Browsing the archives for the Economic Reality category.

Has the Ottawa Citizen Become a Blogspaper?

Economic Reality, Financial Crisis, Political Reality, South March Highlands, Virtual Reality

Today, Jan 12 2013,  there is no news article to be found anywhere on today’s front page of the Ottawa Citizen’s print edition.  The only article is a columnist’s opinion piece.

The Ottawa Citizen, which has recently been steadily displacing news with opinion on its front page, appears to have taken another step in a transition from being a reputable newspaper to being primarily a compendium of opinion articles – in effect a blogspaper.  Actual reporting of news appears to have become a scare commodity on the front page where opinion-based articles written by columnists appear to be increasingly crowding-out fact-based news.

The reason for this is probably economic as more and more people rely on Internet news sources than print sources.  I’ve been told by former Citizen reporters that fewer than half the reporters that worked at the Citizen in 2005 remain due to rounds of budget cutbacks.  Many of the columnists employed by the Citizen are syndicated across more than one newspaper to reduce costs.

The need to protect non-subscription revenue – i.e. advertising – appears to explain why news reporting over the past few years at the Citizen seemed to become skewed, by what appears to be selective editing, in favour of the interests of its largest sources of ad revenue: new home sales, real estate, car sales, and city notices.

Selective editing is invisible to those not intimately familiar with an issue being “reported”.  It wasn’t until I participated in the Coalition to Protect the South March Highlands that I personally realized the extent of news that simply was not being reported in the Citizen.

  • For example, on more than one occasion I or someone else in the Coalition would be interviewed by a reporter, only to see the Coalition’s perspective omitted or under-represented in the subsequent article.
  • Other media (TV, radio) would report our perspective in a more balanced way, but compared to the print space allocated to support a developer’s or the City of Ottawa’s perspective, it appeared that an editorial slant was silently at work.
  • From discussions with spokespeople for other environmental groups in Ottawa, it appears that selective editing is widespread.  One can only wonder if it will naturally lead to selective reporting by reporters who will see the futility in reporting more than will ever be printed.

I also see the same signs of lack of depth & balance in the reporting of the Idle No More movement that I also have first-hand knowledge of.  For example, prior to running sensational headlines about the audit at Attawapiskat, did the Citizen bother to investigate the other side to the story?

  • How many qualified accountants even exist within a 1000-mile radius of a tiny, isolated, northern community in which few have any opportunity for post-secondary education?  Attawapiskat has an on-reserve population of less than 1,600 people and 1/3 of them are under the age of 19.  Most of its 1000 adults are unemployed, living in crowded, substandard, housing with no running water.
  • As for education, the state of deteriorating buildings caused the elementary school to be closed in 2000 and replaced by crowded portables which hardly promote a positive educational experience in the average -30 C weather during the school year. The space in those portables is only 50% of the standard that is supposed to be funded by the Federal Government.
  • So is it surprising that record-keeping is not to the standard expected by Certified Public Accountants?  There isn’t even a doctor in Attawapiskat, so why would anyone expect to find a professional accountant in a warm and comfy office diligently recording receipts?  The real story is that the Chief’s husband upgraded his accounting skills in a best-effort to try to improve financial accountability and, according to the audit, this resulted in fewer audit concerns.  Much has been made of the daily rate charged for this service, but has anyone inquired into how many days he billed?
  • More to the point, is there actually any evidence of misappropriation of funds?  Or is it possible that it was more expedient for the Citizen to run a story that required less investigative journalism?

The Federal government, who does not advertise much in the Citizen, appears to be the main target for investigative news which provides the illusion of continued balanced reporting to many.   But with fewer reporters on payroll, how long will even this continue?

Today may be remembered as a day of infamy for journalism as no news content at all was reported on the front page.  Headlines and a columnist’s article do not make much of a newspaper – especially for the advertising enriched weekend edition.

There once was a time when the Ottawa Citizen won awards for the high-quality of its investigative journalism.  Sadly those days appear to be gone, and so now I personally rely on the Globe and Mail for old-fashioned, real “news”.  Most bloggers like me are not trained journalists.  Some of us, like some of the columnists in the Citizen, try to present facts along with opinion but our primary service is to share our fair comment on the news – not report the news.

As the Internet inevitably eviscerates the Fourth Estate and replaces it with the Fifth Estate, I for one will miss its professionalism.  Meanwhile I still subscribe to the Citizen because my wife enjoys its extensive funny papers.

