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 Whistleblowers Need Protection


How '08 went bust

It began with a general feeling that the economy, though struggling, would be fine. Then the mortgage crisis hit. Then the bottom fell out. Now, market players are in shock.
By JESSICA LEEDER, Globe and Mail
December 26, 2008

"I do not have a hangover and I am in good spirits." This is how the grey-haired, grin-inducing Ira Gluskin, a dean of wealth management in Canada, began his first formal address to clients this year.

Having recharged over the holidays at his Florida retreat, he put pen to paper on the first morning of 2008 and etched out a two-page rambler in the whimsical, shoulder-shrugging tone that is his trademark in things of this sort. Mr. Gluskin uses it to coax his roster of multimillion-dollar clients (one must invest at least $2-million just to get in his 46th-floor door) to imbibe the financial wisdom that elevated Gluskin Sheff & Associates, the firm he helped found in 1984, to elite status.

He also uses it as a salve to reduce inflammation among worried investors. "In a nutshell, the problems of the U.S. economy are very real, but the stock market has already discounted most of them," he wrote, going on to quip: "Our little firm buys stocks. If and when they go down faster than they go up, we are highly embarrassed."

Back then, Mr. Gluskin, who spent most of a recent hour-long interview with The Globe and Mail in his stocking feet (striped navy, pastel pink, white and baby blue, elevated on the seat of a sleek boardroom chair), did not foresee that he was about to spend the brunt of the coming 12 months with a designer-sock-clad foot firmly in his mouth. In his interview with The Globe, he conceded as much. But he didn't need to — his writing last January was clear: "There will continue to be ups and downs," he wrote. "In the long run, I am confident that things will be up."

Mr. Gluskin was not the only financial demigod who had his back turned at the start of 2008 to the economic apocalypse that was about to begin. While no one was forecasting the onset of boom times — there was a relative consensus that it would be a bumpy year — neither was anyone forecasting precisely such a monstrous bust. Back in January, there was widespread speculation that the economy could repair itself just as quickly as it had soured. The hope was that maybe the worst had already passed.


There is a small cadre of finance whizzes and fringe academics who have, at various volumes, been predicting a market crash and burn for years. In Canada, one of the most prominent among those is Prem Watsa, the humble CEO of Toronto-based Fairfax Financial Holdings. Back in 2003, he and his team concluded that the U.S. housing market was in a speculative froth; from 2003 to 2007, his group hedged against the conventional wisdom in their industry, buying up protection against banks and other entities exposed to the lending and mortgage boom. "We just thought it was a question of time before that came to haunt people," Mr. Watsa said in a recent interview. "We've had 20 years of a great economy without a recession."

He waited several difficult years, repelling attacks for his unorthodox position. But by mid-summer of 2007, the apocalypse Mr. Watsa sensed began to rear its head. The subprime mortgage crisis exploded, bringing some of the biggest U.S. mortgage lenders and insurers to their knees. The market for asset-backed commercial paper — short-term loans made up of bundled assets, including mortgages and car loans, that investors purchased in droves because of their seeming low-risk and high yields — had been frozen, starving banks and spawning a credit crisis. The Dow Jones industrial average went haywire, dipping and then closing one day in July of 2007 above 14,000 for the first time.

That fall, nearly a year before most of the world would witness the devastation firsthand, some of Wall Street's most historic financial institutions hit record lows on the stock market. In October of 2007, Merrill Lynch posted a doozey of a loss: $8.4-billion, all chalked up to subprime. Two months later, it was Morgan Stanley's turn: in December, the company posted its first ever quarterly loss: $5.7-billion, also related to subprime.

But the public, and most investment professionals, remained indifferent to, or unaware of, the gathering storm.

"We were worried, and we kept looking, turning over rocks to see where the leeches were," said David Dodge, who wrapped up a seven-year term as governor of the Bank of Canada this year. "We turned over a lot of rocks in that period. Every time we did, it looked like the market was going to be able to handle this, the distribution of credit risk was not all that bad. We didn't appreciate how much underlying real bad credit had actually got out there.

