Back in the summer of 2007 when the current credit crunch was just getting underway, Thomas Caldwell, chairman of Caldwell Asset Management Inc., suggested the coming meltdown would resemble a peewee hockey game he had witnessed that past winter. “I was at one of those games where the kids looked like Easter eggs on skates,” recalls Caldwell. “They were just learning to stay up on their feet. But when one kid fell down, he knocked another down, and that kid fell into another until everyone was on the ice. This is going to look something like that.”
How prescient his prediction has become. Over the past decade, a long chain of causality was created that stretches from subprime mortgages written for people who could barely afford the payments, to the hedge and pension funds that bought piles of these bundled mortgages, to big banks that offered money on margin to lever up the power of the investments. If all of this sounds risky, it is, and the world just brushed as close as it ever has to a 1930s-style banking crisis.
The house of cards began to crumble last summer when the first defaults on the badly written mortgages began to register. Apparently, you can’t suspend the laws of financial physics. People with bad credit still can’t pay no matter how complexly you securitize the obligation, and a second wave of defaults and writedowns followed in November and December. But the big crunch came in early March when rumours began circulating that Bear Stearns Cos. Inc., a storied U.S. investment bank catering to the hedge fund crowd, was having trouble funding its operations. The Ides of March were upon the Street as the interbank interest rate (a proxy for the faith banks have in each other) began to rise again. The U.S. Federal Reserve quickly manoeuvred Bear into the hands of JPMorgan Chase & Co. before it failed and sent even larger shock waves through the system.
In terms of Wall Street history, this was an epic event. Bear is a massive firm with some 14,000 employees, some of whom had their life savings wrapped up in bank stock. The company had been trading at US$145 a year earlier and had fallen to US$30 on the Friday before the final crisis. But after a tense weekend of negotiations (including phone calls to the White House), JPMorgan scooped up the mortally wounded Bear for a mere US$2 a share — a price so low many thought it a typo when it was announced. It later upped the bid to US$10.
More importantly, the master meltdown had been avoided, and in that lay victory. The Dow Jones Industrial Average celebrated with a 420-point gain a few days later, spurring some to talk about a light at the end of the tunnel. “I think there is some confidence that the worst of it may be passing,” says Michael Gregory, a senior economist with BMO. “Expectations that another big bank will go have dwindled.”
We’re not out of the woods yet, though. Some think a small regional bank and more hedge funds could be next, there are worries around corporate junk bonds and, here in Canada, negotiations are ongoing over the freeze on trading in third-party asset-backed commercial paper (ABCP).
Canadian banks were no strangers to writingand distributing securitized paper (some of it on dodgy sub-prime loans), and some of those securities found their way into the portfolios of about 1,600 retail investors, steered by financial advisers who made assurances this stuff is as safe as a GIC. The contentious products were not traditional money market products, but were often represented as such. Unsuspecting Canadians like Larry Caskey, a retired Edmonton businessman, were surprised to find they were holding it when the market for non-bank ABCP froze. “I didn’t have a clue what this was,” says Caskey. His retirement money was frozen last August when Canada’s $32-billion non-bank ABCP market seized up and the assets became the subject of the Purdy Crawford–led Montreal proposal. Caskey was surprised to find he was involved, and he was soon scrambling to get up to speed on the agreement Crawford is attempting to reach between investors, including small ones like Caskey, and the institutions that manufactured the paper. On March 17, an Ontario court granted bankruptcy protection to 20 ABCP trusts. But a final agreement has yet to be reached: many small investors question whether they should bother signing at all.
It has been suggested investors would lose up to 40% of their money under the agreement, and that is unacceptable to Caskey. In his mind, the banks were negligent and need to fully reimburse the small investors who were misled. “How could we be in something that was levered up 30 times?” he asks. Several small investors are talking about launching a class-action suit rather than sign on to the final agreement, which includes language precluding signees from taking any legal action later. “I’ve heard Purdy Crawford and the rest of the lawyers are going to make millions on this,” says Caskey. “But I’d never heard of ABCP, let alone non-bank ABCP, before this. I want to see the banks that were a party to its creation buy it back.”
Adds Caskey: “Some people are in real dire straits here. There is no collective solution that is reasonable. I don’t see a light in the tunnel.”