British Columbians have been told the Enbridge Northern Gateway Pipeline and Marine Terminal represents 220 tankers a year when it could be upwards of 340 per year.
We’ve been told that twinning Kinder Morgan’s Trans Mountain means a tanker a day in Vancouver’s inner harbour, when its possible the project could represent upwards of 475 oil tankers a year.
Taken together the two projects could expose BC to 2 million barrels of crude oil a day by land, and around 800 tankers a year transiting vulnerable coastal waters.
I have prepared an 11 page report–Proposed Pipelines and Tanker Spill Risk for BC–explaining how this could occur if Northern Gateway and Kinder Morgan proceed.
If, after reviewing the report, you are concerned about the volume of crude oil and condensate planned for transport across BC’s and First Nations’ land, freshwater streams and coastal waters, please let Premier Clark know. Please ask her to take back BC’s sovereign right to conduct a meaningful environmental assessment and have the final decision making power as to whether Northern Gateway proceeds or not.
Premier Clark’s email address is premier@gov.bc.ca
On April 19, 2012 I wrote an open letter to Premier Clark requesting she advise Prime Minister Harper that she is taking back—on behalf of the people of BC—our right to have the final say on the Northern Gateway pipeline project.
That right was signed away in June 2010 under an Equivalency Agreement with the National Energy Board, but can be reclaimed with 30 days notice.
This request to the Premier is necessary because the Federal government has informed the Canadian people that Northern Gateway will proceed. To ensure it has the power to enforce its decision, the Harper government has introduced legislation that can over-ride the National Energy Board. Under the previous rules, if the National Energy Board in its wisdom had rejected the pipeline, the project would not proceed.
Since the National Energy Board has not completed its review, and numerous people affected by this project have not yet presented to the panel, the Federal government has violated procedural fairness and the expectations of all involved. This is not just or fair.
In order to rectify this situation and protect the rights of British Columbians the Premier needs reclaim our right to due process and decision making.
The letter to Premier Clark was posted on this blog April 19, 2012.
A reply from the Office of the Premier was received April 27, 2012. The Premier’s Office has informed me that the letter has been forwarded onto the Minister of the Environment, Terry Lake. Minister Lake has the power to reclaim our right. I have posted the reply below.
From: Office of the Premier
To: Robyn Allan
Friday April, 27, 2012
cc Minister of the Environment, Honourable Terry Lake
Subject: BC’s Right to Environmental Assessment Needs to be Reclaimed
Thank you for your email, and attached letter addressed to the Honourable Premier Christy Clark, regarding the proposed Enbridge Northern Gateway pipeline. Your comments relating to the environmental review process currently being undertaken by the National Energy Board (NEB) and the Canadian Environmental Assessment Agency (CEAA) Joint Review Panel have been noted.
We appreciate the time that you have taken to share your views and insight with us and have forwarded your correspondence to the Honourable Terry Lake, Minister of Environment, for his review and consideration as well. You can be assured that the specific points you have raised in your letter will be included in related discussions between Minister Lake, members of his senior staff and officials in the Provincial Environmental Assessment Office.
Again, thank you for writing.
Because it is not clear to me that Dr. Lake will reply to my letter once he has discussed it with his officials, I sent the following letter to Dr. Lake.
April, 28, 2012
Dear Dr. Lake,
The Premier’s Office has replied to me and indicated that my letter to Premier Clark has been forwarded to you.
I am following up with you as the reply indicates that you will review and consider the letter and discuss the points with your officials. However, it does not confirm that you will address my comments in a reply to me.
I would appreciate it if you could please confirm that after you have had a chance to review my letter with your officials that you will be responding to the specific points in my letter directly in a reply to me.
Sincerely,
Robyn Allan
cc Premier Christy Clark
Please write Dr. Lake, and copy Premier Clark, requesting that the Province inform the Federal Government that BC’s right to review and decide on Northern Gateway is being reclaimed.
Dr. Lake’s email address is ENV.Minister@gov.bc.ca
Premier Clark’s email address is Premier@gov.bc.ca
April 19, 2012
Dear Premier Clark,
Your government has not spoken out for or against the Northern Gateway pipeline proposed by Enbridge Inc., rather preferring to wait until the National Energy Review Board process is complete. I am writing to you today to explain that, unfortunately the current Northern Gateway environmental and public interest process is flawed and as a result the public interest of BC is not protected.