"But even then, I would say, I didn't anticipate that the global situation would deteriorate as much as it did," Mr. Dodge said. In August of 2007, central bankers attempted to respond aggressively, launching what they considered a pre-emptive strike against tightening credit markets as the subprime mortgage problems in the United States seeped into other lending markets. Some central bankers, including Timothy Geithner, president of the Federal Reserve Bank of New York and U.S. president-elect Barack Obama's nominee for treasury secretary, were warning about the still unseen but brewing financial storm.

But the pervasive view as 2008 dawned was that in these sophisticated times, there were limits to how much could go wrong.

Still, plenty did. But, in retrospect, the latter half of 2007 looks like a bitter foretaste of the large dose of financial poison that 2008 produced. Throughout the course of the year, the global economy bucked and shuddered until it imploded so catastrophically in the fall that the debris is still streaming down.

It turned out even those who were prudently bearish in their original economic outlook for 2008 didn't roar loudly enough.

"I thought there would be a major recession coming, probably one of the worst ones since the big Depression," said Stephen Jarislowsky, the 83-year-old Montreal-based asset manager who Forbes listed as worth $1.9-billion in 2007. "But I had absolutely no clue that the very biggest banks, the biggest mortgage companies, the biggest insurance companies in the world effectively would fail," he said. "I thought the year would be very tough. And I can tell you that the year proved even tougher than I thought by a mile. I think the situation is really very catastrophic."

Mr. Jarislowsky, an advocate for corporate-governance reform, was four years old when the market crashed in 1929; his memory of the Great Depression is intact. As early as 2004, he said, he began warning that the housing bubble was "going to end extremely badly."

"It's not that I didn't see the problem. What I didn't see was the extent of the problem."


Thomas Caldwell, the 65-year-old chairman of Caldwell Financial Ltd. and its Toronto and New-York based subsidiaries, encountered a similar blind spot.

"It was the latter part of '07 where I thought, 'No, this is going to be very bad, this is going to be very, very bad,'" recalled Mr. Caldwell, an investment genius renowned in world financial circles for his strategic purchases of stock-exchange seats. "I'd rather have been wrong," he chuckled, having just stashed the cigars he scooped up at a lunch meeting in a metal machine-gun-ammunition box he keeps in a corner of his Toronto board room.

He was disquieted by signs that confirmed his hunch that something was brewing. "There was a lot of money sloshing around the system. There were lots of products that people did not understand. There was always money to do deals. Stock prices were going up. It was a euphoric period," he said. "But you started to see the cracks toward the latter part of '07 that some of this stuff was breaking … This was a slow, evolving revelation with most people."

It was perhaps that creeping sense of unease that drew Ira Gluskin back into writing mode only three short weeks after his New Year's Day client communiqué — two days after global stock markets suffered their biggest fall since Sept. 11, 2001.

Analysts attributed the quake in global markets to a "crisis of confidence" sweeping investors around the world, tied largely to the subprime and credit problems rooted in the United States.

"I spent the better part of this past weekend reading newspapers, magazines and financial reports, with only the NFL playoffs as a distraction," Mr. Gluskin wrote. "Our portfolios have not been immune from the rapid market decline … Naturally I am not pleased," he continued. "Unfortunately reality is a huge wakeup call."

That wakeup call would continue to intensify as the winter drew on. The British bank Northern Rock was nationalized in February, 2008, to prevent it from going under, and the Swiss banking giant UBS reported more than $18-billion in writedowns because of exposure to U.S. real estate markets the same month. By March 10, the Dow had fallen to its lowest level since October, 2006. In financial circles, chatter over whether banks were in danger began to grow louder. On March 16, Bear Stearns, a key underwriter of subprime securities, teetered on the verge of bankruptcy and was swept up by its rival, JPMorgan Chase, for a pittance: JPMorgan bought Bear for $2 a share — a little over a cent on the dollar of its share price in January, 2007.

