The Debt Crisis 2007/2008Client Seminars

Wednesday 24th & Thursday 25th September 2008

•How it has happened•Putting it into context•Where to from here•Strategic Decisions for Individuals

Slide 1 - How It Happened….

• It really did start with mortgages to people who could not afford them.

• They were sold by salespeople (mortgage brokers) on commission.

• The loans did not ‘stay’ with the financial institution who provided the loan (as tends to happen in Australia), they were ‘sold’ to other financial institutions. Therefore institutions were not so concerned over the credit worthiness of borrowers, because they were just selling the loans on.

Slide 2 - Non Recourse Loans

• These loans were ‘non recourse’ loans – that is if the borrower could not pay the loans back, the lender could take back the property – without any further claim on their assets or income. (again, unlike Australia where borrowers have to pay back all of the loan amount).

• This is where the term ‘jingle mail’ comes from: USA homeowners posting their keys back to their lenders – because that is where the responsibility for their loan ends.

Slide 3 – Bundling the Loans

• The loans were bundled together, sometimes with further borrowing, into various products including ‘Collateralised Debt Obligations (CDO’s)’.

• In Australia some superannuation funds, councils and banks invested in CDO’s.

Slide 4 – No-one Trusts Anyone……..

• The problem is in debt markets. If these CDO’s can cause an investment bank to fail (Bear Sterns), then no-one wants to lend money to an institution that might have significant exposure to them.

Slide 5 – This is a Debt Problem

Slide 6 – The Credit Rating Agencies

• In the early part of this decade there was another ‘sub-prime’ mortgage crisis in the USA. However house prices were still going up, so more than 90% of the value of loans were recovered.

• This time house prices are falling…..so far less is being recovered.

• Credit ratings agencies rated a lot of debt as much less risky that it really was.

Slide 7 – Why House Prices(in the USA) Matter

• Stopping the fall of house prices in the USA will put a floor under the valuations of these CDO’s.

• It is an important plank in resolving the crisis.

Slide 8 – Putting it into Context

• We don’t want to diminish what is happening in any way – this is a very serious financial problem; however there have been others that have gone before.

Slide 9 – Putting it into Context

The media enjoys reporting ‘fear or greed’.

– "This economic convulsion is unprecedented in the post-World War II era.” Robert J. Samuelson, "A World Meltdown?" Newsweek September 7, 1998

– "This time it is different. This time the market won't be so quick to bounce back. . . . Who can look at the world right now and not conclude that things have changed dramatically?”

Joseph Nocera, "Requiem for the Bull," Fortune, September 28, 1998.

– "The nation's top auditor said today that many more banks were effectively bankrupt than regulators had recognized. . . . 'The bank insurance fund is nearly insolvent, and I cannot overemphasize how important it is to restore it as quickly as possible,' Mr. Bowsher [Comptroller General] told the Senate Banking Committee.“ Stephen Labaton, "Bank Deposit Fund Nearly Insolvent, US Auditor Says," New York Times, April 27, 1991.

Slide 10 – USA Investment Banks vs. Australian Banking System

• Lehman Brothers is an investment bank – a trading bank dealing in investment

• Australia’s banks are better ‘capitalised’, the Government’s credit rating is AAA (can raise cheap debt if needed), the RBA has not had to ‘prop up’ any institutions and we have an official interest rate of 7% - which provides room to cut interest rates if growth slows.

Slide 11 – The Real Economy

• In Australia:– Unemployment is at historical lows (less than 5%)– There is no serious expectations of a recession– The economy is forecast to continue to grow (albeit at a slowing

rate – which is not a bad thing in that it keeps inflation under control)

– An International Monetary Fund (IMF) study suggests Australia is well placed to weather the global economic downturn

– Even in the USA the ‘real economy’ seems to be surprisingly strong, unemployment is reasonable, consumer spending strong – and against forecasts they seem to have avoided a recession up till now (although that may change in the future).

Slide 12 – Corporate Activity

• In the last week Warren Buffett has made 2 significant investments, including $5 billion into Goldman Sachs overnight.

• Talk of BHP making a hostile bid for Rio Tinto.• Lehman Brother’s assets purchased.• Macquarie purchasing Channel 10??

Corporate activity might be a sign of increased confidence in markets, and the values of companies.

Slide 13 – The Bailout

• The proposal for the USA Government is to buy back large amounts of the mortgage debt.

• This potentially improves the situation by taking this ‘toxic debt’ out of the companies – making it easier for companies to lend and borrow with certainty.

• Many commentators have said that this takes the ‘depression scenario off the table’.

Slide 14 - The Bailout

• It does seem to be a potentially solid solution.

• However, it has the ‘political risk’ that means that until it is passed, there will be uncertainty.

Slide 15 - What is Priced Into Shares?

• There is an obvious desire to sell shares, and put the money into cash at such a difficult time. However, the price of shares at the moment must reflect a great deal of fear – from the USA problems and the reporting of this as a ‘crisis’.

• The value of shares at the moment would likely reflect:– The probability of a USA recession– Continued problems in credit markets– A slow down in company earnings

Slide 16 – Strategic Decisions for Investors

• Keep a reasonable level of cash• Diversification is a positive strategy (avoid collapses like

MFS, ABC Learning, Macquarie Fortress Notes, Asset Loans, Babcock and Brown, Basis Capital, Absolute Capital, City Pacific, MFS Premium Income Fund, Centro Property………………)

• Aggressive Long Term Investors – possibility to buy in a distressed market (but a strategy with risk)

• Keep an eye on the ‘income’ from investments – Australian shares are paying a dividend yield of 5.02%; that is very attractive

• Get in contact with us at any stage that you want to discuss your situation