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Credit Crisis Presentation - Oct 9th 2008


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Presentation for the Canadian MoneySaver Share Club. How did we get here? What's ahead? Is my money safe? Should I sell? Opportunities in the wreckage. Most common mistakes investors make during bear markets and how to avoid them.

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Credit Crisis Presentation - Oct 9th 2008

  1. 1. The Credit Crunch Crisis and Opportunity Wynn Quon Oct 9, 2008
  2. 2. How did we get into this mess? <ul><li>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. </li></ul><ul><li>Go for a ride: </li></ul><ul><li> </li></ul>
  3. 4. If you believe that real estate prices always go up then…. <ul><li>...It doesn’t matter what interest rate you as a homebuyer pay on your mortgage, because you can always sell your house for a higher price.... </li></ul><ul><li>...high-interest mortgages are safe </li></ul><ul><li>...Wall Street can package high-interest mortgages and even rate many as safe AAA securities (and make billions of $ in fees)…. </li></ul><ul><li>… and since the mortgages are AAA, they can make billions more in selling insurance against default (CDS - credit default swaps) </li></ul><ul><li>… so Wall Street said “Gimme more mortgages!” </li></ul>
  4. 5. Attack of the NINJA loans! <ul><li>“ 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.’ ” </li></ul><ul><li>-- This American Life, NPR, “The Giant Pool of Money” May 9 2008 </li></ul>
  5. 6. You can’t make this stuff up <ul><li>In one case, mortgages were also granted to 23 dead people in Ohio. </li></ul>
  6. 7. Wall Street Mortgage mania <ul><li>Banks float $2.6 trillion of mortgages in 2006 alone. (20% subprime) </li></ul><ul><li>Investment banks issue $45 trillion of mortgage/debt insurance (credit default swaps). </li></ul><ul><li>Use of 30x leverage - $1 down on a $30 loan </li></ul><ul><li>Amount of bad investments >> bubble </li></ul>
  7. 8. End of illusion
  8. 9. Bad news <ul><li>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... </li></ul><ul><li>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. </li></ul><ul><li>U.S. stock market falls 20%, wiping out $4 trillion in wealth. </li></ul>
  9. 10. Worse News <ul><li>Credit crunch - Without banks lending, the economy will grind to a halt. (car loans, mortgages, business loans e.g. Ford Sept. sales down 35%) </li></ul><ul><li>Default rates increasing on prime mortgages, auto loans, credit cards </li></ul><ul><li>Unemployment in the U.S. growing; 6.1% up from 4.7% a year ago. </li></ul><ul><li>Real-estate bubbles in U.K., Ireland, Spain, China. Stock market crashes in China (-60%), India(-43%)... </li></ul><ul><li>Danger of a decline spiral </li></ul>
  10. 11. What about Canada? <ul><li>We’re the tail on the U.S. dog </li></ul><ul><li>real-estate bubble in Vancouver, Calgary, Edmonton </li></ul><ul><li>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. </li></ul><ul><li>the credit crunch is already here - ABCP mess, 5 yr mortgage rates have increased to 7.2%, CIBC troubles , interbank lending has stopped </li></ul>
  11. 12. How bad will things get? <ul><li>The longer and bigger the boom, the bigger the crash </li></ul><ul><li>Lack of transparency breeds fear </li></ul><ul><li>“ rational panic” </li></ul><ul><li>Bank crises strike at the core of the global economy </li></ul><ul><li>$850 billion U.S. bailout unlikely to stop recession </li></ul>
  12. 13. Lessons of history <ul><li>5 severe post-war banking/real-estate crises (Japan, Spain, Finland, Norway, Sweden) </li></ul><ul><li>On average, home prices fall 20% from peak, stock prices fall 20%. </li></ul><ul><li>Bear market average length 2 yrs. </li></ul><ul><li>But every crisis is different... </li></ul>
  13. 14. Optimistic case <ul><li>An average crisis? </li></ul><ul><li>Stocks have already fallen by more than 20% as have real estate prices in the U.S. </li></ul><ul><li>Bear market has already lasted ~1 yr </li></ul><ul><li>Optimistic case - we’re near the bottom </li></ul><ul><li>What’s the pessimistic case? </li></ul>
  14. 15. Japanese Super Bear market
  15. 16. Japanese Super Bear market <ul><li>13-year bear market </li></ul><ul><li>Stocks lost 78% of their value </li></ul><ul><li>Real-estate prices still down 50% from 1991 peak, down 64% in six largest cities. </li></ul>
