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THE CANADIAN ESCAPE FROM THE AMERICAN SUBPRIME CRISIS?

THE CANADIAN ESCAPE FROM THE AMERICAN SUBPRIME CRISIS?. 2 nd CUTS-CIRC Conference: Tuesday April 19 2011 15:00-16:30 New Delhi Derek Ireland - Carleton University Ottawa Kernaghan Webb - Ryerson University Toronto . Two Quotes That Explain A Great Deal.

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THE CANADIAN ESCAPE FROM THE AMERICAN SUBPRIME CRISIS?

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  1. THE CANADIAN ESCAPE FROM THE AMERICAN SUBPRIME CRISIS? 2nd CUTS-CIRC Conference: Tuesday April 19 2011 15:00-16:30 New Delhi Derek Ireland - Carleton University Ottawa Kernaghan Webb - Ryerson University Toronto

  2. Two Quotes That Explain A Great Deal … we knew there were a number of such practices going on, but it’s very difficult for banking’s regulators to deal with that. Alan Greenspan (2007) … The only thing we got wrong was how bad banks’ lending practices were, how nontransparent banks really were, and how inadequate their risk management systems were. Joseph Stiglitz (2008)

  3. Two Major Arguments for the Canadian Escape • Some aspects of the Canadian financial regulatory regime may be superior • But non-regulatory factors are also important • Market structure, business culture, timing, luck • Despite these regulatory and non-regulatory mitigating factors • Subprime practices were starting to creep into Canada in 2006 • Political economy realities cannot be ignored

  4. Overview of the American Subprime Boom and Collapse • Huge growth in subprime mortgage market • Twenty-fold increase in absolute value over a decade • Accounting for more than 20% of all residential mortgages by mid-2000s • 80% had adjustable rates

  5. Overview (continued) • Major deterioration in borrower and product quality and underwriting standards by 2005 • Housing and Subprime Markets in freefall by early 2007 leading to • Global financial crisis and recession of 2008-2009 • And a tepid and uncertain economic recovery in the United States and many other OECD economies

  6. Major Features of the Boom and Collapse • Bipartisan support for American home ownership for at least two decades • Low interest rates and high liquidity through most of the 2001-2008 period • Never ending search by highly competitive financial sector for • More innovative and profitable low risk products

  7. Major Features (continued) • Substantial increases in house prices • House becomes a “piggy bank” to support consumption • Leading to large and geographically concentrated target markets for high risk subprime mortgages • Permissive regulatory regime with major gaps

  8. Causative Factors from a Demand Side Perspective A Perfect Storm Throughout “Subprime Value Chain” • All the things that could go wrong did go wrong • Based on economic literature of last 40 years Information asymmetries, product complexity • And behavioral biases/mistakes at every stage • From the household, through the mortgage issuers, other financial intermediaries and regulators • Ending with politicians and senior government officials who believed that financial regulation was no longer needed

  9. Causative Factors from a Demand Side Perspective (continued) Fundamental principal-agent • Incentive alignment problems • And conflict of interest and corporate governance problems • Including moral hazard, adverse selection/”market for lemons”

  10. Causative Factors from a Demand Side Perspective (continued) Over-confidence of all participants • Interest rates would never go up • House prices would never go down • Credit rating agencies were doing their job • Mortgage brokers and issuers and financial advisers and intermediaries were serving their customers’ interests • Financial intermediaries knew what they were doing • And would not place the entire sector at risk • Markets would function exactly as described in microeconomics textbooks

  11. Causative Factors from a Demand Side Perspective (continued) Overly complex and rigid contracts • Shifted most of the risk to the most vulnerable groups • Low income households, small business and the taxpayer • The most complex high risk mortgages were issued to the least experienced consumers

  12. Causative Factors from a Demand Side Perspective (concluded) As demand side components • Of systemic risk and financial market contagion • Were ignored or misunderstood • No recognition that consumer protection laws are needed to • Protect consumers from excessive risk • And protect financial institutions and systems from excessive systemic risk

  13. Why the Canadian Escape – Importance of Many Factors • More complete and comprehensive regulatory system • Few regulators monitoring and working closely with comparatively few regulatees • Oligopoly financial markets and industries • Traditional “boring” retail and other products and lending practices still highly profitable • More risk averse and less innovative banking, corporate, consumer, and government cultures

  14. Why the Canadian Escape (continued) • Much smaller and less geographically concentrated target markets for high risk mortgages • And perhaps greater awareness of the needs and vulnerabilities of financial consumers • Political decisions in the late 1990s that impeded the “going global” strategies of the five largest banks • Later introduction of high risk mortgages into Canada • Result was fewer information, behavioral, incentive alignment, risk and related demand-side problems

  15. And Yet, With New More Laissez-Faire Canadian Government in 2006 • Subprime and other higher risk mortgages, practices and economic agents in 2006-2008 period were • Creeping into Canada, gaining a foothold and building momentum • Becoming increasingly popular in the high growth western provinces • Accounting for a rising proportion of all mortgages – at least 5% by 2007

  16. And Yet (continued) • If American collapse had come three years later • Canadian problem could have exploded from modest to substantial • Pure conjecture but consistent with • Federal government’s Financial Literacy Taskforce • And tightening of mortgage rules by the Canadian government in 2008 and 2010

  17. Final Thoughts on the American Crisis and Canadian Escape (?) • Alleged Canadian regulatory superiority provides only part of the answer • Explaining the Canadian/American differences • And identifying possible lessons for financial market regulation and re-regulation in the future • Requires appropriate attention to demand side factors • And political economy context and realities • In short, a more holistic approach to regulatory analysis and reform Thank You – I Look Forward to Your Comments

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