[R-G] The Credit Crisis in Canada: The First Six Months

[Anthony Fenton]

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A Socialist Project e-bulletin .... No. 92 .... March 21, 2008
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The Credit Crisis in Canada: The First Six Months

Fletcher Baragar

The 2007 credit crisis irrupted in Canadian financial markets in mid- 
August. The immediate backdrop to this was the growing concern in  
financial markets about the value of assets underlying commercial  
paper, and especially the extent to which these assets were connected  
to a deteriorating real estate market in the United States. The  
subprime mortgage sector in particular was facing increasing degrees  
of delinquency, and growing appreciation of the extent of increasingly  
problematic mortgages. In conjunction with great uncertainty about the  
extent to which commercial paper and other securities were exposed to  
this troubled mortgage sector, confidence in the quality of a wide  
range of financial assets dramatically eroded.

The greed that underpinned the search for yield was quickly displaced  
by the fear that fuelled a need for liquidity. With the irruption, the  
risk premium on short-term commercial paper zoomed upwards and non- 
liquid asset prices plummeted. For some securities, the market froze  
and trading ceased. Non-market crisis options were hastily arranged,  
most notably the Montreal Accord which sought to convert the short  
term assets of 23 commercial paper trusts into longer term assets  
through a negotiation process under the auspices of major banks and  
other institutional investors, such as the Caisse de depot et  
placement du Quebec.

The Growth in Credit Markets
It is significant that one aspect of the larger economic environment  
underlying these events is the relatively sustained period of solid  
economic growth. Beginning in 2004, the real annual growth rates of  
the Canadian economy have been slightly better than 3%. For capital,  
however, profitability, rather than growth per se, is the objective.  
By this measure, recent years have been especially rewarding. Net  
corporate profit, after recovering from the slowdown of 2001 and 2002,  
jumped to a record $102.6 billion in 2003 and then continued to new  
heights of $132.3 billion, $157.6 billion and $168.2 billion in 2004,  
2005 and 2006 respectively.  Figures for the first three quarters of  
2007 show a further $131.5-billion (unless noted, data is from  
Statistics Canada). The return on capital employed, which had fallen  
to 5% in 2002, has rebounded strongly and has averaged better than  
8.5% between 2005 and the 3rd quarter of 2007. The return on equity in  
2005, 2006 and the first 3 quarters of 2007 was 12.6%, 12.5% and  
11.9%, respectively, levels which had not been realized since 1988.  
The figures suggest that, in Canada at least, these have been good  
times for capital.

A breakdown of the aggregate figures shows that the finance and  
insurance sector has in fact done even better than the Canadian  
average. After virtually no growth between 1995 and 2002, the net  
profit of the finance and insurance sector in Canada has increased  
sharply. The $25.6 billion in net profit received by this sector in  
2003 appears quite modest beside the $43.8 billion recorded for 2006.  
A further $35.5 billion were racked up in the first three quarters of  
2007, with the $12 billion sum for the third quarter being the highest  
on record. Beginning in 2006, the return on capital employed has been  
at its highest level since Statistics Canada began compiling those  
returns back in 1988. For the second and third quarters of 2007, the  
return exceeded 10%, markedly better than the 8.5% average for the  
Canadian corporate sector as a whole. Finance and insurance also did  
better than the national average when assessed by the return on  
equity. Through the first three quarters of 2007 the sectoral returns  
have been consistently 0.4% to 1% higher.

Although low and falling profit rates can directly contribute to  
increased economic instability and increase the probability of some  
disturbance or miscalculation precipitating a crisis, the 2007 credit  
crisis underlines the point that a bout of low and falling rates are  
not necessary preconditions. Simply put, high and rising profit rates  
are no guarantees against the outbreak and spread of economic crisis.  
Economic instability and the possibility of crisis are rooted in the  
structure of capitalist production. The development of the credit  
system, and the increasing complexity of financial markets incidental  
to the development of capitalism, offer flexibility and considerable  
elasticity for the agents involved in the myriad circuits of capital.  
These developments offer new opportunities for favoured agents to  
appropriate portions of newly produced value, but they cannot  
guarantee that the atomistic decisions of private participants will  
necessarily be appropriate or timely. There is always the possibility  
that purchases will not smoothly follow sales, that sales will not be  
followed by payments, and that any of the many individual circuits of  
capital may be ruptured.

