Much has been written over the past week concerning the US Federal Government’s $700 billion rescue plan for the nation’s financial firms. As of this writing no plan has been passed, but in the meantime the US Federal Reserve and most central banks in the developed world have been flooding the markets with US dollar loans to meet the demand for funds from banking institutions. There is no indication that this support will be capped – so in the absence of a formalized plan, a widespread ad-hoc assistance initiative is already underway.
It is tempting for Canadians to be smug and assume that they will not be adversely affected by the fallout from the US financial tumult. The reality is that the Canadian banking system is integrated with that of the international financial community and most closely with the US. Decisions made in Washington this coming week will have a direct effect on the value of the US-denominated financial instruments held as investments by Canadian banks as well as future lending practices in Canada.
Issue 1: How much is that doggie in the window? Valuing the debt!
There is a lot of bad US mortgage debt out there that has been securitized and sold to banks, pension funds, investment funds and the like. These institutions will have to write down, or in some cases, write off, these investments to reflect their true market value. For many US institutions with very thin capitalization, the write-offs of these securities could erase the firm’s capital and push them into bankruptcy; it is precisely this risk that forced US banking regulators to seize Washington Mutual and sell off its assets last week.
In order to determine what these assets are worth, there has to be a market. To offer these securities for sale assumes that there is a buyer willing to purchase them and then all there is left to haggle about is the price. To determine the price, there have to be multiple buyers and sellers competing in the marketplace to facilitate and conclude transactions and determine fair pricing.
At the moment, there is no market for these securities. Since no one will buy them, the ability for the market to set a price is non-existent and as a result the institutions that own these securities have no reliable means of pricing them as assets on their balance sheets. If we look back almost 20 years to the junk bond crisis in the United States, there were many “vulture” investors who bought up these junk bonds at massive discounts (like 20 cents on the dollar) then pushed the debt issuer into bankruptcy to realize a profit when the debt was paid back with proceeds from the selloff of the assets. Since the assets in this case are millions of individual mortgages, the current basket of mortgage-backed securities cannot be unwound and sold off so easily without decimating US home ownership. The US government will become the only source of recourse to which these securities can be sold, leading to the bailout plan now before US legislators.
Banks will want to offload the debt to the US government at prices that are as high as possible to minimize the losses on their balance sheet and preserve their capital. If the government buys these assets at unrealistically high prices, any subsequent losses will have to be absorbed by US taxpayers – to which many Republicans voiced prolific objections this week. The downside risk of pricing these assets too low is that once the government sets a price, all the institutions holding that security will have to adopt that price and reflect it in their balance sheets and declare the losses. If the losses are too steep, more financial institutions could erase their capital and face liquidation, deepening the financial crisis and costing the US Treasury even MORE money in the long run as they take over and liquidate more companies. Thus, the price will be key – it has to reflect some devaluation of the underlying assets, but not so drastic a drop that the ensuing losses would make the financial crisis even worse.
By now you have a headache and are wondering how our Canadian financial institutions are affected. Our Canadian banks and pension funds bought some of these securities as investment instruments offering handsome rates of return, and now the prices allotted to these assets under the US workout will affect the financial performance and health of Canadian institutions. The important difference is that the Canadians will not be at the bargaining table with the American banks discussing how these assets will be valued. Nor are the Canadians likely to have the same bailout recourse to the US Treasury as the American institutions. Consider the following reports from the Financial Post from last week:
Canadian banks have been lobbying in Washington to be part of the US bailout. Canadian banks are well aware that they will have prices for these devalued financial assets imposed upon them (devaluation without representation) and are trying to get a seat at the table. They are trying to convince legislators to include “foreign flagged” firms to sell assets to the US government under any plan that gets approval. The reaction on Capitol Hill has been to link foreign central bank participation in the bailout plan to any opportunity to relieving foreign banks of these assets.
The US SEC is pursuing Canadian banks for misrepresentation of asset security. The SEC (Securities and Exchange Commission) has announced that it will charge the Royal Bank of Canada with misrepresenting the safety of investing in the $330 billion market for auction-rate securities. The SEC alleges that retail investors were sold investment vehicles that used auction-rate securities to offer higher rates of return, while portraying these securities as being as safe as cash deposits. According to the Financial Post, RBC is facing a potential $1 billion settlement with US regulators and other financial institutions, as well as a class-action lawsuit from retail investors.
