For a while there, it seemed like the fair-weather types on Bay Street, and elsewhere in the financial world, had it right. We could all sit back, put our feet up and relax.
The tempest that convulsed the world's capital markets in late July and early August would be short-lived. Even those of us who were enjoying family vacations when the turbulence hit could hardly overlook the alarming reports on TV and radio newscasts and the startling headlines that appeared on the front pages of our newspapers.
Stock-market indexes were tumbling from the record highs achieved just a few weeks earlier. Lenders of every sort suddenly became wary of putting money into products that had, only a short time before, held out the promise of good returns. Central banks in the U.S., Canada, Europe and elsewhere responded by pumping some US$300 billion into financial markets to maintain liquidity.
Fear and uncertainty suddenly took hold of investors and all the trouble originated in the U.S. sub-prime mortgage business, a small and rather arcane part of what is now a vast, global financial system.
Sub-prime mortgages are a relatively new financial product, first made available in the late 1990s to low-income Americans, many with poor credit records, who previously would not have qualified. Lenders were taking a little extra risk, which seemed reasonable enough when the job market was booming, interest rates were low and inflation stable. At the same time, the lenders could grow their businesses by reaching out to millions of people who had never before owned a house.
"By 2006 sub-prime mortgages accounted for a fifth of all home loans," according to Sebastian Mallaby of the Washington Post, "and the social consequences were marvellous.”
These loans have created some 12 million new homeowners, about half of them from racial minorities. They have also boosted the rate of home ownership in the U.S. to 69 per cent whereas it had been stuck at about 65 per cent from the mid-1950s to the mid-1990s.
So far, so good. The problem is that some of these high-risk borrowers are now in arrears while others are defaulting on their obligations. Their sub-prime mortgages are disrupting international financial markets because American lenders packaged them and sold them as securities to financial institutions around the world.
Many of these institutions in turn put them into investment funds comprised of similar asset-backed securities, which they peddled to buyers in their domestic markets. In this country, the Canadian Imperial Bank of Commerce has disclosed that its third-quarter results will include a $290-million writedown ($190 million after tax) to take account of its sub-prime holdings and the falling value of those assets. But it appears to be the only Canadian chartered bank with exposure to this segment of the market.
Political leaders, financial analysts and many voices in the business pages have downplayed the potential repercussions and fallout - a sentiment nicely expressed in a Globe and Mail headline that read: "Don't let subprime tremors ruin the party."
Others have taken a more dire view. They have been warning for months that the meltdown in the sub-prime market is part of a wider problem - a credit bubble caused by low interest rates and easy access to money that has led to inflated prices and values - and they foresee a day of reckoning.
According to Eric Sprott, founder and chairman of Toronto-based Sprott Asset Management, we have been living for the past five years or so in a "world of easy credit, copious liquidity, seemingly riskless investment and overtly reckless financial engineering.
"It was a world where the prices of commodities and capital projects could double, even triple, and yet inflation could still be reported as subdued," Sprott wrote earlier this year in his monthly electronic newsletter Markets at a Glance. "It was a world where just about anything could be bought with leverage (even houses with no downpayment) and all the risks could be pawned off to the burgeoning derivatives market."
Sprott contends that those analysts who say the damage will be confined to the mortgage market are indulging in wishful thinking. "As calamitous as the sub-prime blowup seems, it is only the beginning," he argues. "The credit bubble spawned abuses throughout the system. Sub-prime lending just happened to be the most egregious of the lot, and thus the first to have the cockroaches scurrying out in plain view."
In his view, easy money has led people with good jobs and solid credit ratings to overextend themselves. It has driven housing prices and share values to unrealistic levels and it has fuelled consumer spending. It was all unsustainable in the long run and, so, what happens next?
"The housing market will collapse," he writes. "New-home construction will collapse. Consumer pocketbooks will be pinched. The consumer spending binge will be over. The U.S. economy will enter a recession."
If that happens - and let's hope it doesn't - you can bet that the Canadian economy will go into a tailspin as well.
(D'Arcy Jenish can be reached at jenish@businessedge.ca)
