The credit crunch is spreading to Canada, causing a freeze-up in an esoteric but important area of the market known as the money markets - where companies and investors go to trade very short-term loans.
This has led to a plunge in the stock of one Canadian company - Coventree Capital Group Inc. - and concerns that money market funds could be hurt. The Bank of Canada is trying to step in and stop the carnage by making liquidity available, but so far it's not working.
What's going on, and why does it matter? And where could the contagion spread next.
Andrew Willis and Boyd Erman answered your questions at noon on Thursday. Your questions and their answers appear below.
Mr. Erman is a long-time business journalist who has worked at Dow Jones, Bloomberg and The National Post before joining The Globe and Mail. Over the years, his areas of coverage have included economics, monetary policy, debt markets and corporate finance. In addition, he is a regular commentator and guest host on Business News Network.
Mr. Willis writes the Streetwise blog and column, and is a veteran observer of Canada's business scene. Before joining The Globe and Mail, his career included stints at publications including The Financial Post, The Financial Times of Canada, Dow Jones/Wall Street Journal and MacLean's magazine. He also appears on BNN TV and CBC Newsworld.
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Gordon Edall, online business editor, ReportonBusiness.com: Before we dive into the questions in the queue, and there are a lot of questions, I just want to put this discussion in context for our readers. How serious is the credit crunch the market is currently trying to deal with?
Boyd Erman, capital markets reporter, Report on Business: It's quite serious, and here's why: Credit is what makes the modern financial world work. People borrow to buy stocks, they borrow to buy homes, they borrow to buy cars.
The net result of this is going to be that interest rates are going to rise for riskier borrowers, but how much? No one seems sure yet, and that's paralyzing the markets. And even when markets do get going and the price of credit is set higher for borrowers such as hedge funds and buyout funds at the Bay Street end of the spectrum, and people at the Main Street end of the spectrum, that higher cost of credit is going to slow certain activities - namely speculation on housing and stocks. And that's what we're seeing happen today on the TSX, to some extent.
Andrew Willis, columnist, Report on Business: At the moment, the problems are confined to a specific sector of a rather obscure part of the market. That little segment is $40-billion of asset-packed commercial paper that has been issued by financial companies such as Coventree Capital that are rivals to the big six banks. That portion of the market shut down this week.
The good news today is that $40-billion market has been bailed out, and for organizing that rescue, the Caisse in Quebec deserves credit (in the form of applause, not capital). The situation would have become very serious if $40-billion of commercial paper suddenly went into default.
Unwinding all the assets underlying that commercial paper would have been a nightmare. Investors of all stripes, including the money market mutual funds most of us own, would have lost money. And the problems would have spilled over into other parts of the debt market. It would have become more difficult for companies to borrow and more difficult for homeowner to get mortgages, to give just two examples.
So the system worked the way it should. We seem to have put a fence around a specific problem in asset-backed debt market.
Karen Lieberman from Toronto writes: What does all this mean and will it have an effect on the regular people who have nothing to do with the corporate investment stuff?
Boyd Erman: Hi Karen, this could play out in a number of ways that might affect the people on Main St., not just Bay St. The likely effect is that credit will be tougher to come by, which will be a big adjustment for people who have become used to living off easy, cheap loans.
The reason is this: The banks are likely to pull in their horns on all types of lending, after getting burned a bit in some markets. That means they'll still make loans, that after all is their primary business, but they are going to want to make only the safest loans, and they are going to want to charge a lot more for any risky loans.
The Bank of Canada will try to curb that impulse to tighten credit by adding "liquidity" (a fancy word for more cash) to the system, but in the end, it's the commercial banks that decide how much to lend. And at the moment, they are becoming rapidly more conservative.
Sam Slick from Canada writes: In this day and age why are financial institutions, or more specifically, the money managers that are hurt or will be, making such bad financial decisions to lend people money on such risky business? Is this kind of event anything new to us? Are we living beyond our means?
Andrew Willis: Here is the weird thing about this crisis - most of these loans that the money managers hold, in the form of asset-backed commercial paper, are fabulous loans that anyone would be glad to take. For example, a lot of this commercial paper we are writing about represents loans made by auto companies to car buyers. The vast majority of those loans will be repaid. So that stuff is, well, safe as houses.
There is a specific sector here were American lenders clearly lost their heads. The subprime mortgage market allowed people who never had the financial wherewithall to own homes and buy houses. Like the third world debt crisis a few years back, we will all look back on subprime and wonder: What were they thinking. Some people did live beyond their means, and must now pay the price. But prudence is still being rewarded.
The problem now is investors are gun shy. They don't want to own any exposure to subprime, or any other debt that might be go sour, and there are well-founded fears that the economy is rolling over. The natural reaction is to shift to low-risk assets, such as government bonds. When that shift in portfolios happens, it happens fast, and you get the big swings of the past week.
Jean Prettie from Canada writes: Will the feds hold the line on interest rates? Would lowering interest rates alleviate the credit crunch?