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Virtual Fixed Assets

Economic Reality, Virtual Reality
According to the US Bureau of Economic Activity, the real US economy (i.e. non-public sector) spends just over $1 Trillion / year on non-structural fixed assets.
This number excludes the cost of buildings, warehouses and factories but includes all household, farm, business, and non-profit organization spending on fixed assets.  A precise definition is found here.
Roughly half of that amount ($537 Billion in 2011) is on information processing equipment and slightly over half of that amount ($279 B) is software.
Spending on transportation equipment (trucks, cars, ships) was $232 B and industrial equipment (engines, lathes, robots, …) $178 B. Furniture and other types of equipment (e.g. agricultural, mining, oil rigs, …) was $194 B.
Within the $537 B on information processing equipment, is spending on computers ($79 B ) and network equipment ($77 B).  The 3rd largest sub-category after software is medical equipment at $72 B.
So the largest single spending area for fixed assets is for software which is a virtual asset! Henry Ford must be spinning in his grave!
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Demystifying The Price of Gold

Economic Reality, Financial Crisis

Putting long-term savings into GICs is turning out to be riskier than investing in hard asset such as precious metals, land, or other commodities such as oil, copper, etc.

The World Gold Council just published a historical view of central bank “balance sheets” since the 2007 crisis: (click on the chart if you need to make it larger)

A central bank’s “balance sheet’ is a relative measure of money supply.  Although there are more exact measures of money supply, when you see a central bank’s “balance sheet” tripling in the case of the USA, or quadrupling in the case of the UK, it really doesn’t matter which one you use and this one is good enough to understand the price of gold.

The buying power of money over time reflects the forces of supply & demand in an economy.  Basically you have money supply on the one side and economic demand for money on the other (i.e. the size of the economy).  If these are not in balance, then inflation or deflation will occur.

  • Suppose a country has $1 T dollars and an economy measured using a hard asset (like gold) worth $1 T dollars.
  • If the economy grows, as it has since 2007, by roughly 2% compounded per year, it will have grown 10.4% after 5 years – i.e. to $1.1 Trillion.
  • If money supply had stayed constant, each 2007 dollar would be able to buy 10% more in 2012 than it did in 2007 since there is more economic value for the same amount of dollars.
  • But if the money supply tripled over the same time period, as it did in the USA, there would be $3 T dollars to balance that $1.1T in economic activity.
  • So each 2012 dollar is actually worth 1/3 x 1.1 = $0.37 compared to its buying power in 2007.

Can that be true?

  • Consider that the price of gold on Jan 2, 2007 was $639.75 in USD.
  • On Oct 18, 2012 it is $1752 in USD.
  • Deflating back to 2007 dollars, we get $1752 x 0.37 = $642.33!
  • Not quite spot on since we used an average of 2% for economic growth over 5 years instead of individual values.  But you can plainly see what has happened.

By inflating the money supply beyond the natural growth in the economy, the buying power of our long-term savings has dropped by 60%.  The reason why we haven’t seen prices radically increase depends on the type of good:

  • Any commodity which is consumed by economic activity (oil, copper, iron, etc.) will have its price primarily determined by the forces of supply and demand for that commodity (to establish a value) and secondarily by the buying power of money (to establish a price for that value).
  • As an example, we’ve seen a significant increase in the cost of oil & gas but this increase is also affected by global consumption of the fixed supply of oil.  Recently global consumption has been dampened by the global recession being experienced everywhere except Asia, causing a drag on what would otherwise be a soaring price.
  • A manufactured good contains both commodity and labour as inputs.  While the input commodity prices in a manufactured product like a refrigerator or car has increased, the labour cost has decreased since most manufacturing has moved to low cost labour centres such as China, Thailand, and Vietnam.
  • Cheap labour has acted as a brake on inflation in developed economies – effectively exporting the inflation problem to Asian economies.  As an example, the official inflation rate in China has been 2 – 4x the North American rate since 2007 and the actual rate is widely believed to be higher than the official numbers.
  • A precious metal such as gold, or a non-consumable good such as land, will act as a perfect reflector for the buying power of money.  For example, although the value of land in the USA was artificially depressed by the explosion of the housing market bubble in 2007, the price of housing in economies unaffected by that crash, such as Canada, has soared.
  • Much of this increase is not due to another bubble forming, but due to the decline in the buying power of the dollar.  In other words, the house is still worth what it was in 2007, it just takes more 2012 dollars to buy it since a 2012 dollar buys less than a 2007 dollar.