Merrill Lynch says that a housing crash could happen in Canada. The Canadian housing market is also showing signs of over-valuation and price declines could lead to mortgage woes here as well. Canada had very few 40-year, zero-down mortgages and income justification requirements were much more stringent here, but if prices decline 10% then clients who only put 5% down on a house with a retail mortgage would be underwater. Canada cannot decouple its financial and real-estate markets from those of the United States, and a US recession would spill over into Canada and reduce the financial ability of Canadians to purchase new housing or even support their current debt obligations. The result is billions in potential losses for Canadian banks. Today, the major Canadian banks are taking precautions by no longer issuing mortgages with only a 5% downpayment.
Sun Life is holding bonds issued by Washington Mutual. Sun Life announced on Friday that it is holding a total of $270 million of bond securities issued by WaMu and its affiliates. While this represents far less than 1% of Sun Life Financial’s $100 billion in managed assets, it demonstrates that Canadian financial firms are holding US investment instruments and the write-off amounts that we will face north of the border have yet to be determined.
No one financial institution is interested in launching the wave of write-offs since without asset pricing provided by the US government there is no guidance as to how much less the assets are worth. For example, if Sun Life decides that the WaMu securities are worth 70 cents on the dollar and writes off the 30 cent balance, then that will force the hand of other Canadian institutions to value similar US securities issues by failing US institutions the same way. Now, Sun Life could be wrong, and the US Treasury may only decide to value the assets at 50 cents on the dollar; this would force Sun Life to announce a second round of devaluations of the same security, impose the same result on other Canadian banks as well, and undermine investor confidence in the Canadian banking sector.
For the time being, expect Canadian banks to enjoin in a collusion of silence regarding the true value of these US assets. As long as there is no resolution of the financial crisis in the US and no prices have been imposed, it is not in the interests of Canadian banks to pre-empt their US cousins and initiate asset write-downs.
Issue 2: Brother, won’t you lend me a dime?
Banks depend on each other to supply short tern liquidity via the overnight market. Firms will offer excess funds for lending to other institutions at varying rates of interest depending on the floor interest rate, the rate offered by the Federal Reserve (the Fed rate) plus a premium that reflect s the perceived risk of the transaction. For example, a US bank with $100 million in excess short term liquidity may offer that money in the marketplace at the Fed rate plus 0.5% to a AAA-rated US bank, but at a higher premium, say Fed rate plus 1% to a lesser regional institution or a foreign bank. This massive liquid funds market is the grease that keeps the financial machine running and fuels the short-term financing need of the US, and indeed the international economy. It is a market based on trust – and that trust is based on the financial stability of the institutions doing the borrowing.
The problem is that for the last week or so, the banks don’t really trust each other. Since many banks hold financial assets that have an indeterminate market value, the banks are not in a position to evaluate each other’s financial solidity. The result last week was that one night the interbank lending rate hit 7% (!), even though the Fed overnight rate was more like 2%. This type of risk premium (5%) is unprecedented in the overnight market. While interbank lending rates retreated to the 3-4% range later in the week, this was largely due to the US Federal Reserve and other central banks pushing billions in US dollars into the market to keep it running.
How does this affect Canada? Canadian financial institutions are players in this market as well, offering and borrowing US funds along with other international banks. They are facing the same dilemma as the US institutions – they want to keep the market working, but are unsure of the quality of the institutions they are dealing with. The result is that the Bank of Canada pushed $2 billion in the market itself, along with billions from the European and UK central banks to make the market work.
This uncertainly in the veins of the international financial corpus affect Canadian’s ability to get lines of credit, bridge loans, business operating margins and other short-term credit sources that are critical to our daily transactions. Do not imagine for one minute that credit requirements have not been tightened as a result of the crisis in the US – ask any businessperson coming to their account manager for an increase in their credit line. Reports from the Toronto construction market indicate that developers seeking incremental financing are having to compile package loans from multiple institutions in order to complete their projects.
Conclusion: Let’s hope that we share the liferaft
While it may be unfair that Canadians are facing credit restrictions due to the excesses of our US neighbors, it is the unfortunate result. Canadian investors who are facing losses on their US investments will eventually face the same catharsis in Canada, as our banks incur write-offs related to the crisis and their share prices decline. Canadians who were considered excellent credit risks a year ago could be turned away from their regular banking institution or pay a much higher premium for their loans.
We can hope that the US financial rescue package will allow Canadian institutions some recourse for these assets, since the US institutions who created them presented them as far safer than they actually were when they were securitized and sold into international debt markets. Any attempt to freeze out non-US firms will only deepen the mistrust of the US banking system and prolong the recovery period. In the meantime, investors holding Canadian financial stocks and their retail clients should demand transparency and full disclosure to determine our true overall exposure to the US mess.
As for all this money being pumped into the system? The only long tern result is inflation – more on that next time, you must be reaching for your third Tylenol about now!