For Wall Street, the deal was both a shock and a harbinger of what was to come.

"In a sense, this subprime issue in the United States had really begun to undermine confidence," Mr. Dodge recalled. "By the spring of 2008, it was quite clear that central banks would have to throw everything but the kitchen sink, and maybe even the kitchen sink, at the problem to try to deal with it."


By the end of March, Mr. Gluskin was again composing an explanation to his clients, although this time his customarily meandering "musings" barely filled a page. "You must appreciate that I have not been looking forward to writing this particular edition," he said. "The funds that I personally manage had an extremely difficult quarter, and on balance, the funds that my partners manage didn't fare much better," he wrote. "So what is there to say?"

Despite this, as May melted into June, Don Coxe, a veteran money manager and global portfolio strategist for BMO Capital Markets, was feeling optimistic. His new fund, the Coxe Commodity Strategy Fund, launched publicly, and he saw market activity outside North America as encouraging.

"I saw the stock market coming down, but the economy was still in positive territory in the world, and commodity prices were going up to an all-time high," he said. "In past cycles, you would get a signal from the commodities, particularly from the base metals and energy, that the economy was turning down. Instead, we had a new high for oil, and copper was trading close to an all-time high.

"The rest of the global economy was doing just fine. I refused to believe that this behaviour on Wall Street was enough to bring down the whole world.

"I got that wrong," he ruefully said. For Mr. Coxe, the moment of truth arrived on what he has dubbed "the midnight massacre," the evening of Sunday, July 13. Two days earlier, a large mortgage lender in the United States, IndyMac Federal Bank, folded, squeezed by tight credit, falling housing prices and mounting foreclosures. Now, the fear of more troubles spread to the country's two main mortgage securitization companies, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). They were in danger of going bankrupt.

While technically private, both companies had financed mortgage purchases by issuing more than $5-trillion in complex debt securities — the same poisonous securities that, it would later be revealed, had filtered through investment banks where they were repackaged into products that promised, among other things, to protect investors from losses, and thereby stimulated riskier practices. The securities were then shipped out to investors around the globe, on a scale large enough to infect worldwide markets.

Fannie and Freddie's debt was essentially guaranteed by the government in a structure intended to encourage home ownership. But if Fannie and Freddie went into insolvency, the government itself would have a huge credit problem on its hands.

In an effort to avoid that scenario, on the night of July 13, U.S. Federal Reserve Board chairman Ben Bernanke and Treasury Secretary Henry Paulson announced plans to prop up Fannie and Freddie, which Mr. Coxe called "essentially the bastard spawn of a union between expansionists in government and greedy private-sector people."

For many, that move by the Fed was the clearest signal yet that the unfolding economic troubles could have implications more devastating than anyone had foreseen.

"They were the biggest mortgage lenders in the world, and they basically set up the mortgage disaster because of their participation with greedy investment bankers on Wall Street," Mr. Coxe said. He blames investment bankers for being the architects of "horrible products, what I call Jurassic Park Avenue creations, because they were built out of locations on Park Avenue and they were based on what amounted to bad science, bad formulas, and therefore designed to explode."


Across the ocean, in Basel, Switzerland, William White, a former Bank of Canada deputy chief and former head of the monetary and economic department at the Bank for International Settlements, watched as the forecast he first issued in 2003 began to come true. Back then, he had warned that the economic boom in the United States was a speculative bubble that was sure to burst.

"For those of us who have been basically urging caution for such a long period of time … there was an element of Greek tragedy about this whole thing," he said. "You could see the thing starting to unfold and you knew that it would continue to unfold the way it always unfolds. There wasn't a very great deal when you were far enough down the line that you could do about it, which is your standard Greek tragedy stuff."

And the tragedy was spreading far beyond the financial sector.

Around the same time, Glenn Mullan, CEO of Canadian Royalties Inc., a small, Quebec-based mining company, was learning that his own company, far removed from the subprime crisis, had nevertheless been deeply ensnared by it.