So if you think that the banking crisis is over in Europe and that the USA can afford its ridiculous debt levels without either raising taxes or cutting military spending, then go ahead and invest your hard-earned savings in GICs.

Or you can invest some of your savings in gold as a safe hedge against further erosion of your buying power in future.

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Ontario Just Killed Contracting

Canadian Politics, Economic Reality

The surprise changes made to the Ontario Employment Standards Act has effectively killed the contracting option for unemployed professional or white collar staff.

Under the new changes to this law, there is no such thing as a “contractor” unless an individual works for his or her own independent consulting company.  Anyone reselling the services of another is deemed to be an employment agency and the contractor is deemed to be an employee of that agency.

This means that the “agency” must provide the “employee” with severance even if they have not been on assignment when the “employment” ends and holiday pay even if the contractor does not work on a statutory holiday!! The “agency” cannot protect themselves by charging a finders fee in the event that the client ultimately hires the contractor.  So who in their right mind would ever contract out work to an Ontario resident?

In the past, The Lanigan Group and a great many other small consulting businesses would subcontract out overflow work that they could not handle with their staff.  Often this work would go to subcontractors who more often than not were temporarily unemployed professionals.  These assignments would often help bridge that professional until they could find a full time job.  In fact, according to the Canadian Federation of Independent Business, fully 22% of all “self-employed” persons in Ontario pursued contract work because they were in-between full time jobs.

However, the Ontario government, in their zeal to “protect” temporary employees, has now made it prohibitive for small consulting businesses to continue that practice.  Now overflow work will either be directed outside of Ontario to contractors, or to another incorporated consulting company.

Over 60% of small businesses in Ontario are sole proprietors who are unincorporated.  In fact there are 21% more unincorporated sole proprietors than paid employees in Ontario.  As a result of this new law, NONE of them have any hope of obtaining contract assignments unless they are fortunate enough to find their own contracts.

It’s difficult to see how these changes to the law help reduce the high unemployment rate in the tech sector in Ontario.  Perhaps if the Ontario government had actually taken the time to consult with industry before killing the practice of technology contracting, the economy might actually have recovered next year for those in the tech sector.

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Bank of Montreal Credit Rating Slips

Financial Crisis

Credit Downgrade

Moody’s announced that they were reviewing the BoM’s credit rating in anticipation of downgrading it this week.  They are concerned over the health of BoM’s US-based Harris banking unit but otherwise do not appear to be concerned over the BoM’s asset quality.

That is not a view shared by the DBRS rating agency whose most recent credit ratingreport indicates that they are very concerned over the BoM’s continuing exposure to $6 B in loans to prop-up off-balance sheet Structured Investment Vehicles.

In fact the DBRS report bluntly states that they rate the BOM’s debt as high as AA(low) only because they believe that the Canadian government will offer “systematic and timely external support” to BoM.

Other analysts are also concerned over the continuing SIV exposure.  This is due to the  fact that:

  • the market value of these derivatives is significantly less than the bailout loans provided by BoM and
  • the BoM continues to publicly deny that they have a problem here.

SIV Exposure

So how much of a problem does the BoM have with SIVs?  It’s on the same scale as the Israeli problem with Iran’s nuclear program.

According to the BOM’s published Q3 Supplementary Financial Information, the total Regulatory Capital of the bank is $24 B.  That’s the amount of real investor capital put into the BoM.  As previously described in earlier posts, banks inflate this asset by also counting the loans that they have made as “assets” since those loans generate interest revenue.

The total BoM’s “asset” base of $334 B includes $65 B of derivatives of which $49 B are securitized assets.  According to the Q3 Supplementary Report, 90% of the $49 B is impaired and a full $37 B is rated as having a high risk of default ( Risk weight >7%).

Prudently the BoM has reserved $735 M of capital against this risk, however, that provision will be about as effective as a fart in a thunderstorm should these derivatives prove worthless.

Given the recent signs of economic recovery, it is likely that not all of the $37 B will tank.  A risk weight of >7% means that roughly 1/2 of these loans will likely default in 5 years (1.07^6 = 1.50).  Many analysts believe that the $6 B in SIV loans made to support Link SIV and Parkland SIV are at greatest risk however.

To put the danger posed by $6 B in bad loans in perspective, the BoM’s entire quarterly revenue in Q3 was $3 B and its net income is currently approximately $1 B / quarter.

