A brief overview of the past few months

Subprime. Subprime. Subprime. Mostly everything going on in the markets today can be traced to the subprime situation developing in the U.S. The whole fiasco has spawned talk of a recession in the U.S. In fact, many people believe we're in a recession (defined as two consecutive quarters of negative real GDP growth).

So how did we get here? Well, if you came out to our meetings in the fall, you got a pretty good answer (we hope). However, I'll give a quick general summary as to what got us here.

If you remember way back when in 2001/2002, the U.S. was reeling from 9/11 and the bursting of the technology bubble. Alan Greenspan, then Fed chief, cut rates to historic lows - for a time they were as low as 1%. These phenomenally low interest rates jumpstarted the economy, and sent the markets on a torrid bull run. The availability of cheap credit fuelled the LBO boom, as companies could borrow large sums of money at a low cost, and then use this money to snap up these firms.

However, the bull run that followed the low interest rates also spawned another industry in the U.S. The subprime mortgage industry. Typically, a prime mortgage is awarded to people with good credit scores (usually above 700). A subprime mortgage, however, is awarded to borrowers with below-average credit scores - hence subprime. These subprime borrowers could afford these mortgages, as interest rates were so low. Moreover, many of the companies that were handing out these subprime mortgages were playing fast and loose with the regulations, so people who really shouldn't have been getting loans were getting them by the boatload.

However, as is the case with a quickly growing economy, inflation and other factors associated with rapid growth forced Greenspan to raise interest rates 17 times. Rates hit 5.25% by 2006, and stayed that way until September of 2007. Now, unfortunately for many of the subprime borrowers, as rates rose, their ARMs (adjustable-rate mortgages) began to 'reset' or adjust to the new higher rates. All of a sudden, the payments that seemed reasonable and affordable to these borrowers were now much higher, and in many cases, unaffordable. Worse yet, a recession in the southern U.S. housing market began to impact the loans awarded to new borrowers, and the quality of loans already made (due to the deteriorating value of the homes - the collateral).

So here we sat, many of these subprime mortgages were set to go into default. Many in the markets began to realize this through 2007, but the scope of the problem wasn't really felt. The markets continued to climb through May, June, and July. The Dow closed above 14,000 for the first time ever on July 19th 2007. However, shortly thereafter, the markets began to discover the extent of the burgeoning subprime problem.

Now, common sense would dictate that a problem mostly in the southern U.S. However, in the global search for yield, many firms took these high-yielding subprime mortgages, and sliced and diced them up. They took bits and pieces of subprime loans and packaged them up into CDOs (collateralized debt obligations) and ABCP (asset-backed commerical paper). These investments were sold throughout the world: to mining companies in Alberta, school trusts in Florida, banks in Dublin, and to investors in Singapore. It got so complicated, that no one really knew what they were holding. As the market began to digest possibility of a large number of defaulting loans, panic began to grip investors. August saw rapidly eroding stock values, worst among them: the homebuilders and the financials. However, since this was such a widespread problem, almost every stock took a hit (save for tech stocks like Apple and RIM). No one exactly knew what they were holding; that is, no one could really know if they had acquired a slice of the subprime pie.

Many Canadian companies were particularly hard hit by the credit crisis. A lot of these companies held ABCP on their balance sheets. ABCP, which is typically rolled over after 90 days, allows companies to capture a higher yield that cash, and is generally a liquid investment. However, as questions began to arise about just what was 'backing' this paper, the liquidity dried up. Suddenly, companies like Redcorp and Transat AT were left in a serious cash crunch. (As an aside, the fact that much of this paper was highly leveraged added to a lot of the fear and headache in the markets). A subtle distinction that is often overlooked, is that it was the non-bank ABCP that seized up, not the bank-sponsored ABCP, as liquidity provisions were contained in the latter. These provisions allowed the banks to step in and provide liquidity. The non-bank commercial paper was a different story. The market completely froze, and a committee was formed to develop an action plan known as the Montreal Proposal. Only after months of debate and study (and several extensions of the freeze in the market) did the group come up with a solution. Basically, the solution involves turning the short-term notes into longer-term paper maturing in 5 to 8 years. The committee has ensured that investors will get most, if not all, of the face value back within this time period.

So all of this news began to hammer away at stocks. Specifically, many financials were hard hit, as rumours of massive write-downs dominated the news for months. Financial stalwarts like Merrill Lynch, Citigroup, Morgan Stanley, UBS, Credit Suisse, CIBC, HSBC, Bank of America and many others were forced to writedown billions of dollars in assets, as these assets had lost a substantial portion of their value. Stocks gained and lost 5% simply on rumours of financial writedowns, and this trend continues today.

The Federal Reserve and Uncle Ben Bernanke had long parroted that inflation remained the primary threat to the economy. Even throughout the dark days of August, the Fed refused to cut interest rates, much to the chagrin of many investors. They did provide liquidity through other open market operations, but most felt it wasn't enough. Finally, at the September meeting, the Fed cut rates by 50 basis points to 4.75%. They cut rates at the next two meetings, taking the overnight rate to 4.25%. Finally, just a couple days ago, the Fed cut rates further by 75 basis points to 3.5%. Now, even though the Fed has been criticized by many for its slow response, it should be noted that they have had to battle conflicting data suggesting slowing economic growth and rising prices, which could lead to stagflation.

So there is a Coles notes version of what's gone on the last few months. Of course, there have been a tonne of other subplots and sidestories, which we hope to get to in subsequent blog postings.