Boyd Erman: I think that the central banks in Canada and the U.S. want to hold the line on interest rates as much as possible. They are adding cash to the economy in a bid to keep the cost of loans down at the current targets, rather than letting them drift higher, but as for cutting rates I think that's a last resort. A senior Federal Reserve official, who votes on interest rates, said today that it would take a "calamity" to prompt a U.S. rate cut. And, as bad as this feels, it's not a calamity. It's just barely a correction in equity markets.
There are at least two reasons the central banks want to keep rates where they are, rather than lowering them. For starters, inflation has been a potential problem on both sides of the border, and both central banks are leery of cutting rates when inflation is a threat. And secondly, I think central bankers are of the view that lowering rates to bail out the markets would send a poor message - that if you mess up in markets (which are all about taking risks in hope of reward) the central bank will be there to save you. Alan Greenspan developed a tendency to do this, and won a derisory reputation for creating the "Greenspan put" - meaning that if something went wrong, Alan would be there to catch your fall. That's not what central banks are for.
Garlick Toast from Mill Village, Canada writes: I see injections of liquidity as inflationary, the cure for which is interest rate hikes. If that happens, then what? Is credit card debt bundled and resold? If so, could it be the next domino or just the other shoe?
Andrew Willis: The Bank of Canada and other central banks are not going to let inflation take hold. They simply want to keep debt markets functioning smoothly, and buy giving commercial banks greater ability to lend, with liquidity injections, they are doing just that. They will pull back the liquidity when the markets calm down.
The central banks are ensuring that specific problems don't snowball into system-wide crisis. Providing liquidity ensures that the market can deal with issues such as the U.S. subprime mortgage meltdown and the Canadian problem of selling asset-backed commercial paper.
Credit card debt seems manageable, in Canada.
The next domino I see is a political/social issue: How does a cash-strapped American government deal with the fact that millions of people are living in homes and can't afford to make their mortgage payments? You can't throw all these voters out on the street and repossess the homes. So how do you refinance all those mortgages?
Ben De Castro from Toronto writes: Will the additional liquidity not add to the financial problems by throwing good money after bad? If the asset-backed securities cannot be serviced due to default by the primary obligants of the original loan/debt, some are saying that the additional liquidity is deferring the inevitable loan loss provisioning and further, that we in North America are making the mistake that Japan made in the 1990s.
Boyd Erman: As one senior bank official put it to me, what we have here in the commercial paper market is a liquidity problem, not an asset problem. For the most part, people who have had a look at what's in these baskets of assets say they are likely to be repaid. But, if nobody is willing to buy commercial paper day after day, the baskets will go into default and have to be blown up, no matter what the quality of the assets in them. So the argument of the proponents is that if we can just keep the market going, and keep finding buyers, these baskets will go on to pay everybody back because the assets are sound.
Now, are the assets sound? That's a tougher question. There's not much disclosure about what's in some of these baskets, and that's contributing to the problem - some investors are saying if you can't tell me what's in here, I'm not going to buy, just to be on the safe side. And that's why some players in the market are looking to the banks, many of which helped put these together and do know what's in them, to step up and buy to support the market.
Norman Bortnick from Canada writes: How will the present credit crunch affect the housing market in Canada?
Andrew Willis: Fortunately for Canadians, the mortgage mess is an American problem.
If you want to buy a home in Canada, banks are still going to be falling over themselves to lend you money. It remains one of the most profitable lines of business in any bank, which is saying something. Canadians are diligent about paying back home loans. And because mortgage interest isn't tax deductible in Canada, we never got as heavily leveraged on our homes as the Americans did - lots of our friends to the south owe far more on their mortgages than their houses are now worth.
I'm really not smart or prescient enough to guess where mortgage rates will go, or what will happen to Canadian home prices. But at worst, I would predict that the Canadian home market simply cools slightly, with the air coming out of some speculative pockets, such as Toronto condos and that weird recent spike in Saskatoon home prices.
My fearless second prediction is rates remain around the levels we have today for at least the next 12 months, which makes me happy, because I have to renew my mortgage in January.
Greg Kiel from Canada writes: I have a question in light of the fact that I am about to take out a new home mortgage. What does all this mean for the prime rate and what impact will it have in the future?
Boyd Erman: As far as the prime rate goes, there's a chance it could drop if things go really bad and the Bank of Canada decides it's going to cut rates to ease the situation.
For now, what we're seeing in the bond market is that longer-term loans are getting more expensive relative to short-term loans - which makes sense, because as lenders grow more uncertain about what the future holds they are more inclined to want their money back sooner. That's a change from just eight months ago, when bankers were so confident about the future that a five-year mortgage was actually cheaper than a floating rate. That was probably just as irrational as anything we're seeing today.
So, here's the upshot: If you've got a rate guarantee, you're fine and you'll get the money. If you are a qualified borrower with a healthy down payment, the banks will still be thrilled to see you and will probably cut you a good deal. But if you are a dicey borrower, trying to stretch to cover a mortgage payment or unable to prove that you have the employment or income history needed to justify a mortgage, you may find the welcome a little less hearty and the price of a mortgage higher.