Hence, a $6 B default can cause a life-threatening liquidity crisis that would require a government bailout to prevent outright bank failure.

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BMO Q3 Update

Financial Crisis

Interest Rate Exposure

Banks are experts at  financial obfuscation when reporting their results.  The latest Q3 reports from the Bank of Montreal are a great example of this.

On page 11 they describe their exposure to risk in interest rates in a reasonably positive light: for each negative change in interest rates by 100 basis points they lose $231 M on their loan book, but if interest rates go down the same amount (highly unlikely by the way), they make $204 M.

What they don’t tell you is that due to the structure of their interest rate gap position (which you can see if you dig into BMO’s Q3 supplementary statistics) the actual exposure is $333 M decrease in asset value for the first 100 basis point increase and a whopping $706 M decrease for a 200 basis point increase.

But asset value is only part of the story when it comes to Banks.  The real question is how is the bank making money on those loan “assets”?  After all it doesn’t matter if the asset is more valuable if the bank loses liquidity by carrying it.

So what is really revealing in the supplementary statistics is the fact that the Bank’s interest earnings will go down no matter which way interest rates move!!

A 100 basis point increase causes earnings to drop $27 M while a 100 basis point decrease causes earnings to drop by $51 M!!  Heads you lose and tails you lose.

So How Is BMO Doing?

BMO’s Q3 results are not encouraging.  At best, the bank is treading water.

For example, despite having $413 B in assets, it’s cash position of $10.7 B is basically flat compared to the previous quarter.  Although liquidity improved by about $500 M, 80% of this was due to the fact that BMO issued $400 M in preferred shares during the 3rd quarter.

Thin liquidity is very dangerous for a bank.  A bank may crow about Tier 1 capital ratios, but it is liquidity that determines whether they stay in business or not.

BMO’s loan book is still toxic.   The sum of PCL+GIL (sick and sicker loans) is 3.3 B largely unchanged from Q2 to Q3.  PCL is Provision for Credit Losses (loans the bank admits are dead) and GIL is Gross Impaired Loans (loans that are not being paid back).  And of the loans that BMO has yet to admit are bad, according to the BMO’s own risk weights, $37 B (nearly 10% of the entire loan book) are so risky that they are statistically likely to default within 5 years.

To put this in perspective, BMO’s non-investment grade loans  is 10x higher than the amount (in total dollars) the Royal Bank has in the same risk categories.

Looking at BMO’s Canadian delinquency ratios, Q3 personal loan and mortgage delinquency ratios are unimproved in Q3 over the past 3 quarters, and credit card delinquency ratio has increased quarter over quarter for the past 4 quarters.  BMO’s US delinquency ratios have deteriorated in all categories quarter over quarter for the past 4 quarters.

Meanwhile BMO’s market share is slipping with quarter over quarter declines in Canadian personal loans, mortgages, retail deposits and commercial loans.

Overall Moody’s rates the BMO’s financial strength as B-grade risk with a negative outlook.  For the most part, BMO’s ratings by S&P, Moody’s,  DBRS and Fitch are generally one notch less than the Royal Bank’s ratings.

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China’s Gold Reserves Up 75% In 6 Months

Financial Crisis

It’s obvious from the recent global reserve statistics published by the World Gold Council what is replacing China’s waning interest in US Treasuries.

China has nearly doubled it’s gold reserve holdings in the past 6 months, increasing gold holdings to over 1,054 Tonnes of gold.

Meanwhile recent sales of gold by European countries were basically offset by an increase in gold buying by Russia over the past 6 months.

No doubt this as been the main reason for the recent increase in the price of gold to over $1000 an ounce.

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US Inflation Warning

Financial Crisis

Although economists were expecting a $23 billion inflow of capital due to foreign purchases of all US securities, recent Treasury International Capital data showed there was a net outflow of $31.2 billion.

This means that foreign investors are less willing to subsidize the US economy in general.  An important subset of this total is the market for US Treasuries and T-Bills since the market for this debt sets the interest rate benchmark for all other debt.

China is the single largest foreign holder of US Treasury debt – to the tune of $776 Billion out of a total of $3.4 Trillion and China reduced this holding by approx $25 B from May to June 2009. Interestingly  Russia, the 7th largest holder of US Treasuries, has also reduced its holdings by $20 B since March.  Maybe the commies aren’t so dumb when it comes to economics after all.