The Federal government, as I am sure you are aware, has publicly endorsed the project, stated it is in the national interest of Canada, and has systematically demonized individuals and groups who oppose the project. This behaviour has made a travesty of the necessary arms length relationship between government and an independent regulatory body.
As long as there was some sense that the Joint Review Panel (JRP) was independent and had the authority to reject the proposal regardless of the political pressure imposed by the Prime Minister’s Office, a semblance of due process was maintained. That necessary condition was violated when Federal Natural Resources Minister Joe Oliver unveiled proposed legislation on April 17, 2012.
The Federal Government now intends to further weaken environmental protection and favour large oil companies operating, primarily, in Alberta. This has betrayed any remaining trust in federal energy decisions as they relate to the province of British Columbia.
With the overhaul of the environmental assessment rules and process, and making final decision on oil pipelines—such as the Enbridge Northern Gateway and proposed Kinder Morgan projects—a Federal cabinet prerogative, there is no confidence that the Government of Canada will make decisions that will be in the best public interest of the residents of this province.
A major change in policy in the midst of nation breaking events such as Northern Gateway or Kinder Morgan requires deliberate action on the part of your Office to protect the public interest trust and rights of BC residents and First Nations.
Certainly when the NEB process for Northern Gateway commenced in June 2010, the BC government thought the JRP would be objective and have the power to recommend a binding decision which would reflect the public interest of British Colombians and Canadians. I can imagine that the safety and efficiency inherent in one independent review body—which the NEB was believed to be at the time—and the belief that our public interest would be protected were reasons why the Liberal government of BC under the leadership of Gordon Campbell, felt it acceptable to sign away our right to conduct an environmental assessment under B.C.’s Environmental Assessment Act.
During my review of the Enbridge economic documents as part of their Application to the NEB, I wondered why there was no real or meaningful review of their case by various ministries of the BC government. The deliberate intent in the Enbridge documents to increase the price of oil for Canadian consumers and businesses, and the lack of concern over the impact our petro-currency has on forestry, agriculture, tourism and manufacturing, appeared to be glaring examples of an economic case intent on presenting only the benefits to the oil industry without due consideration to the economic costs for the rest of us. The development of a strategy to export raw crude to Asia at the cost of value added jobs and control over environmental standards also seemed worthy of provincial comment.
I felt surely, there should be professional economists, paid by taxpayers, that would stand up and present a fair picture of the macroeconomic impact rapid resource expansion and export has on the economy of British Columbia, not to mention the threat to the environment and First Nations rights. That is when I discovered that BC had signed away the right to actively assess the project. I then understood that not only have you, as Premier, elected to remain silent on the issue, but our provincial departments have effectively been muzzled as well.
I draw to your attention the Environmental Assessment Equivalency Agreement signed between the NEB and BC’s Environmental Assessment Office (EAO) on June 21st, 2010. I have attached a link to the agreement for your ease of recall.
Essentially the agreement states that the EAO will accept the NEB’s environmental assessment for four proposed projects, including the Enbridge Northern Gateway Project, which would otherwise have to be reviewed under BC’s Environmental Assessment Act. The NEB’s review would be treated as an equivalent assessment.
If the province of BC had not signed away its right to the NEB, under the terms of the legislation the EAO would have had to undertake a review. According to the EAO, it is a “neutral agency that manages the review of proposed major projects in British Columbia, as required by the Environmental Assessment Act. The environmental assessment process provides for the thorough, timely and integrated assessment of the potential environmental, economic, social, heritage, and health effects that may occur during the lifecycle of these projects, and provides for meaningful participation by First Nations, proponents, the public, local governments, and provincial agencies.”
We have the power within BC to undertake meaningful environmental assessment within provincial jurisdiction, but signed it away. However, not all is lost. Clause 6 of the Environmental Assessment Equivalency Agreement states: ”Either Party may terminate this Agreement upon giving 30 days written notice to terminate the other Party”.
May I recommend that the Government of British Columbia inform the Government of Canada that the province is now exercising its right with 30 days notice in order that it may undertake a proper environmental assessment under the terms of the provincial Environmental Assessment Act, for the Enbridge project, and it will not entertain signing such an agreement for the proposed Kinder Morgan pipeline.