Aaron C. from Toronto writes: Hi, I was just wondering, if the current financial crisis originated from problems in the American market, then why is the Canadian dollar falling relative to the U.S. dollar?
Andrew Willis: Most second-tier currencies (and that's what the Loonie is) are currently falling against the U.S. dollar. The currency moves aren't really tied to the credit market problems, although there is an overall move to the least risky assets, which include U.S. dollar denominated government bonds.
The downward move in the Canadian dollar reflects a view that the Bank of Canada will likely drop interest rates, that commodity prices will fall, which will take some of the air out of our economy. Also, hedge funds are cashing in liquid positions, and currencies are easy to sell. And currencies tend to move on momentum - if the trend is towards a weaker currency, a lot of traders will keep trying to push the Loonie lower until it reverses. The saying on currencies desk is "the trend is your friend."
KJ Larson from Waterloo Canada writes: Has there been the kind of sub-prime lending in the Canadian mortgage industry that there has been in the U.S.?
Boyd Erman: The short answer is no. Canada generally lags the U.S., and we haven't had the same kind of exotic mortgage products that infected the U.S. market. But they were on the way - go to the movies these days and you'll see Scotiabank advertising the 0 down payment mortgage (You're richer than you think, apparently). What we're seeing in this market will likely put a stop to any further advances down the road to looser lending standards.
Joanne Kuchard from Canada writes: I worked hard and my salary was below normal. I diligently deposited money in my mutual funds RRSPs for almost 20 years. Now I see it all going down the drain. Do I pull out now while there is some left or wait to see if it rebounds ? I have 8-10 years before I would start to withdraw money.
Andrew Willis: Good for you for saving your money. You have ridden the best bull market in the history of the human race. In the time you have been investing, Canadian stocks are up 372%. The drop in Canadian stocks this summer simply took us back to the levels seen in March. That's just a few months ago. With your long time horizons, you can ignore this noise. It's always worthwhile to keep an eye on markets, and I hope you enjoy reading what we write about the problems of the day. But don't change your approach or lose sleep based on scary headlines that deal with obscure sectors such asset-back commercial paper, or junior resource stocks.
Albin Forone from Toronto writes: There has been press that this is the notice period for hedge fund redemptions 45 days from now at end of September, and this could add another dynamic to the sell-off if redemption notices are high. I haven't read anything about when the public will know how heavy the redemption requests have been or if the hedge funds are sweetening their fee structures or otherwise enticing investors to hang in. There's a lot of money in these black box funds, and little information publicly available. Do you have any insights into this, and how important it might be?
Boyd Erman: Alvin, you have hit on one of the big reasons for this morning's sell-off on the TSX. Hedge funds are trying to hang on to investors, but it seems investors would rather be somewhere else and the redemption requests have been significant, and that may account for the huge declines in commodity stocks, which were the belles of the hedge fund ball. It could take a few days to play out, and if there's no significant improvement in the market in time for the next quarterly redemption period, you may see it snowball in winter.
Darren Maloney from the United States writes: Is today's bailout of asset-backed commercial paper only delaying the inevitable, which is simply a dramatic reduction in the value of these instruments to the point where price reflects the risk associated with owning these securities?
Andrew Willis: With the bailout today, a lot of sophisticated investors and banks (including the Bank of Canada) are saying they don't believe the underlying value of these instruments has been diminished. The total lack of transparency on this commercial paper means I can't double-check their math. I can't tell how much toxic subprime mortgage debt is lying behind these commercial paper programs, for example. But the Caisse and the rest of these institutions are stepping up, and continuing to hold this paper. So they are signalling the haircut is not that severe.
Lots of people are revising their attitudes towards risk - they don't have as much tolerance this week as they did last week - and that process is clearly knocking back prices on all kinds of assets.
I do know this on the commercial paper problem: The worst-case scenario would have been default and liquidation of billions in commercial paper, and that would have reduced their value not because the underlying assets are impaired, but because there would have been a lengthy and expensive legal battle to sort out just who owns what. It seems to be common sense to avoid a situation in which no one wins, except the litigators.
Gordon Edall: I am afraid that we are out of time, but I wanted to thank both of you for taking the time to talk with our readers on a day when there is a lot going on in the markets that matters to people across the country and around the world. Is there anything else you have to add before we say goodbye for today?
Boyd Erman: If anything, I would say that what we are experiencing is healthy and necessary, if not pleasant. Think of this as the market's version of a trip to the dentist.
People spent much of the last year talking about how credit standards made little sense, and how loans were being made too easily and too cheaply, but for all the talk, and all the realization that things had gotten out of hand, nobody did anything about it. Now it's happening all at once, and it hurts. But, so long as the system doesn't shut down, markets will find a way to work through this. That's what markets are for.
Things got too sweet for too long, and now we're finding the cavities from all that sugar. It will take some time, and hurt some, to fix them, but it has to be done.
Andrew Willis: Thanks for inviting us into this forum, and stay tuned. We may have dealt with a brushfire in the deservedly obscure asset-backed commercial paper market, but we get a sense that there may be more trouble brewing in places we've never heard from before.