June 19, 2008

Autopsy of a Liquidity and Credit Crisis

L'Institut canadien des actuairesCanadian Institute of Actuaries

Assemblée annuelle 20082008 Annual MeetingQuébec

Autopsy of a Liquidity and Credit Crisis

L'Institut canadien des actuairesCanadian Institute of Actuaries

Assemblée annuelle 20082008 Annual MeetingQuébec

2

The Mechanic of a Global Crisis

Over-priced asset class (low risk premium) following a long period of economic prosperity

– Financial crisis almost always occur when some assets are overly expensive (1929, 1987, 1998, 2000-2002, 2007-2008).

Correlation risk has a significant impact on amount of losses

– Leverage increases correlation risk;– The source of correlation risk is not always obvious.

Securitization increases risk of contagion

– It improves diversification of investors, but securitized products are more opaque and similar products have their own systemic risk.

3

The Trigger of the Current Liquidity Crisis(a significant credit issue)

Number of households 7,2 millions% ARM with high adjustments 90%% ARM with 5% adjustments 70%% approved without sufficient documentation on income 45%% approved without fiduciary account for taxes 75%

All mortgagesDollar amount of ARM set for reset in 2006 400 billionsDollar amount of ARM set for reset in 2007 1,000 billionsDollar amount of ARM set for reset in 2008 450 billions

Number of foreclosures (Jan-May 2008) 825,000YoY decline in home prices (May) Nearly 15%

2003 2006-2007

Amount of subprime mortgages outstanding

332 billions 1,400 billions

1,000 billions (Alt-A)

Origination as % of total 8% 20%

4

Expected Losses (Loans and Securities)(Banks – Insurance cies – Hedge funds – GSE- pension funds)

Entities Amount of losses

Banks 440-510

Insurance 105-130

Pension 90-160

GSE – Gov. 70-140

Hedge funds and others 110-200

Total (MTM) 815-1140

OECD estimate (RL) 400-450

ABCP-Canada (Provisions)

5-8 (15%-25%) Source IMF

According to the BIS, methodology used to valuate MTM losses on AAA subprime related securities may have inflated estimated MTM losses by 60%.

5

How it Started

New legislations passed in early 80s:

Depositary Institutions Deregulation and Monetary Control Act of 1982:

Abolished caps that limited the rates that banks could charge on primary mortgage.

Alternative Mortgage Transactions Parity Act of 1982:

Allowed other mortgages than fixed rate mortgages:

- ARM- Balloon-payment mortgage- IO mortgage- Option-ARM

6

Factors that Led to Growth of the Market

Excess of liquidity, low interest rates, low inflation, high employment.

Securitization – Higher spreads: 75% of subprime mortgage origination has been securitized; 80% were funded by AAA MBS.

AAA 80%

AA 11%

A 4%

BBB 3%

BB-Equity 2%

Mortgage pool

7

Factors that Led to Growth of the Market

Rating agencies – High % of AAA assets required (80%): Assumptions: 50% to 65% default required with 65% recoveries; 70% losses are now considered possible which means a default rate break even

point of 28%; Anything A and below likely to have no residual value.

Regulators Lower capital requirements on securitized assets than on similar corporates.

Instrument Significant exposure through money market instruments.

Investors Excess leverage; From too trusting to negligence (RMBS vs. contagion resulting from RMBS).

8

Contagion – the Spread of the 30-100 Tranche

The 30-100 tranche exposes investor to a default risk in the event 30% of losses are recorded over a period of "X" years.

AAA rating for an investment grade portfolio such as the CDX requires a subordination of about 10% for 10 years, 7% for 7 years and 5% for 5 years (approximately).

Other tranches are available such as: 0-3, 3-7, 7-10, 10-15, 15-30, 15-100, etc.

Tranche 30-100 IG7Y

01020304050607080

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07

-06

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07

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07

-08

-06

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07

-09

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07

-10

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20

07

-11

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07

-12

-06

20

08

-01

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08

-02

-06

20

08

-03

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-05

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08

-06

-06

9

Factors that Led to Demise?

Securitization – from monitoring to originating role:

When the economic interest of the originator is no longer in line with that of investors:

Financial institutions with two sets of investment standards;

Some hedge funds had warned in 2006 that all BBB tranches and below would be wiped out.

Total Mortgage Originations

(Billions)

Subprime Originations

(Billions)

Subprime Share in Total Originations (percent of dollar

value)

Subprime Mortgage Backed

Securities (Billions)

Percent Subprimes Securitized (percent

of dollar value)

2001 $2,215 $190 8.6 $95 50.4

2002 $2,885 $231 8.0 $121 52.7

2003 $3,945 $335 8.5 $202 60.5

2004 $2,920 $540 18.5 $401 74.3

2005 $3,120 $625 20.0 $507 81.2

2006 $2,980 $600 20.1 $483 80.5Source: Inside Mortgage Finance, The 2007 Mortgage Market Statistical Annual, Top Subprime Mortgage Market Players &

Key Data (2006).

10

Factors that Led to Demise?

