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The Credit Crunch Crisis and Opportunity Wynn Quon Oct 9, 2008

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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Page 1: Credit Crisis Presentation - Oct 9th 2008

The Credit CrunchCrisis and Opportunity

Wynn Quon

Oct 9, 2008

Page 2: Credit Crisis Presentation - Oct 9th 2008

How did we get into this mess?

• 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.

• Go for a ride: http://www.speculativebubble.com/videos/real-estate-roller-coaster.php

Page 3: Credit Crisis Presentation - Oct 9th 2008

Attack of the NINJA loans!

• “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.’ ”

--This American Life, NPR, “The Giant Pool of Money” May 9 2008

Page 4: Credit Crisis Presentation - Oct 9th 2008

You can’t make this stuff up

• In one case, mortgages were also granted to 23 dead people in Ohio.

Page 5: Credit Crisis Presentation - Oct 9th 2008

Wall Street Mortgage mania

• Banks float $2.6 trillion of mortgages in 2006 alone. (20% subprime)

• Investment banks issue $45 trillion of mortgage/debt insurance (credit default swaps).

• Use of 30x leverage - $1 down on a $30 loan

• Amount of bad investments >> dot.com bubble

Page 6: Credit Crisis Presentation - Oct 9th 2008

End of illusion

Page 7: Credit Crisis Presentation - Oct 9th 2008

Bad news

• 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...

• 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.

• U.S. stock market falls 20%, wiping out $4 trillion in wealth.

Page 8: Credit Crisis Presentation - Oct 9th 2008

Worse News• Credit crunch - Without banks lending, the economy will

grind to a halt. (car loans, mortgages, business loans e.g. Ford Sept. sales down 35%)

• Default rates increasing on prime mortgages, auto loans, credit cards

• Unemployment in the U.S. growing; 6.1% up from 4.7% a year ago.

• Real-estate bubbles in U.K., Ireland, Spain, China. Stock market crashes in China (-60%), India(-43%)...

• Danger of a decline spiral

Page 9: Credit Crisis Presentation - Oct 9th 2008

What about Canada?

• We’re the tail on the U.S. dog• real-estate bubble in Vancouver, Calgary,

Edmonton• 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.

• the credit crunch is already here - ABCP mess, 5 yr mortgage rates have increased to 7.2%, CIBC troubles, interbank lending has stopped

Page 10: Credit Crisis Presentation - Oct 9th 2008

How bad will things get?

• The longer and bigger the boom, the bigger the crash

• Lack of transparency breeds fear• “rational panic”• Bank crises strike at the core of the global

economy• $850 billion U.S. bailout unlikely to stop recession

Page 11: Credit Crisis Presentation - Oct 9th 2008

Lessons of history

• 5 severe post-war banking/real-estate crises (Japan, Spain, Finland, Norway, Sweden)

• On average, home prices fall 20% from peak, stock prices fall 20%.

• Bear market average length 2 yrs.

• But every crisis is different...

Page 12: Credit Crisis Presentation - Oct 9th 2008

Optimistic case

• An average crisis?

• Stocks have already fallen by more than 20% as have real estate prices in the U.S.

• Bear market has already lasted ~1 yr

• Optimistic case - we’re near the bottom

• What’s the pessimistic case?

Page 13: Credit Crisis Presentation - Oct 9th 2008

Japanese Super Bear market

Page 14: Credit Crisis Presentation - Oct 9th 2008

Japanese Super Bear market

• 13-year bear market

• Stocks lost 78% of their value

• Real-estate prices still down 50% from 1991 peak, down 64% in six largest cities.

Page 15: Credit Crisis Presentation - Oct 9th 2008

Fog of forecasting

• Huge Unknowns:

How much bad debt will there be?

Policy response - competence?

Investor response - confidence?

Investment companies - liquidity?

System feedback loops

• As difficult as hurricane forecasting

Page 16: Credit Crisis Presentation - Oct 9th 2008

Wrong question

• How bad will it get?