This action will ensure that the public interest of the people of BC will be protected and will not be severely curtailed by the actions of the Government of Canada favouring primarily Alberta’s oil producers.
Sincerely,
Original Signed by Robyn Allan
Robyn Allan
cc. Dr. Terry Lake, Minister of the Environment
Mr. Adrian Dix, Leader of the Opposition
Mr. Rob Fleming, Environment Critic
Mr. John Cummins, Conservative Leader
Mr. John van Dongen, Conservative MLA
Mr. Bob Simpson, Independent MLA
Ms. Vicki Huntington, Independent MLA
What can you do? If you would like Premier Clark to reserve the right for British Columbians to decide what is in our public interest and whether or not Northern Gateway and the proposed Kinder Morgan pipeline should proceed, please write to her. Ask that she take Northern Gateway off the list of projects under the Equivalency Agreement with the National Energy Board and that she make it clear that when Kinder Morgan applies for approval, BC will exercise its right to conduct its own review process on behalf of the people of our province.
The email address is premier@gov.bc.ca. It is also helpful to cc your MLA.
Sincerely,
Robyn Allan
Efficient and effective development of Canada’s natural resources is a critical component in the determination of long term economic growth and stability. In the past decade—despite the financial crisis—international market conditions have developed whereby rapidly rising crude oil prices and strong foreign demand have combined to generate significant resource wealth, but they have also contributed to creating economic challenges in the Canadian economy.
There have been numerous studies released during the past two years that extol the economic benefits of continued rapid expansion and export of Canada’s crude oil resources on the Canadian economy. The reports are used extensively by industry proponents who quote the vast benefits as if they were written in stone. Momentum has taken hold and too few pause with curiosity as to whether the benefit numbers actually make sense.
The purpose of “An Analysis of Canadian Oil Expansion Economics” (click link below to access the report) is to review these studies and examine whether or not the economic benefits served up are reliable and useful. What is revealed is that the reports present a biased narrative where industry benefits are falsely estimated while economic, social and environmental costs are ignored.
An Analysis of Canadian Oil Expansion Economics April 10, 2012
Premier Redford has decided that the benefits from Alberta’s crude oil resources are so extensive, and the sharing of those benefits through free market forces so obviously clear, that other Canadian provinces, such as Ontario and Quebec, need to jump at the chance to support oil resource development.
Ms. Redford repeatedly cites a Canadian Energy Research Institute (CERI) study’s findings that the Ontario economy is the second largest beneficiary of Alberta’s resource development. These benefits trickle into the Ontario economy through the demand her resource sector provides to Ontario companies. If Ontario will come to Alberta’s aid and support continued rapid oil sands expansion, Ms. Redford maintains Ontario will get as many as 65,520 person years of employment and $63 billion in second hand economic benefits. These gains, its suggested, will be realized between 2010 and 2035.
We will get to the CERI study and the reliability of their numbers in a minute. Pinning a national energy strategy on the findings of a report, such as this, is a pretty big deal. We should make sure the numbers make sense before charging ahead with Ms. Redford’s belief that “we can grow a Canadian economy around energy that benefits Canadians across the country”, when it fact, the benefits being recited are not really there.
The bigger issue is that Premier McGuinty has told Premier Redford that he is, quite rightly, concerned about the negative impact the rapid development of the oil sands has on the Ontario economy. Rapid petro-returns put upward pressure on the Canadian dollar. Given the dependency of Canadian export competitiveness to the value of our dollar, this will continue to depress manufacturing and other industrial activity and lead to even more job losses. Premier McGuinty doesn’t believe that Ontario will benefit from the rapid development of Alberta’s resources and would prefer the benefits of a lower dollar.
It turns out that CERI has similar concerns about the rapid expansion of oil sands production because of its impact on our dollar and negative consequence for all exports, including crude oil. The CERI report that Ms. Redford cites—Study No. 124 published in May 2011—is based on Study No. 122, also published in May 2011.
Study No. 122 states that “there is a negative and statistically significant relationship between the Canadian-US exchange rate and the price of crude oil…78 percent of the variations in the exchange rate can be explained by changes in the price of crude oil.” The report goes on to explain that because of our appreciating dollar, “Canadian goods and services become relatively more expensive to purchase with US dollars, and Canadian exports to the U S decline correspondingly.” The report states that between 2004 – 2009 exports to the US declined by 23 percent while the Canadian dollar appreciated 14 percent.