As China’s appetite for U.S. Treasuries wanes the yield for U.S. Treasuries will have to go up. This will suck more money out of the economy just as the Fed is trying to pump it up to prevent further economic collapse.   The other alternative is for the US to devalue its currency either overtly (not likely) or with the help of inflation (far more politically expedient).

This is bad news for the Canadian high tech and manfacturing sectors that depend heavily on a low Canadian dollar.  A devaluation of the USD means a higher Cdn dollar and also the illusion of higher prices for oil, resources, and gold which are normally denomiated in USD.

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Grim Outlook for US Banks in 09

Financial Crisis

According to RBC Capital Markets, more than 1,000 US banks may fail over the next 3 – 5 years as commercial loan losses pile up.  This would be on the same level as the great savings & loan collapse back in 1988 – 1990 when 1,386 lending institutions failed.

To put that into perspective, according to the US Federal Deposit Insurance Corp, FDIC, there are 8.309 lending institutions in the USA and only 25 failed in 2008.  Yet 9 have already failed in one month so far in 2009.

The Royal Bank’s recently published Q109 financials also bear witness to the sorry state of US banking.  The Royal’s Provision for Credit Losses (PCL) in US banking soared from $10M in Q107 to $71M in Q108 to $200M in Q109 = 75% of the total PCL for the Royal Bank. 

Royal Bank Gross Impaired Loans

The Royal’s US Gross Impaired Loans (GIL), illustrated above, – which are loans that are highly likely to become credit losses – also soared from $0.1B in Q107 to $0.6B in Q108 to a staggering $2.2B in Q109 = 63% of the total GIL. 

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The day the music on hold died

Canadian Politics, Economic Reality, Virtual Reality

Helping Nortel

Today Nortel became another casualty of the deepening financial crisis by filing for creditor protection.  Amazingly the Canadian federal government, fresh from extending billions of dollars of credit to the auto industry of the past, managed to scrounge up all of $30 M in credit financing for the digital industry.

What a joke.  $250 Million for GM vs $30 M for Nortel.  GM with all of 19,000 employees in Canada is smaller than today’s Nortel that weighs in with 26,000 employees (mostly in Canada) – let alone the Nortel of yesteryear that once employed 95,000 with over 20,000 in Ottawa alone. 

Perhaps the fact that our federal finance minister is the member of parliament representing the GM employees in Oshawa has something to do with the smell of conflict of interest in this.

Meanwhile, McGuinty’s Ontario government is actually bragging about how they turned down Nortel’s application for financing under the NGOF pork barrel.  But McGuinty can find easily find $8 M to create 133 jobs at some outfit called Cyclone Manufacturing – is this a way to ensure that Ontario is a global leader in anything?

When, Nortel, the largest and one of the oldest companies in Canada is in trouble, our politicians don’t give a shite.  As recently as 2001, Nortel alone was 1/3 of the entire value of the TSX.  If job creation was actually important to our provincial government, a reasonable person might expect them to consider helping companies that actually have proven that they can employ Canadians in high tax-paying jobs.

Nortel’s Legacy

The impact of Nortel on the global economy across the 115 year history of the company is impossible to count. 

Every time you pick up a touch tone phone, use digital communications of any kind, experience broadband Internet access enabled by optical technology, or DSL, or high speed wireless – you are using technology invented by Nortel.

Every time you access your bank or brokerage account online, or use your mobile phone, you are riding on one or more protocols designed by Nortel. 

The first corporate email system in the world was built by Bell Northern Research.  So was the first use of digital packet communications, high-speed fibre optic rings, etc.  These are the very foundations of the Internet.

Nortel’s impact on the tech sector extends far beyond communications.  Engineers at Bell Northern Research contributed enabling technology to the electronic design community, distributed computing, advanced man-machine interfaces such as speech recognition, visualization graphics, dignital signal processing, etc. 

Nortel’s patent portfolio extends across Wireline, Wireless, Datacom, Enterprise and Optical technologies and services.  As of December 31, 2007, Nortel had approximately 3,650 US patents and approximately 1,650 patents in other countries. In fact Nortel has consistently ranked in the top 70 in terms of number of granted U.S. patents since 1998. 

Nortel has received patents covering standards-essential, standards-related and other fundamental and core solutions, including patents directed to CDMA, UMTS, 3GPP, 3GPP2, GSM, OFDM/MIMO, LTE, ATM, MPLS, GMPLS, Ethernet, IEEE 802.3, NAT, VoIP, SONET, RPR, GFP, DOCSIS, IMS, Call-Waiting Caller ID and many other areas.  The term “standards-essential” means that the technology would not be viable without the contribution of Nortel’s engineers.

