The Finance Crisis and Bailout

Rotman Experts Discuss: “What Went Wrong? Why? What Lessons Can Be Learned”

The U.S. sub-prime mortgage crash in 2007 has now snowballed into the current ongoing credit crunch and ensuing world financial crisis which has engulfed the global markets and news media. Even with a $700 billion bail-out plan from the U.S. federal government, stock prices have not recovered as evidenced by all the major indices continuing on a downward trend. Investors are panicking, banks are approaching insolvency, and Main Street businesses are steadily feeling the pressure of tightening credit terms.

On October 8, 2008 four leading thinkers from the Rotman School of Management, University of Toronto spoke about the current financial crisis and what went wrong. Ramy Elitzur (Edward Kernaghan Professor of Financial Analysis and Associate Professor of Accounting), John Hull (Maple Financial Group Chair in Derivatives and Risk Management and Professor of Finance), Eric Kirzner (John H. Watson Chair in Value Investing and Professor of Finance) and Peter Dungan (Adjunct Associate Professor of Business Economics) spent one hour primarily discussing the sub-prime mortgage crisis and the over-leveraging of related asset-backed securities (ABS) and collaterized debt obligations (CDO).

So exactly what went wrong? A number of factors contributed to what developed into a perfect economic storm. When banks extended ‘teaser’ mortgages, containing favourable terms, to individuals who otherwise could not afford a home, these new homeowners found it increasingly difficult to meet their debt obligations when interest rates increased. In addition to this, the oversaturation of housing in the United States prompted residential prices to plummet. Finally, the miscalculation of mortgage default rates coupled with inappropriate use of unregulated credit swaps resulted in a shortfall of capital holdings by banks to cover the risk exposure generated. These factors rapidly overwhelmed markets and natural correcting mechanisms were not able to react fast enough. Misrepresented risk levels in ABS and CDO caused by multiple levels of securitization added to the toxicity in the wider market as interbank lending and trade became negatively affected.

From an economic standpoint, Professor Dungan emphasized that the real economy (i.e. not just focusing on the financial economy) is in a classic overbuild scenario in the housing and automotive sectors specifically. Professor Dungan also highlighted that those high inventory levels will work themselves out over time, with the market re-pricing this inventory (albeit painfully for the average consumer). In addition, the US Federal Reserve and the Bank of Canada are reacting strongly to the crisis (as indeed are world central banks) taking clear steps to enable recovery, including introducing the widest coordinated interest rate cuts (1) ever to help steady markets and supply lower cost capital. Professor Dungan forecasts negative real economic growth in North America for the next few quarters, before moving toward recovery. Yet he also issued the warning that if short term lending continues to be contained (or tightens further) then we will have a serious macroeconomic issue to contend with.

There is still a great deal of uncertainty and volatility in the market worldwide, and by all accounts this volatility will continue as average consumers and investors react to present conditions. While the effects of this crisis will continue to be felt, it is important to take steps to protect your business and mitigate systemic and market risk as much as possible. At C&Co we can help to provide assurance through the reduction of asymmetric information, performance of due diligence, and review of your capital requirements. In addition, our financial modeling services can perform specific tailored sensitivity analyses to help with your strategic planning during these turbulent times.

Contact us today for a free private consultation.