CERI predicts that by 2030 the value of the Canadian dollar will be $1.23 US and by 2044 it will take two US dollars to buy one Canadian dollar—yes, a 50 cent US dollar. This is because CERI anticipates a significant rise in oil prices over the period, reaching $200 per barrel US, in real dollars, by 2044. When the price of oil goes up, so does the value of our petro-dollar.
The way CERI deals with this very undesirable outcome is fascinating—it doesn’t. It calls on the Bank of Canada to implement monetary policy and the Canadian government to implement fiscal policy to “prevent excessive appreciation of the Canadian dollar against the US dollar”. Assuming government policy makers rush to the aid of the oil industry, CERI then adopts the assumption that exchange rate parity will be maintained throughout the projection period—that is, the Canadian dollar will stay at a dollar U.S., and not rise for 35 years.
If this fixed exchange rate assumption is not maintained—that is, if the Canadian dollar appreciates over the forecast period—it looks like CERI’s oil sands production forecast won’t stand up. This would largely be because the benefit of higher oil prices to oil producers are effectively unrealized when the increasing value of our dollar erodes them. If the production forecast doesn’t hold up—neither do the projected benefits presented in Study No. 124.
Simply put, if real financial returns aren’t realized in a meaningful way, why would the oil industry expand production by developing higher cost projects. When you read the annual reports of the major producers, exchange rate sensitivity and the appreciation of the Canadian dollar is often cited as a major concern regarding profitability, and hence their investment decisions.
Based on the production forecast from Study No. 122, CERI uses an Input Output (IO) model in its Study No. 124 to predict economic growth and person years of employment from oil sands expansion—this is the study being used by Premier Redford to convince Premier McGuinty that the economic troubles Ontario is experiencing aren’t real. This study is a serious misrepresentation of the real story.
As has been explained, oil production volumes used as input into the model rely on an unrealistic exchange rate assumption and depend on real oil prices doubling over the forecast period. So its very likely the input numbers into the model are unusable.
However, even assuming the input is valid, the use of an IO model to try to represent the macroeconomic impact of resource expansion on the Canadian economy over a long period of time is unreasonable. The results essentially present only benefits to the oil industry, without acknowledging any costs—to the oil industry as well as the rest of the economy and society.
The CERI report itself says that “these models are primarily used over a short-run time horizon, where relative prices and productivity are expected to remain relatively constant”, but then uses the model anyway to predict what might happen between now and 2035. Employing a static model, such as an IO framework, to measure a dynamic macroeconomic process and think you have any idea of what the impact actually will be, is delusional.
An IO model will treat the oil sector’s expansion as if there is no negative impact on consumer demand, or non-oil producing businesses as they try to adjust to higher oil prices. It certainly cannot acknowledge the jobs lost when demand falls off, or how exports are impacted when the dollar strengthens and how that leads to slower economic growth. An IO model by design is incapable of any feedback mechanism so it assumes all the relationships that existed in the year the tables were produced stay the same—for example we will buy as much gasoline at $2.50 a litre as we did at $1.10 a litre, although our real incomes to purchase this higher priced gasoline, have not increased.
So it turns out that Mr. McGuinty’s understanding of these complex issues is not so “simplistic” and his concerns regarding the exchange rate and the negative consequence of declining economic growth in every other area of the economy are shared by CERI—and probably secretly by the oil industry itself.
His stance that suggests a national energy policy that follows the every whim of the oil industry might not be in the public interest, is well founded. But as a provincial leader, Canadian industrial policy, exchange rate management and inflation control should not solely be his concern—he certainly doesn’t have the policy tools or the mandate to deal with them.
Unfortunately leadership at the national level has been focused elsewhere. The Harper government has been determined to support the national energy strategy of China which is seeking to lock in energy security for Chinese citizens. As well, it has been blindly championing the needs and desires of national oil companies such as Sinopec, CNOOC and PetroChina, as well as multinational oil corporations, who would like to produce and export raw resources. When they do, it is at the expense of upgrading and refining in Canada, and results in a permanent loss of value-added and jobs, while simultaneously avoiding effective labour and environmental standards.
