BC Pension Forum December 2008 The Sub-Prime Crisis: Origins and Implications For Canadian Pension Funds December 4, 2008

Transcription

1 The Sub-Prime Crisis: Origins and Implications For Canadian Pension Funds Presented by: Moderator : Bruce Geddes, Vice President George Doubt, President, Telecommunications Workers Union

2 Overview of Sub-Prime Mortgage Discussion Who created this mess? Chronology of meltdown and subsequent events Capital markets reaction Impact on plan sponsors Implications for plan sponsors -1-

3 The Mortgage Crisis - Key Contributors Home buyers/builders Rent/own trade-off Affordability/Serviceability Ratings Agencies Leverage/Speculation Aggressive ratings Conflicts (?) US Government Lax standards Home ownership policies F & F role Federal Reserve Mortgage brokers Easy monetary policy Deal facilitation Not fully grasping risk Investors Feeders of ownership frenzy Moral hazard Leverage Yield chasing/risk aversion? Commercial Banks Revenue model change Reduced emphasis on traditional banking High risk mortgage structures Lax lending practices Investment Banks Underwriting revenues Securitization practices Risk appetite/practices -2-

4 Mortgage Crisis Became a Global Credit Crisis Chronology of Events Stage I: Fuel for the Fire ( ) Cheap & Easy Credit Financial innovation Leverage; lax lending practices Rising asset values Stage II: Storm Clouds on the Horizon (2007) Falling Real Estate Prices Financial assets backed by subprime mortgages decline in value Uncertainty about quality & value of RMBS and CDOs. Liquidity dries up De-leveraging and forced asset sales further weaken asset prices Stage III: Week of Reckoning (Sept , 2008) Crisis of Confidence Lehman fails and Merrill Lynch is taken over by Bank of America AIG teeters and is bailed out by the U.S. Government Largest U.S. mmf breaks a buck F&F put into conservatorship Stage IV: Salvation? Unprecedented Government Intervention and Bailouts Fed lending facilities opened wide & short selling temporarily banned -3- Federal guarantee extended to mm funds and deposit insurance expanded * Troubled Asset Relief Program, Economic Stimulus Act, Housing and Economic Recovery Act Multi-pronged relief TARP, ESA 2008, HERA 2008 Monetary easing

5 Not Very Comforting Words: I and others were mistaken early on in saying that the subprime crisis would be contained The causal relationship between the housing problem and the broad financial system was very complex and difficult to predict Ben Bernanke, New Yorker Magazine December 2008 Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust, carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA Michael Lewis, The End, November 2008 Britain, Spain, Ireland and Hungary have, to date, been the most conspicuous imitators of American housing folly. (Could Canada be next)? as the subprime problem was becoming a crisis, investment banks had begun justifying horrendous losses in supposedly low-risk mortgage funds by claiming they had been hit by 26 th Standard Deviation Events {that} should only occur once every 100,000 years. Don Coxe, Basic Points, November

6 Capital Markets Update As of October 31, MSCI EAFE Index (U.S.$) S&P/TSX Index (Cdn.$) Data Source: MSCI Data Source: IDC / Exshare Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Oct-08 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Oct S&P 500 Index (U.S.$) 690 DEX Universe Index Total Return Data Source: IDC / Exshare Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Oct-08 Note: Equity markets: price indices in currency as noted, bond index: total return in Cdn Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08

7 Suddenly the World Became Much More Volatile 90 CBOE Volatility Index (VIX) Index Above 35 = Panic Below 20 = Complacency Source: Chicago Board Options Exchange. Note: pre-1990 data based on S&P 100, post-1990 on S&P

8 Banks Concerned About Peers Month T-Bill Eurodollar Spread (TED Spread) The TED spread is a leading indicator of liquidity conditions and credit risk. T-bills are risk free while eurodollar deposits reflect borrowing conditions in the short-term corporate credit market. A widening spread indicates rising risk aversion. Basis points Eurodollars are US dollar deposits in banks outside the USA. The eurodollar rate reflects the cost of US dollar funds for large non-us financial institutions. Source: Datastream -7-

9 Increased Asset Correlations have Resulted from the Crisis DEX Reuters/ MSCI MSCI MSCI S&P/TSX Universe Jefferies CRB Dec 31, 02 - Nov 26, 08 World EAFE Emerging Comp. S&P 500 Bond Index IX Index MSCI World 1 MSCI EAFE MSCI Emerging S&P/TSX Comp S&P DEX Univ. Bond Index Reuters/Jefferies CRB IX Index DEX Reuters/ MSCI MSCI MSCI S&P/TSX Universe Jefferies CRB Sept 30, 08 - Nov 26, 08 World EAFE Emerging Comp. S&P 500 Bond Index IX Index MSCI World 1 MSCI EAFE MSCI Emerging S&P/TSX Comp S&P DEX Univ. Bond Index Reuters/Jefferies CRB IX Index