Credit Cycles and
Financial Instability
The strong economic conditions for capital that preceded the crisis of  
2007 induced behaviour in the financial sector of the sort identified  
and analyzed by theorists and critics ranging from Karl Marx and  
Thorstein Veblen to John Maynard Keynes and Hyman Minsky. The  
expectations of agents representing financial capital are essentially  
endogenous and are powerfully shaped by yesterday’s events. Rising  
profits and profitability induce expectations of further rises,  
resulting in increased demands for financing on one side, along with  
the relaxation of credit standards and risk assessment on the other.  
An expansion of credit is the result. To this general tendency, then,  
is added the specific elements that characterize the setting of  
financial markets today in Canada and worldwide.

First is the regime of low interest rates, nationally and globally,  
which settled in after national governments and their central banks,  
supported by the interests of wealth holders, successfully lowered  
inflation rates in most of the leading industrialized countries from  
the mid-1980s onward. The success of this initiative -- waged at the  
expense of the working class through slow employment growth, attacks  
on unions and workers’ rights, and repressed real wage gains -- was  
visible by the mid-1990s. Low interest rates encouraged private sector  
demand for credit. Much of this demand, especially in Canada and the  
USA, emanated from consumers. Upper income and economically well-off  
households availed themselves of the more favourable borrowing rates.  
But the growth in credit demand was not confined to the privileged  
strata. The harsh regimen imposed on workers through the 1980s and  
1990s had not nullified their desires to at least maintain the  
standard of living identified with the ‘middle-class.’  Nor in many  
cases had it sufficed to negate the material success associated with  
the American dream. Extended credit at lower rates offered an  
attractive means by which income restraints imposed by a more austere  
labour market could be relaxed, if not altogether transcended.

On the supply side, the financial sector was more than forthcoming.  
Through a combination of instruments, including personal loans,  
personal lines of credit, credit card balances and primary and  
secondary mortgages, household credit in Canada more than doubled  
between 1996 and 2006, and exceeded the $1 billion mark for the first  
time in 2006. More than two-thirds of this total is mortgage credit,  
although the fastest growing component is the non-mortgage portion  
(referred to as consumer credit by Statistics Canada), which tripled  
in size over the same period. Similar expansion of household debt  
occurred in the U.S., where total outstanding values of household  
mortgages doubled between 1999 and 2005 and increased a further 10% in  
2006 (Federal Reserve Bank, Statistical Supplement to Federal Reserve  
Bulletin: January 2004 and October 2007).

Falling interest rates tend to reduce interest rate spreads. One  
response of credit issuing institutions to the fall in rates and  
spreads was to try to increase volumes, which meant aggressively  
seeking new clients. And as the pool of prime customers is drained,  
those with less sterling credentials are courted.

The Minskyian theories of financial fragility mentioned above  
emphasize the subjective shifts of the demanders and issuers of credit  
as the expansion phase gathers momentum. As noted above, on the supply  
side, conventional valuations of risk are revised downward as credit  
is extended. The run-up to the 2007 crisis, however, added to this by  
introducing new financial instruments. These new instruments  
constitute the second specific ingredient distinguishing the current  
credit crisis. These financial innovations are a subset of the larger  
market of financial derivatives -- a market which has been growing  
rapidly since the liberalization of financial markets in the early  
1990s. Taken as a whole, the market for derivatives is approximately  
$516 trillion (US) and comprises about 75% of global liquidity  
("Knowing the known unknowns of a possible market disaster," Globe and  
Mail 24 November 2007).

The complete Bullet is available here:
www.socialistproject.ca/bullet/bullet092.html

Also check out "Loonies, Greenbacks & American Empire" by Ingo Schmidt
www.socialistproject.ca/relay/relay21.pdf#page=14


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