Without a meaningful national energy strategy that recognizes the economic, social and environmental costs of rapid resource extraction–and effectively manages the windfall benefits for all Canadians while meeting our energy security needs in eastern Canada–significant tensions across the country will continue to mount, and certainly be heightened at the inter-provincial level.
As part of the National Energy Board’s Joint Review Panel process of whether or not Northern Gateway is in the Public Interest, Intervenors are able to submit evidence as to the consequence of the project. In an effort to shed light on the economic consequences of this project as it affects Canadians and Canada, I prepared this report. I had applied for and was anticipating that I would be granted Late Intervenor Status. When that status was not forthcoming I approached the Alberta Federation of Labour and asked them to consider this document as part of their evidence. The evidence was filed as part of the AFL’s evidence on Tuesday January 31, 2012.
The AFL full submission is available here. There is some excellent material regarding the consequence of the project and what we need to do before contemplating Northern Gateway or any other pipelines to the west coast or the US.
Economic Assessment of Northern Gateway January 31, 2012
“You are either in the process of living your dreams or denying them. Living them is easier.”
Have fun, Robyn Allan
In order to address the road ahead as the western industrialized world grapples with the fallout from the financial crisis of 2008 there are three serious questions: what went wrong, how will we fix it and how long will it take? Not surprisingly the answers to question two and three depend on adequately answering “what went wrong”?
Unless we understand how the financial market floated out of control to create the most severe economic crisis in human history, solutions prescribed to fix it will be mediocre at best. They will prolong the downturn or create a false recovery setting in motion the preconditions for another round of turmoil.
For this reason I am going to explain in clear economic terms what went wrong with the financial system. First, a few assumptions about the economic system and who it belongs to.
1. The Economy Is An Invention
We invented the capitalist market system as a method of allocating society’s resources efficiently and effectively. We equipped it with a sophisticated credit structure and enforced it with property rights to fulfill wants and needs because it can work so effectively. Critical to the invention of the market system is the acceptance of a series of beliefs about how people will behave within it.
As a culture we agree business people operate in their own self-interest; we believe it makes them work harder. We agree that profit maximization is a worthy goal for entrepreneurs to determine the least cost method of production for the highest quality output. We have decided that price is the most important signal in the market place for identifying consumer demand. We support the availability of dependable information in a timely and reliable manner. We believe that it’s unacceptable to misrepresent, mislead or lie. We rely on competition to reward success and discipline failure and thereby expect that the best and brightest ways and means of doing things will surface. Much of how we operate in the market is based on trust and the notion of good faith.
When the market fails, we feel shocked, but we also feel betrayed. We forget that the nature of the economic game is such that is can easily become bigger than the players–and that the players are us. We need to remember that the system is our invention. We need to reclaim control over it by adjusting the terms of how it operates so we achieve economic success for the benefit of society.
A sustainable economic system must support our dreams and desires and, over time, improve the quality of life for all people. The economic system should not be structured to benefit the privileged or the few at the expense of the many. Participation in the economic system is a basic human right. The game works on the notion that if you practice hard and play fair there is every reason to believe you can improve your standard of living and quality of life.
Why would sane people invent a system to work any other way?
2. Expect Market Failure
The market system requires sound regulatory control because there is nothing inherent within it to avoid market failure. Market failure occurs when the pursuit of self-interest by one or a few players results in an unfair advantage in market power. This unfair advantage results in actions that lead to unsatisfactory results for society, and in the extreme can cause the demise of the system.
Government regulation, intervention and policy direction is very important in maintaining the balance of an effective and efficient system. Government has been charged, through the democratic process, with protecting and serving the public interest. Unfortunately, during the past three decades the role of government intervention–effective regulation–in the economy has increasingly been demonized. Many leaders now behave more like marketing VPs for corporate interests than protectors of the integrity of the market system. They have abdicated their responsibility for ensuring that unjustified rewards don’t make their way to one group at the expense of another. What this is costing consumers, workers and independent small businesses is excessive. It is also creating a sense that the system is rigged and that no amount of hard work and fair play will make a difference.
