assets turn out to be mainly made of property, which isn't worth what it used to be

Share prices (a reflection of what the banks are worth) collapse, as fears that the banks will be caught short

Casualties... Homeowners caught in negative equity Estate agents have no deal volume, no income Ditto mortgage brokers, valuers, etc. Banks Nationalised Bought out for a fraction of their former value Closed

Homeowners caught in negative equity

Estate agents have no deal volume, no income

Ditto mortgage brokers, valuers, etc.

Banks

Nationalised

Bought out for a fraction of their former value

Closed

Bank Closure (USA) - 2008 September Silver State Bank, Henderson, NV August Integrity Bank, Alpharetta, GA The Columbian Bank and Trust, Topeka, KS First Priority Bank, Bradenton, FL July First Heritage Bank, NA, Newport Beach, CA First National Bank of Nevada, Reno, NV IndyMac Bank, Pasadena, CA Earlier in year: 2 in May, 1 in March, 1 in January

September

Silver State Bank, Henderson, NV

August

Integrity Bank, Alpharetta, GA

The Columbian Bank and Trust, Topeka, KS

First Priority Bank, Bradenton, FL

July

First Heritage Bank, NA, Newport Beach, CA

First National Bank of Nevada, Reno, NV

IndyMac Bank, Pasadena, CA

Earlier in year: 2 in May, 1 in March, 1 in January

MegaBanks in trouble Fannie Mae – Nationalised Freddie Mac - Nationalised Bear Stearns Shares went from high of $153 to $4.78 14 th March, emergency loan from US Government 16 th March, sold at $2 ($10) a share by JP Morgan Chase Merril Lynch Bought by Bank of America on 14 th September, for 40% of value a year ago Lehman - 4 th largest US investment bank Filed for Chapter 11 (Bankruptcy) on 15 th September Debts of $768 billion - assets worth $639 billion $12 trillion between them ... $12,000,000,000,000

Fannie Mae – Nationalised

Freddie Mac - Nationalised

Bear Stearns

Shares went from high of $153 to $4.78

14 th March, emergency loan from US Government

16 th March, sold at $2 ($10) a share by JP Morgan Chase

Merril Lynch

Bought by Bank of America on 14 th September, for 40% of value a year ago

Lehman - 4 th largest US investment bank

Filed for Chapter 11 (Bankruptcy) on 15 th September

Debts of $768 billion - assets worth $639 billion

What to expect – Q4 2008 My personal view – I am NOT an IFA I am expecting a further fall in house prices See next slide I am expecting it to get harder to get mortgages I'm expecting a witchhunt, shorty

My personal view – I am NOT an IFA

I am expecting a further fall in house prices

See next slide

I am expecting it to get harder to get mortgages

I'm expecting a witchhunt, shorty

Where do house prices need to be? 2 bedroom EOT/Semi in Maidenbower I bought two 28 SC Bought for £165k in August 2003 Sold for £205k in early 2008 5, BC Bought for £135 in October 2001 Sold for £180k in April 2005 Currently worth about £180k All the gain between April 2005 and Early 2008 is gone I will buy again back at about £140k

2 bedroom EOT/Semi in Maidenbower

I bought two

28 SC

Bought for £165k in August 2003

Sold for £205k in early 2008

5, BC

Bought for £135 in October 2001

Sold for £180k in April 2005

Currently worth about £180k

All the gain between April 2005 and Early 2008 is gone

I will buy again back at about £140k

The Elephants in the Room Stagflation Why being a member of the MPC is a hard job Bailout Central, DC ( Saturday morning's update ) AIG – Insurer As of 1 st January, 18 th largest COMPANY in the world 17 th September Loan of $85 billion in exchange for 80% of shares If it fails, it's pretty much game over for the world credit market, and the property market will crash, crash, crash

Stagflation

Why being a member of the MPC is a hard job

Bailout Central, DC ( Saturday morning's update )

AIG – Insurer

As of 1 st January, 18 th largest COMPANY in the world

17 th September

Loan of $85 billion in exchange for 80% of shares

If it fails, it's pretty much game over for the world credit market, and the property market will crash, crash, crash

Important things to learn... At the moment, so-called BMV is SETTING the market price Now is a better time to buy than any time since early 2005 but Patience is a key skill of the good investor BMV today? Better be sure Better start getting ready, though Cash is not so much King as God-Emperor Rising tides are out, skill is back in play

At the moment, so-called BMV is SETTING the market price

Now is a better time to buy than any time since early 2005 but Patience is a key skill of the good investor

BMV today? Better be sure

Better start getting ready, though

Cash is not so much King as God-Emperor

Rising tides are out, skill is back in play