  16. 17. Fog of forecasting <ul><li>Huge Unknowns: </li></ul><ul><li>How much bad debt will there be? </li></ul><ul><li>Policy response - competence? </li></ul><ul><li>Investor response - confidence? </li></ul><ul><li>Investment companies - liquidity? </li></ul><ul><li>System feedback loops </li></ul><ul><li>As difficult as hurricane forecasting </li></ul>
  17. 18. Wrong question <ul><li>How bad will it get? </li></ul>
  18. 19. Right questions <ul><li>What is your risk tolerance? </li></ul><ul><li>What is your time frame? </li></ul>
  19. 20. Most common mistake <ul><li>…of investors is to overestimate their risk tolerance. </li></ul><ul><li>- during bull markets, the downside is completely theoretical </li></ul><ul><li>- during bear markets, losses are real. Investors suffer loss aversion. </li></ul><ul><li>- fear, regret and panic overwhelm rational decision-making </li></ul><ul><li>- 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%. </li></ul><ul><li>Use scenarios to test drive your risk tolerance </li></ul>
  20. 21. Hope for the best, prepare for the worst <ul><li>If we are hit by the equivalent of a Japanese Super bear scenario: </li></ul><ul><li>Dow Jones Ind. Avg would fall to 2800 </li></ul><ul><li>TSX would fall to 3000. </li></ul><ul><li>… .prices would begin recovery sometime after 2021. Yikes. </li></ul><ul><li>A $100,000 all-stock portfolio would fall to $20,000. </li></ul>
  21. 22. Impact of a Super Bear <ul><li>Assume a $100K portfolio at the market peak. The following is what would happen in a Japanese Super Bear scenario. </li></ul><ul><li>100% stocks, 0% fixed income - your $100K portfolio would fall to $20K. (Don’t do it!) </li></ul><ul><li>80% stocks, 20% fixed income - your $100K portfolio would fall to $36K. </li></ul><ul><li>60% stocks, 40% fixed income - your $100K portfolio would fall to $52K. </li></ul><ul><li>40% stocks, 60% fixed income - your $100K portfolio would fall to $68K. </li></ul><ul><li>20% stocks, 80% fixed income - your $100K portfolio would fall to $84K. </li></ul><ul><li>Notes: Fixed income = cash, gov’t bonds, GICs. Results ignores dividends. </li></ul><ul><li>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? </li></ul>
  22. 23. Is your money safe? <ul><li>In a credit crisis, trust is lost. </li></ul><ul><li>E.g. Lehman Bros bonds rated ‘A’ by S&P, Sept. 9th 2008. </li></ul><ul><li>Less than one week later the company collapsed. Bonds are worthless. </li></ul><ul><li>This is a good time to check that your deposits/GICs are with CDIC-insured institutions. Gov’t guarantees $100K of deposits. ( </li></ul><ul><li>CIPF protects up to $1M in your brokerage account. All securities you’ve paid for are segregated. ( </li></ul><ul><li>*** </li></ul>
  23. 24. Not insured <ul><li>Money market funds, mutual funds -note: money market funds are now neither ‘low-risk’ or ‘high risk’. </li></ul><ul><li>Principal-protected notes, aka ‘index-linked GICs’ </li></ul><ul><li>Foreign currency accounts, etc. </li></ul>
  24. 25. Success in the stock market <ul><li>In bull markets investors ignore risk. </li></ul><ul><li>In bear markets investors ignore return. </li></ul>
  25. 26. Bear market buying <ul><li>Bear markets are the best time to buy </li></ul><ul><li>But if your portfolio doesn’t match your risk tolerance, you will be too scared to do it. Or buy too soon. </li></ul>
  26. 27. Buying strategies <ul><li>Make a plan beforehand! </li></ul><ul><li>Decide how much $ you want to commit </li></ul><ul><li>Divide it into chunks </li></ul><ul><li>Tie your buying decisions to price points or index levels. </li></ul><ul><li>E.g. TSX - 8000, 6000, 4000, 2000…. Or say MCD @ $40, $30, $20…. </li></ul>
  27. 28. Stocks to watch <ul><li>Dividend-payers (e.g. Telus, Enbridge, Cameco) with relatively low debt in the TSX60 </li></ul><ul><li>Avoid for now: financials (banks, insurance companies) unless you know something I don’t; </li></ul><ul><li>Add some gold (Barrick, Goldcorp) </li></ul><ul><li>Pfizer, yield 6.5%+; Analog Devices </li></ul>
  28. 29. Speculations <ul><li>Nortel Networks - Common shares @ $2.00; Floating-Rate Preferred Cumulative F shares. $4-$5. Guess the yield! </li></ul><ul><li>BCE. Currently @$33. Upside to $42. Downside to $16. A gamble. </li></ul><ul><li>Gold Fields, currently $7, 3.2% yield. </li></ul>