Markets are not self-adjusting and therefore intervention is necessary. Effective regulation is a sign of a healthy system because it keeps the game honest and clean. It is not the role or responsibility of business people to regulate their behavior in the public interest. Their job is to play the game and endeavor to win–to try to seek an advantage. It is the job of elected policy makers to make sure that any advantages gained enhances the overall effective functioning of the system in the public interest. If not, then the opportunity for advantage must be removed. It is imperative that as citizens of democratic nations we hold both business and government accountable.
3. Capitalism and Democracy Are Not Inherently Compatible
Capitalism is good and democracy is good but they are not inherently compatible. They both must be nurtured and protected to ensure they continue a healthy co-existence.
Capitalism is efficient and effective in deciding how goods and services are allocated and wants and needs met. But our reliance on the market economy moves us away from democracy–away from one person; one vote. It moves us toward a reliance on wealth to determine voice. The price system determines that whoever has more money, has more decision making power, has more control, power, and hence, has more freedom.
Our reliance on democracy to govern our capitalistic society attempts to redress this imbalance. If efficiency was the main criteria for government then monarchy, dictatorship, fascism, or any other form of authoritarian control would be preferable. But we have chosen to uphold the values of fairness, equality, and justice and we believe that each person has the right to participate. Market capitalism attempts to exclude, democracy attempts to include. By its very nature an effective democracy requires a bureaucracy that needs to be effective more than it needs to be efficient.
To ensure democracy remains strong people must participate and hold the system accountable. We must be engaged in the democratic process to ensure that the free market is not taken over by the interests of the few and powerful. We must guard against the power of vested interests who attempt to weaken consumers and overburden taxpayers with the costs of their irresponsible and irreverent pursuit of money. We must understand that the international financial institutions will continue to behave in the same manner that created the financial crisis unless the rules of the game they play are changed.
As this crisis unfolds we must use the opportunity to demand full disclosure. If public investment and/or loans are required then it is necessary the public obtain commensurate ownership and/or right to collateral that reflects the risk of the support. We must reintroduce access to the credit markets for consumers–not just the business elite. As businesses complain about how hard it is to cover cheques they never should have written in the first place–we must remain strong. These are alligator tears.
As government rushes to the rescue of huge financial corporation using our future to underwrite their plan, without adequately protecting our interests, it must be stopped. Government has spent the past thirty years perfecting the art of benign neglect, how can it be expected to understand how deep the problems run or how difficult it’s going to be to come out from under them.
This is going to be a long and drawn out problem, make no mistake. You can’t create a tangled web of contracts, complete with inadequate security, unbridled risk, and destabilizing side-bets that amount to more than $55 trillion of toxic hot air and not have it pollute the workings of the entire system when it explodes. It’s time to shift the balance of power. We are being called upon to be accountable. The least we deserve in return is commensurate control. If nothing more, it makes good business sense.
The major bailout of automakers seems to be focused on giving them financial room for survival while they restructure to make better, more fuel efficient and modern cars. However, if we check under the hood, the bailout might actually be all about bad money management linked to the US sub-prime mortgage mess.
The looming bankruptcy is said to be caused by high fuel prices, changing consumer demand, wages and benefits, and an unexpected downturn in sales as a result of the global financial crisis. There’s little argument those factors play their part in Detroit’s problems. But, in fact, the problems today relate in large part to what auto manufacturers have been doing in the non-manufacturing side of their business. Financing activities through General Motors Acceptance Corporation (GMAC), Chrysler Financial and to a lesser degree so far, Ford Motor Credit, have put at risk the jobs and retirement security of more than 400,000 Canadian workers.
By way of background, General Motors owns 49% of GMAC having sold 51% to Cerberus Capital Management in 2006. Chrysler owns Chrysler Financial but as of August 2007, Cerberus bought 80% of Chrysler from Daimler AG who still holds 20%. Ford owns Ford Motor Credit Co.
The interlocking relationship between manufacturing and financing must be understood. Steps need to be taken to ensure that any bailout package borne by Canadian taxpayers does not find its way to feeding the losses in the financial arms of the auto makers. If not, taxpayers could find themselves footing the bill for not only sub-standard auto loans to US consumers, but also bailing out a good chunk of the US sub-prime mortgage crisis. Without carefully negotiated rescue terms, layoffs and job losses are likely to continue with automakers failing anyway.