Canadian Royalties had been steamrolling along on a $500-million nickel and copper mine project slated for Northern Quebec. Mining industry conventions normally dictate that if the company can raise the first half of the financing, banks will match with the second half in credit. The project sailed on full speed — more than $200-million had been spent on infrastructure — through the ugliness of January and March, right up to July of this year, when Mr. Mullan found his company "suddenly being caught in this vacuum."

"This is still early … before the deluge happened. You get a feeling that something is wrong, but no one will actually say it out loud. We couldn't have picked a worse time to be raising that kind of money," he said.

Looking back, Mr. Mullan wonders if that's because no one, not even the company's banking partners, understood exactly what they were looking at. "You can't recognize what you haven't seen before."

Whatever it was, by the end of July, it became clear that the banks had gotten cold feet. Even though Canadian Royalties had nothing to do with subprime mortgages or the complex debt securities blamed for instigating the economic upheaval, they too were caught in its destructive web. By August, instead of gearing up to hire a host of employees to build and support the project, Mr. Mullan was gearing down.

"We had 400 staff in July. We have 30 today," he said in an interview this month. "We've had 370 layoff notices in less than 90 days, everything from day workers … to the warehousing people shipping and receiving. There's nothing to ship and there's nothing to receive now. Our accounting department has retracted. Our investor relations [department] has been completely gutted. Even the VP was let go. There's no story to sell right now," he said. "The priorities have completely changed. Now it's all about survival."


All this unfolded before the now notorious weekend that changed Wall Street, when executives of the biggest banks in the United States were summoned to the Federal Reserve building in Lower Manhattan to discuss how to avert an impending market spiral tied to the mounting problems of several venerable Wall Street institutions.

In particular danger was Lehman Brothers, a top investment bank badly in need of, but unable to find, a saviour.

On Monday, Sept. 15, Lehman, which employed 25,000 people, filed for bankruptcy protection in what was the biggest bankruptcy in the history of the United States. The same day, Merrill Lynch narrowly avoided Lehman's fate by agreeing to sell itself to Bank of America for about $50-billion; insurance giant AIG was rescued by an $85-billion government bailout the next day. Three days later, the government unveiled a massive bank bailout plan, which inspired a brief market up-tick. However, the $700-billion package was rejected by Congress 10 days later. The Dow and the Toronto Stock Exchange recorded what were at the time the largest one-day point drops in history — 777 and 840, respectively. Soon, the reverberations were being felt in Russia, where the market tumbled 18 per cent in one day; there were also plunges in China, Mexico and Brazil.

By the second week of October, ratings agencies were flagging a looming liquidity crisis in the auto industry, oil fell to $77.79 (U.S.) a barrel, and the Dow dropped for its eighth consecutive day, down 36 per cent on the year; the TSX was down 34.47 per cent. Bloomberg News called it the worst week since 1933.

"August turned into September, turned into October, which turned into a roar," recalled Mr. Mullan, whose mining company was delivered a particularly acute blow during "a span of days in early October … when the floor just really fell out.

"The selling in the public markets just became epic. We had several institutions capitulate, unloading their entire positions within hours, which just causes basically a death spiral to a public company. You just get hit by wave after wave after wave of selling in an instant. You can't possibly find buyers quick enough to take the shares that are being sold … so all you can do is hide under the table and wait for it to pass."

In Toronto, Mr. Gluskin sat down to write another confessional to his clients. "It is not easy to find anything that will provide solace to you," he wrote in a tone that was distinctly darker than usual. "Many of our portfolios have suffered great damage this year, and particularly over the past three and a half months, with the worst performance coming from the models that I personally manage," he wrote. "This is definitely the financial crisis of our time."

Just before he signed off, Mr. Gluskin offered his clients a ray of hope in the dark economic times.

"I must acknowledge to you," he wrote, "that this has been the most trying period in my professional career. As much as I would like to be able to do so, I cannot tell you when we will recover — but I am confident that we will."

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