My own career at Nortel was relatively brief, but in the less than 10 years that I was there I personally witnessed meetings where Nortel’s engineers educated IBM, HP, Intel, Cadence, Mentor Graphics, Microsoft, and a hundred other companies on advanced technology.  The spin off impact of those meetings alone on the tech industry was incalcuable.  Intel actually modified silicon designs, HP introduced new products, and Cadence & Mentor acquired new technology to rev up their revenues.  These were non-patent related discussions.

Nortel was the largest spender on R&D in Canada through both direct investment in its own labs and through leveraged investment in university interaction.  Literally thousands of doctoral degrees in Canada were made possible though collaborative research with Nortel over the years.  Even the scaled back Nortel of today spends more than 1/3 of its salaries on R&D jobs for Canadians.

Yet McGuinty is proud of denying Nortel’s call of distress?  Shame on him.

Broken Backs

We get what we vote for.  Our politicians both federally and provincially have demonstrated that they would rather prop up the resource sucking industries of the past than enable a modern Canadian economy of the future.

The fact that the digital economy can create more numerous, more interesting, and higher paying jobs for Canadians compared to the back-breaking and mind-numbing jobs of the resource and manufacturing sectors is completely lost on our politicians. 

Perhaps it is because we elect lawyers and not engineers to parliament?

Is the real problem with Canadian voters who sleepwalk their way to the polls if they bother to vote at all? Do Canadian parents not care about the quality of jobs that will be available for their children? 

Why do we tolerate this ineptitude from our politicians?

Yes Nortel’s management laid the seeds for its destruction.  John Roth in particular is to blame, as is his successor Frank Dunn who is now facing charges for misleading shareholders and gross stupidity. 

Nonetheless, allowing Nortel to die is the wrong policy decision for both the Canadian economy and the high technology sector of Canadian industry.  Write your MPP and MP and give them a shake!

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Yet Another Huge Bank Failure in the USA

Financial Crisis

Up until last year, CitiGroup was the largest bank in the USA and in the top 3 globally.  Now Citigroup is breaking itself up as it desperately tries to avoid total collapse:

  • Citi is selling its Smith Barney brokerage and investment business to Morgan Stanley so that it can raise $2.7 B in emergency cash.  Citigroup is selling 51% of Smith Barney now followed potentially by another $2.5 B to follow within 5 years if Morgan Stanley decides to expand its ownership of Smith Barney.
  • Citi is also jettisoning 1/3 of its loan book by spinning off $600 B in bad “assets” into a seperate “bad bank” that can be further broken-up and sold off to the US government and other high-risk junkyard investors.

To put the size of this spin-off in a Canadian perspective, the resulting “bad bank” will have 50% more “assets” than the total assets of the Bank of Montreal and slightly more “assets” than the TD Bank.

The $1.2 T magnitude of the 2009 US economic bailout is approximately equal to the size of the entire Canadian GDP.  According to Statistics Canada, the Canadian economy is dependant on exports for 45% of this GDP and 76% of those exports are based on trade with the USA.  However, Canada’s trade surplus is currently plumeting with November 2008 exports running at 50% less than September’s export volume. 

The worst of the fallout has still to hit the Canadian economy and ultimately Canadian banks.  Given the rate of erosion of exports, this will likely occur within 90 days if the balance of trade dips negative.  

In the last 6 months, the largest (Citigroup) and thrid largest (Wachovia) banks in the USA have crumbled – anyone who thinks that the Canadian banking industry is immune to these issues is simply not in touch with reality.

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Is The Bank of Montreal About To Fail?

Financial Crisis

Danger Signals

On December 15, the Bank of Montreal successfully issued a round of new common and preferred shares to raise $1 Billion in shareholder equity.  This pushed the BMO’s Tier 1 ratio to 10.4%.

However, to sell this equity the BMO had to price the common shares at a 9.5% yield!  Danger Signal #1 is a yield that is significantly above the rate that investment grade securities are priced.  For example, Enbridge is priced to yield 3.8%, Transcanada Pipelines at 4.4%, Manulife at 5.5%.