Securitization – declining standards

ARM Share IO ShareLow-No-Doc

ShareDebt Payments to-

Income RatioAverage Loan-to-

Value Ratio

2001 73.8% 0.0% 28.5% 39.7 84.042002 80.0% 2.3% 38.6% 40.1 84.422003 80.1% 8.6% 42.8% 40.5 86.092004 89.4% 27.2% 45.2% 41.2 84.862005 93.3% 37.8% 50.7% 41.8 83.242006 91.3% 22.8% 50.8% 42.4 83.35

Source: Freddie Mac. obtained from the International Monetary Fund via http://www.imf.org/external/pubs/ft/fmu/eng/2007/charts.pdf

Notes: "ARM" represents "adjustable rate mortgages", "IO" represents interest-only mortgages, where payments, do not retire the

principal value of the loan; "Low-No-Doc" represents low or no documentation mortgages.

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Innovations ? When a AAA is not a AAA

12

Factors that Led to Demise?

Rating agencies

Half of Moody's net income attributed to securitization in 2006. Percentages of mortgage bonds rated are:

Moodys 96,7% S&P 97,6% Fitch 51,3%

Ratings are paid by issuers;

Agencies help issuer achieve desired rating;

Computer error allowed some CDPOs to receive AAA ratings in early 2007 when ratings 4 notches below should have been awarded;

Moddy's separated its credit ratings operations from marketing and analytics;

All agencies are reviewing operations and methodologies;

Agences failed to recognize significant changes in the quality of mortgages being originated.

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Declining Standards Reflected in PricingPRICES 2007 PRICES 2008

07 - Sep

18 - Oct 30 - Nov 11 - Jan 22 - Feb 14 - Mar

ABX 06 (1)AAAAAABBBBBB –EQ

98958465570

98937547380

95856134300

94855931250

93785025190

86643316150

ABX 06 (2)AAAAAABBBBBB –EQ

97886347400

94774525240

87624021190

84603419180

78502215130

71371710100

ABX 07 (1)AAAAAABBBBBB –EQ

95779035330

91653423210

77472820190

73402418170

65311412120

562211990

ABX 07 (2)AAAAAABBBBBB –EQ

95856142330

92704325240

72393221210

70402824220

63302217160

52221713130

OVERALL DEFAULT-LOSS PROBABILITY IMPLIED BY THE WEIGHTED BASKET%RMBS $bnLOSS $bn

87.72378282

84.02303368

75.32303668

73.02228602

67.92228716

60.22228887

Source IMF

14

Contagion: Structure of SIVs (US) and ABCPs (Canada)

Structure / product SIVs* ABCPs

Size 400 billions 32,7 billions

Traditional assets 0% 8,1%

Debt Financail institutions 28%

RMBS / CMBS / ABS 48% 8.2% CMBS / 7.0% RMBS

CDOs / CLOs 22% 76.7% mostly synthetics

Others 2%

Main issue in US is credit.

Main issue in Canada was no so much quality of credit, but MTM risk (related to mismach of assets and liabilities and leverage) and weak or possibly valid, but not enforced liquidity agreements.

7 year duration x 10 leverage x 100 bps increase on credit spreads = MTM loss of 70% even if credit risk remains close to 0% probability.

Skeena restructuring (structure / accounting treatment are important).

* Siv lite (another 12 billions) had high concentration to RMBS

15

Correlation Risk: When a Single Assumption Affects a Large Number of Securities

2007

US based securitization = 92% of 1,448 downgrade actions by Moody's; 2006 / 2007 securitization = 87% of all downgrades; 2007 through Feb. 2008 - 56% of BBB- to BBB+ RMBS downgraded to CCC+ or below.

2008 2000 tranches under reviews; More downgrades expected.

Example – portfolio of 100 equally weighted securities / volatility of losses around expected mean

Correlation Ratio of standard deviation (against 0% assumption)

Subordination required based on 7% expected losses on portfolio and

.1% expected loss on structure

0% NA 8,2%

5% 2,4 9,9%

10% 3,3 11%

15% 4 11,8%

25% 5,1 13,1%%

50% 7,1 15,5%

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Recommandations

Review implicit consequences of investment policies:

In Canada, only 3 corporate issuers offer a money market instrument with a R1H rating. All others are securitized products.

Paying too much is still the biggest source risk:

VAR is not very helpful for this purpose; VAR is lowest when the 1% long run scenario is most likely; It amplifies crisis much like program trading in 1987.

Identify main sources of correlation risks:

Portfolio 1 - An investor holds 10 AAA CDOs with a AAA attachement point of 6% and a detachment point 1% above the attachement point (7%).

Porfolio 2 - An investor holds 10 AAA CDOs with a AAA attachment point of 6% and a detachment point of 100%.

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Lessons from this Crisis

Avoid investment with mismatched maturities:

Mistmatch design to generate bigger margin from structurers:

Ex.: LSS at 5 bps leverage 10 times with only 5 bps paid to the investor.

What are the consequences if a liquidity crisis affects the maturity of specific instruments at maturity:

Does it trigger a default or will the underlying assets be allowed to run to term? Can your firm support this risk?

Is this risk really off your balance sheet (reputation issues)?

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Two Rating Agencies?

US agencies would not rate CAN ABCPs because liquidity agreements were not necessarily global style.

US approach was lower quality assets with global style liquidity.

CAN approach was higher quality assets with weaker liquidity agreement.

Rating agencies are weak at identifying systemic risk.

Agencies rate probability of losses or expected losses – not a useful approach to evaluate systemic risk.

Rating agencies not well suited to identify correlation risks. That is responsability of investors.

Two ratings may not help as in US. Issue is asset pricing bubble.

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Appendix