Financing arms of automakers were established to facilitate dealer inventories and auto purchases. This relationship was direct and risk underwritten accordingly. The financial side lent money to people to buy and lease cars and was responsible for collecting loan obligations. Funding future loans came from repayment proceeds and from direct debt; the cost of which was a function of corporate bond rating. When market conditions weakened, raising funds from traditional sources became more difficult so manufacturing adjusted and operating strategies more effectively matched economic realities.
Beginning in the early 1990s securitization became a new form of financing for automakers removing their need to rely on debt markets. Securitization takes place when asset-backed securities (ABS) are created from a pool of financial assets, such as auto loans. They are packaged together with the claims on loan repayment being sold in the market.
In 1997 ABS outstanding in the US were about $500 billion increasing rapidly to $2.5 trillion by 2007. Of these, $200 billion were backed by auto loans. What this meant was auto manufacturers had direct access to a new and powerful source of funding auto sales. They effectively front-end loaded consumer purchases. One of the major reasons for the downturn in demand is that the market has been saturated with inexpensive and easy credit terms made possible because of securitization. Many of these loans are now at risk.
Coincident with an increase in auto loan securitization was securitization of mortgages through mortgage-backed securities (MBS). Several major lenders used this market as a way to enter the sub-prime mortgage market. GM was a major player in the sub-prime market. By 2005 GMAC earned over 50% of its net revenue from its mortgage lending activity with total financing profits of $2.4 billion flowing through to GM’s bottom line.
In recent years however, GMAC’s mortgage lending activity has been the source of significant losses. In the third quarter of 2008 it recorded year to date losses of $3.7 billion. This year auto securitization activities also began to deteriorate with rising delinquencies and defaults. For the first three quarters of 2008, total losses in GMAC reached $5.6 billion putting GM on the hook for $2.7 billion.
Securitization isn’t the end of the story. Also important is the relationship between securitization, credit derivatives, and accounting methods used to record exposure. These can be the source of significant future losses.
In an effort to make ABS and MBS more marketable, particularly since the tech bubble burst in 2001, underwriters aggressively tried to minimize default risk through subordination where loan pools are segmented into different tranches. They also introduced a form of insurance called credit default swaps. These enhancements have actually increased risk, volatility and are partially responsible for massive, largely unanticipated losses.
Subordination of securities can result in the issuing agent holding an equity position and facing first claim on any losses. However, in order to place the securities in the first place, the agent may have given up its right to the underlying assets (that is, the cars or the houses the loans were made on). Its quite possible automaker financing arms have significantly reduced access to collateral when loans go sour.
The use of credit default swaps to reduce risk is a complex and sophisticated area of the derivatives market. The degree to which auto financing companies have been involved, either as a buyer or seller of default insurance, would need to be clearly understood. Otherwise, there is a potential for a very long tail of obligations to potentially numerous related financial institutions that has nothing to do with the making and selling of automobiles.
Creative structuring of ABS and MBS in specialized vehicles can allow them to be recorded off-balance sheet thereby reducing capital requirements and providing an appearance of greater return on equity. That is unless market conditions deteriorate and they are brought back onto the balance sheet. More capital can be needed in a hurry.
An effective barrier between manufacturing and financial obligations needs to be established with assurances that Canadian taxpayer money will not used to pay for credit market mismanagement. Last week, automakers asked Ottawa and Ontario for $6.8 billion in assistance. Any funding needs to go to maintaining jobs and supporting communities in Canada, not to paying off the bad decisions of US financial executives in the sub-prime mortgage and auto receivables markets.
In a democratic society the economy should work to support people rather than people working to support it. Let’s not forget we invented the economy—every bit of it, from the creation of money and credit, to the way we keep score with double entry bookkeeping, to the notion of GNP and theories of monetary and fiscal policy. When things go terribly wrong, as they have in recent months, we should be able to reinvent a functioning system not have it turn on us like some Frankenstein monster.
Our market system is exceptional. It needs to be rescued. But to function it requires good information and a clear connection between cause and effect. We have lost that connection. Nowhere is this more evident than the myth the sub-prime market was responsible for the current financial crisis. The facts show that the market was neither large enough nor struggling enough to cause this chaos.