Danger Signal #2 is that other peer banks have yields that are priced considerably lower.  For example, the Royal Bank is priced to yield 5.8%, TD is at 6%, Scotiabank at 6.5%, CIBC at 7.3%.  They average 6.4% , or 1/3 lower than the BMO.

Danger Signal #3 is that the total BMO market capitalization ($14.9 B) is now less than shareholder equity ($17.9 B).  In other words, the BMO is worth less than the amount that shareholders invested in it and regardless of the high Tier 1 ratio, the Bank is worth considerably less than its Tier 1 equity.

When this happened to Wachovia in July 2008, the bank failed in Sept.  When Wachovia failed, its total shareholder equity was $73 B – almost 5x that of BMO.   Wachovia failed quickly – within 90 days.  On Oct 28, the BMO’s market capitalization was $33 B.  Today the BMO is worth half that amount.

BMO’s Bad Assets

According to the BMO’s 2008 Financial Report, the BMO is carrying about $8.7 B in bad assets – fully half of its market capitalization:

  • Bad loans total $3.7 B.  Of significant concern is that $2 B of this amount is so-called “formation of new impaired loans” – i.e. was suddenly added in 2008 alone.  Half of these new impaired loans are attributable to losses in the manufacturing sector and in US real estate.
  • Collateralized debt and loan obligations total $4.5 B.  Most of this is hedged with other banks which is great in theory as long as there is no counter-party risk.  However, in October inter-bank lending actually dried up due to fear of counter-party risk!
  • Subprime mortgages and asset backed securities total another $0.5 B.

The BMO also has $99 B in off-balance sheet credit loaned to its clients.  If only 10% of these default, then the total bad loans of the bank will double.  Remember Enron?

The final straw that broke Wachovia’s back was when bad debts equalled more than the paid in equity of the bank.  When that happens, the bank is insolvent.  The BMO is halfway there!  If its market capitalization falls by another half in another month, or if 10% of its off-balance-sheet lending defaults, or if some combination of these two events occur, the First Canadian Bank will be history.

Other CDN Banks

A quick health test of the other Candian banks shows that they are in much better shape than the BMO:

  • Royal Bank has a
    • market cap of $45.5 B which is almost 2x shareholder equity at $24.4 B.
    • yield of 5.5% which is below the peer group average for Canadian banks
  • Scotiabank has a
    • market cap of $29 B which is 1.5x shareholder equity at $18.8 B
    • yield of 6.5% which is roughly equal to the peer group average
  • CIBC has a
    • market cap of $18.5 B which is 1.3x shareholder equity at 13.8 B
    • yield of 7.3% which is above the peer group average (suggesting risk)
  • TD has a
    • market cap of $33.4 B which is slightly more than shareholder equity at $31.6 B
    • yield of 6% which is below the peer group average.


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Bailout Madness

Financial Crisis

According to the New York Times, the US government has committed $3.1 trillion as an insurer, $3.0 trillion as an investor, and $1.7 trillion as a lender.

However, the Times omits roughly $5 trillion in guarantees made by Fannie Mae and Freddie Mac that are now officially on the government balance sheet.  The total of commiitted bailout funds (without any auto industry funding) is now at $12.8 Trillion.

US GDP is about $14 trillion per year; the budget deficit in recent years has been running in the half-trillion range.  So that means that the total government spending is roughly 13.3 / 14 T = 95% of the entire US GDP!

The US government is betting that actual spending will be less – provided that that banks can repay some of these loan guarantees and preferred securities.  But with dominos now falling across the US auto and other manufacturing sectors, and with the housing and construction sector in the toilet, it is not hard to imagine a second phase to the banking crisis that serioiusly impairs these repayments.

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Mortgage Pain

Financial Crisis


Over 279,500 homeowners in the USA received a foreclosure notice in October – up 5% from September.  According to RealtyTrac, a website that has found a way of profiting from this problem by becoming a clearinghouse for foreclosure-related information, by the end of this year 1/3 of all US homes that are for sale will be bank-owned properties that have been repossessed. 

That represents over 1 million homes.

Can it be that all of those mortgages should never have been granted in the first place?  No. 

Many of these homeowners were credit worthy, but too highly leveraged, property owners.  The foreclosures of the bad mortgages early during the meltdown sent all house prices down the toilet as banks sold at pennies on the dollar to raise cash.  These legitimate property owners were then caught in a situation where their mortgages were considerably higher than the value of the house.

So if you have negative equity in your home, why would anyone pay it off just to make their bank wealthy?