Page 17: Credit Crisis Presentation - Oct 9th 2008

Right questions

• What is your risk tolerance?

• What is your time frame?

Page 18: Credit Crisis Presentation - Oct 9th 2008

Most common mistake

• …of investors is to overestimate their risk tolerance.- during bull markets, the downside is completely theoretical

- during bear markets, losses are real. Investors suffer loss aversion.

- fear, regret and panic overwhelm rational decision-making

- 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%.

• Use scenarios to test drive your risk tolerance

Page 19: Credit Crisis Presentation - Oct 9th 2008

Hope for the best, prepare for the worst

• If we are hit by the equivalent of a Japanese Super bear scenario:

Dow Jones Ind. Avg would fall to 2800

TSX would fall to 3000.

….prices would begin recovery sometime after 2021. Yikes.

• A $100,000 all-stock portfolio would fall to $20,000.

Page 20: Credit Crisis Presentation - Oct 9th 2008

Impact of a Super Bear

• Assume a $100K portfolio at the market peak. The following is what would happen in a Japanese Super Bear scenario.

• 100% stocks, 0% fixed income - your $100K portfolio would fall to $20K. (Don’t do it!)

• 80% stocks, 20% fixed income - your $100K portfolio would fall to $36K.

• 60% stocks, 40% fixed income - your $100K portfolio would fall to $52K.

• 40% stocks, 60% fixed income - your $100K portfolio would fall to $68K.

• 20% stocks, 80% fixed income - your $100K portfolio would fall to $84K.

Notes: Fixed income = cash, gov’t bonds, GICs. Results ignores dividends.

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?

Page 21: Credit Crisis Presentation - Oct 9th 2008

Is your money safe?

• In a credit crisis, trust is lost.

• E.g. Lehman Bros bonds rated ‘A’ by S&P, Sept. 9th 2008.

Less than one week later the company collapsed. Bonds are worthless.

• This is a good time to check that your deposits/GICs are with CDIC-insured institutions. Gov’t guarantees $100K of deposits. (cdic.ca)

• CIPF protects up to $1M in your brokerage account. All securities you’ve paid for are segregated. (cipf.ca)

• ***www.financeprotection.ca

Page 22: Credit Crisis Presentation - Oct 9th 2008

Not insured

• Money market funds, mutual funds -note: money market funds are now neither ‘low-risk’ or ‘high risk’.

• Principal-protected notes, aka ‘index-linked GICs’

• Foreign currency accounts, etc.

Page 23: Credit Crisis Presentation - Oct 9th 2008

Success in the stock market

• In bull markets investors ignore risk.

• In bear markets investors ignore return.

Page 24: Credit Crisis Presentation - Oct 9th 2008

Bear market buying

• Bear markets are the best time to buy

• But if your portfolio doesn’t match your risk tolerance, you will be too scared to do it. Or buy too soon.

Page 25: Credit Crisis Presentation - Oct 9th 2008

Buying strategies

• Make a plan beforehand!

• Decide how much $ you want to commit

• Divide it into chunks

• Tie your buying decisions to price points or index levels.

• E.g. TSX - 8000, 6000, 4000, 2000…. Or say MCD @ $40, $30, $20….

Page 26: Credit Crisis Presentation - Oct 9th 2008

Stocks to watch• Dividend-payers (e.g. Telus, Enbridge,

Cameco) with relatively low debt in the TSX60

• Avoid for now: financials (banks, insurance companies) unless you know something I don’t;

• Add some gold (Barrick, Goldcorp)

• Pfizer, yield 6.5%+; Analog Devices

Page 27: Credit Crisis Presentation - Oct 9th 2008

Speculations

• Nortel Networks - Common shares @ $2.00; Floating-Rate Preferred Cumulative F shares. $4-$5. Guess the yield!

• BCE. Currently @$33. Upside to $42. Downside to $16. A gamble.

• Gold Fields, currently $7, 3.2% yield.