At the end of 2006, when large US mortgage lenders started to fall like dominoes, the entire mortgage market in the US was worth $10 trillion. The sub-prime portion, and its close cousin the slightly better-heeled Alt A, represented 15% and 5%, respectively. At its peak, when financial executives started to call in their insurance policies, the pool of high risks mortgages was about $2 trillion.
Let’s think about that. The tab for the financial crisis in the US is $7.8 trillion. For a quarter of the cost all homes underlying sub-prime mortgages could have been purchased outright. The US could have had a housing program for its low and middle income families envied around the world, rather than what its ending up with; a corporate welfare scheme shoring up the bad decisions of a few hundred financial executives.
When the sub-prime mortgage market allegedly triggered this crisis, delinquency and default rates were lower than they had been in 2001-2002. The problems could have, and should have, been contained and redressed well within traditional mortgage lending practices if the old rules of the game had been in play. But they weren’t.
What’s changed? Enter the monster. In less than five years the rules of the game fundamentally changed due to the rise in power of derivatives markets and the underlying agreements embedded in the clauses of credit default swaps.1
A credit default swap is a contract between two parties where the buyer makes regular payments to a seller in return for protection. Although credit default swaps are often referred to as insurance, unlike insurance which requires the insured party own the protected assets, the holder of the swap does not need to. In fact, the buyer of protection does not have to suffer a loss to collect—all that has to happen is for a predetermined default event to occur and the buyer collects a payment. The existence of these contracts on a wide scale, often providing multiple contracts for the same class of assets, has transformed the historical market incentive to accurately assess and underwrite risk into an incentive to disregard it.
Consider the impact credit default swap protection had on mortgage loans. Historically the prudent course of action, even within the sub-prime sector, was to keep known risks within a certain range: some would-be home owners were refused. Not so when you have unlimited protection. No income, no job, no assets, no problem. Prudent business practices got in the way of gobbling up market share. The appetite of the derivatives market for new mortgages was insatiable, as it was for credit card receivables, car loans, or any other activity that could be leveraged into an ante-up for the default swap market. The market was fattened up and then? Well, the monster sunk its teeth in.
The majority of credit default swaps last 1-5 years with a sizable increase in volume starting in 2004. It’s like these bets against the success of the economy were sitting on the shelf chanting “don’t forget our best-before date”. Remember, these are like insurance contracts without the insurance checks and balances of responsibility. Knowing your pool is insured if defaults begin to climb reduces significantly the desire to mitigate them, particularly if the negotiation process takes you past an expiry date.
This built-in disincentive to take prudent action in the face of adverse circumstances is known in insurance circles as “moral hazard”. The greater the degree of coverage, the easier the claims process, the more likely the insured party will act in a hazardous fashion—will act irresponsibly.
An absence of consequence ruins prudent lending practice and destroys the incentive to workout a solution when borrowers face difficulty. Renegotiating loans, behind closed doors and in good faith, has become old school. In the past we could rely on renegotiation to contain a downturn. Not any more. It’s not so much that credit is unavailable, its that its going to feed the monster leaving the rest of the market to starve.
The unwillingness of lenders to renegotiate loans is now seeping into the consumer retailing sector causing large companies to head straight for bankruptcy rather than seek the useful protection of Chapter 11. The closed door to renegotiation in the private sector is what causes companies to ask for government bailouts.
The recent $326 billion rescue package for Citigroup was in response to the company’s exposure to collateral debt obligations (CDOs). Guess what, behind every synthetic CDO lurks a credit default swap, but its impossible to ascertain how Citigroup’s problems are in direct consequence of these obligations. These contracts are generally held in entities not reflected on the balance sheet and the definition of credit events differ from contract to contract. How, if and when they net out is important to know. Based on their losses to date they’ve found themselves on the wrong side of protection way too often. What we do know–a $25 billion problem grew thirteen times in a matter of weeks.
The powerful role credit default swaps play can not be overlooked in the recent requests for public aid from the top three auto makers. Both US and Canadian governments are being pressured to come up with bailout packages. What assurance is there that the money will not just go to the holders of swaps to pay off their positions? These contracts have a tail and depending on their terms, financial institutions may be able to benefit many times over on the same pool of assets. The nature of these agreements is that they thrive on instability and volatility. When the tangled web of agreements are unwound its quite possible auto manufacturers will fail anyway because the rescue aid was not directed to its intended purpose.