10 Government of Canada Long Bond Yield No Relief to Funding Status Long yields have traded in a narrow range for last 3 years and a very narrow (±25 bpts) range in the past year. Interest rate matching has been important but not the whole story Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Yield (%) Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec Source: yc\can 91d, 5 (30yr yld) 11/10/08

11 Credit Crisis has Broadly Impacted All Credit Sectors Spread (%) Dec-97 Royal Bank of Canada 5-year Sub-debt Spreads Dec-98 Russian debt/ LTCM crisis 4 mths 7 mths 17 mths Dec-99 Dec-00 Dec-01 Source: credit\royalbank 11/21/08 Dec-02 Enron/Worldcom credit crunch Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Sub-prime credit crisis Yield Spread (%) Corporate Bond Yields Less Gov t of Canada Bond Yields Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 mid term corporate spreads 11/5/08 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Yield Spread vs. Canada (%) Ontario Credit Spreads 30-year Term Versus Similar Term Canadas Source: credit\ont 5,10,30 yr spreads 11/19/08 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Ontario 30 Year Spread (%) -10- Canada Housing Trust (CHT) Spreads 1.0 These bonds are guaranteed by the 0.8 Government of of Canada. The wider spreads represent the nervousness of of 0.6 investors and the price of of liquidity. 0.4 CHT Five Year Term 0.2 CHT spreads (5 yr chart) 11/21/ Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08

12 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Expected Inflation Rate (%) Dec-08 Changes in Interest Rate Environment Inflation Expectations - Canada Inflation concerns became deflation worries Canadian Yield Curve 30 Year Yield less 2 Year Yield Source: rrb\real yield 11/26/ Yields sharply lower in frontend only Source: rrb\can 3mth 11/26/08 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec

13 Changes in Pension Plan Funded Status 20.0% Rolling 3-year Returns (Assets - Liabilities) January October % Assets - Liabilities (%) 0.0% -10.0% -20.0% -30.0% -40.0%

14 Impact on Pension Plans Impact on Funded Status Wiped out return-to-surplus status of last 3 years Liquidity Facilitating benefit payments Rebalancing rules Rebalancing practices A lot more work! Increased reporting and monitoring Further due diligence on managers Conference calls, intra period meetings -13-

15 Implications for Pension Plans Regulatory relief Re-assessment of Investment Philosophy and Policies Expectations from Asset Managers Stay the course Seize opportunities -14-

16 Regulatory and Other Potential Relief Federal Government relief plans Adjustment to discount rates in recognition of credit spread widening Extend time period to close funding deficits Impact may be muted if no provincial participation Regulatory relief helps, but Plan Sponsors remain obligated to meet promise Need to address cost of benefit delivery Longevity, indexation DB Plan closures Proliferation of DC structures Sale of liability risk -15-

17 Re-assessment of Investment Approach Fiduciary Obligation Augmented Challenge relevance of traditional 60/40 asset mix Challenge assumptions on risk premiums Move towards surplus risk as opposed to asset-only framework Clearer definition of of risk and Allocation of risk budget Understanding asset manager mandates and liquidity and pricing impact Incorporate funded status in asset mix policy Allow for flexibility to relax policy under certain conditions Challenge relevance of credit rating constraints in SIPP -16-

18 Expectations of Asset Managers Partnership concept product pushers no longer valued Understanding of the liability problem; providers of LDI framework Understanding of risk, and ability to model and manage Skilled at understanding broader scope of credit risks* Multi-disciplined Sound, disciplined investment principles * Risks that credit manager must understand: security structure, liquidity, indenture, LBO, counterparty, ratings -17-

19 Stay the Course Fundamentals will return to market Difficult to make significant portfolio changes Maintain focus on pension promise Risk management remains relevant Sound, disciplined investment principles -18-

20 Seizing Opportunities Increase allocation to undervalued high-quality assets, especially those that address liability risk Maintain allocation to assets that offer liquidity premium Prepare to re-position plan assets once markets improve Contemplate further asset class diversification Contemplate asset mix changes based on surplus risk framework Demand transparency and liquidity Demand manager time/attention; embrace partnership philosophy Prepare for the unexpected -19-