For example, in Northern Virginia where 1 in 200 homes has been repossessed by a bank, this 2700 sq foot home is worth $700 K and has been repossessed. 

Does it look like it could have ever been owned by someone who did not have a decent income?  I used to live near this Great Falls location which is about 30 minutes drive from the US capitol.


In Nevada, 1 in 80 homes has been foreclosed.  In Florida, the foreclosure rate is 1 in 157.


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Anatomy of The Financial Crisis

Financial Crisis

Originally published October 9, 2008 in Facebook.

Subprime Loans

The US subprime mortgage market was approximately $400 B. Nearly half of these loans were enhanced by so-called piggyback loans to help borrowers pay for the equity portion of the first mortgage. It was common for a first mortgage to cover 80% of home value (underwritten by Freddie Mac) and instead of the 20% buyer equity, the piggyback loan (usually from the same bank) would cover the difference – i.e. a second mortgage but with virtually no lien on the property.

Since the first morgage was secured by Feddie Mac, it was easy for the originating bank to sell it to other institutions, so the bank only needed to fund the piggyback portion of the loan. And since, those banks operated with 10x leverage ratios, they only had deposits & equity to cover 1/10 of those bad loans. 1/10 x 20% x $400 B = $8 B. Trouble indeed as the estimate for defaults on those mortgages has esclated from approx 20% to 40%.

Bank of England


The first mortgages in turn were purchased by large lenders who pooled loans of varioius quality which were sold to investment banks who in turn issued preference tranches on each pool. Top tranches would be paid out first, lower tranches would be paid out later, thereby artificially creating different instruments with different levels of credit grade. Since major banks operate with a leverage ratio of appoximately 6:1, the securitized MBS must have had a book value of approx 6 x $400 B x 80% = $2 Trillion.

Bank of England

At the start of the crisis in 2007 as defaults mounted on the mortgages, the market for the MBS securities started to dry up. As shown in the chart above the estimated total impact of impaired MBS securities is $160 B.  The immediate problem facing banks was the rapid increase in their funding requirements when they could not securitise or otherwise distribute their loan warehouses. Banks began to hoard liquidity to meet actual and potential increases in these funding requirements, causing interbank rates to spike during August and September 2007.

Structured Credit

Towards the end of 2007, banks began announcing substantial losses on their own holdings of structured credit products. That $2 Trillion of market value was starting to unwind. Current estimates (see below) show that the structured credit market losses are in the vacinity of $400 B (so far).

Bank of England

Counterparty Risk

An element of counterparty credit risk began to influence interbank lending decisions. Some banks could not gain unsecured funding, amplifying their financing difficulties. As the end of the year approached, banks sought to increase their liquid asset positions, in part to strengthen the appearance of their reported balance sheets. This was a major contributing factor to the rise in London interbank offered rates (Libor) internationally in early December. This was alleviated to some extent by co-ordinated central bank action on 12 December 2007 causing money market conditions to improve during January 2008.

In February and March 2008, however, money markets tightened again as banks reported significant additional write-downs on ABS and the prospect of losses on exposures insured by monolines increased. Central banks provided a second round of co-ordinated liquidity provision on 11 March 2008.

However, by Aug/Sept 2008 not just the originating bad lenders have gone under, but also the major investment banks and large US lenders that created the MBS mess have failed (or been forced to merge). This has extended the counterparty risk substantially to international banks and the dominos continue to fall.

Bank Failures

We are now seeing bank failures in UK, Germany, Holland, and Iceland. These will in turn extend the imprint of counterparty risk and cause even more bank hoarding. Banks hoard by declining to deal with other banks and by raising credit costs to businesses and consumers. The impact on business is growing with each passing week. Already 20% of all US car dealers are facing bankruptcy as they cannot finance their inventory due to tighter credit imposed by their banks and a drop-off in spending by consumers who can’t afford to pay the rising interest on their mortages.

Substantial interest rate cuts will be necessary to improve bank margins (making it easier for them to hoard cash) but don’t expect to see any of it in your personal credit card, car loans, or mortgages and certainly not in your business lines of credit, lease rates, etc.

Coupled with over $1 Trillion so far in bailouts in the USA and UK to guarantee the bad loans and ensure bank creditworthiness, we can expect serious degredation in the buying power of cash. Only by devaluing the purchasing power of the dollar can the central banks suck excess liquidity out and devalue the bad loans at the heart of it all.

So don’t be surprised when everything costs a lot more this time next year.

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