Reappraising Risk

The global ramifications of problems in the
sub-prime mortgage market were first thrown in to stark relief by a blue-chip
French-based investment bank. In a statement released on August 9 BNP Paribas
tipped already febrile equity markets into a dangerous tailspin. The bank froze
withdrawals from three specialist investment funds because of what it termed ‘a
complete evaporation of liquidity in certain segments of the US securitisation

The evaporation contributed to a financial
“Armageddon”, said respected commentator Jim Cramer on CNBC two days later.
Unease in the United States has since mutated into full-scale global contagion.
The sub-prime problems – essentially rising defaults on low documentation loans
provided to those with partial or negative credit ratings – have displaced
private equity as the public face of excessive leverage. In reality both are
symptoms of a wider problem: securitisation.

Securitisation involves transferring
non-liquid asset pools, such as mortgages or corporate loans, into more
fungible or tradable products. The impact of individual default is minimised by
its insertion into a larger pool of similar assets. For the initial provider of
capital, securitisation has the added advantage of unblocking assets that may
otherwise be required to remain on balance sheets under capital adequacy
requirements. The combination of lower risk and immediate value extraction
proved exceptionally alluring to United States and international investors

Securitisation is now integral to many
firms’ business strategy and the products populate many institutional
investment portfolios. Hence the global nature of the crisis now emanating from
the United States. An economist from Lehman Brothers, quoted in the Financial Times caught the mood last
week with a colourful metaphor. ‘We are in a minefield’, he said. ‘No-one knows
where the mines are planted and we are just trying to stumble through it.’

The risks posed of this kind of financial
engineering are not new. In 1986 the noted political economist Susan Strange
warned of the emergence of ‘casino capitalism’. By 1998, on the cusp of global
financial crisis, she argued that reckless gambling had degenerated into
psychosis. The glut in liquidity and rapid expansion of margin trading on
complex derivatives had, she said, inculcated a pathological degeneracy.
Arguably, the implications of that degeneracy are now being played out.

The problems first identified in a small
component of the US mortgage market have spread much faster and more virulently
than expected. All of this year’s gains in the S&P 500 index in New York were wiped out
in a few days’ trading. Stock exchanges from Sydney to London experienced
comparable declines. The re-pricing of risk has instilled fear and distrust in
equal measure. Suspicion reached such dangerous levels that even the inter-bank
overnight money market temporarily evaporated.

The Federal Reserve, the European Central
Bank and the Reserve Bank of Australia injected over US$100 billion into the
markets, with the New York Federal Reserve alone buying US$30 billion of the
mortgage-backed securities that are at the centre of the maelstrom. Further
negative news exacerbated the situation. In a research note accompanying the
downgrade of Countrywide Financial, one of the largest and most respected
mortgage lenders in the United States, Merrill Lynch committed these alarming
words to print: ‘We hesitate to use the word contagion…but this market is
feeling awfully similar to the fall of 1998.’

Here in Australia, RAMS Home Loans is
trading at a discount of two thirds of its listing price, after disclosing
difficulties in re-financing short-term debt obligations linked to US sub-prime
mortgage business.

In the Cold War argot of CNBC’s Jim Cramer,
the escalation imperative was tipping dangerously to ‘Mutually Assured
Destruction’. This forced the Federal Reserve to cut its discount rate to banks
by 50%. Within hours Deutsche Bank was availing itself of the facility, seen in
the past as an indicator of mismanagement. By last Monday, the problems
intensified. More than 80% of the short-term financing obligations on that day
could not be refinanced.

Given the global nature of the crisis, it
was inevitable that the problems would spread to Europe and specifically to
Ireland, which has emerged as one of the key regional centres for hedge fund
and securitisation trading. Three conduit investment funds had amassed such
significant losses that a EURO 17.3 billion credit line had to be put in place
by the German savings bank association to stave off the collapse of Saxsen LB,
the State Bank of Saxony. Coming after the near collapse of IKB last month,
warnings from the German powerhouse West LB that it faces a EURO 1.2 billion
exposure and confirmation from the Bank of England that it has extended a UK£314 million
facility to an undisclosed recipient and it appears a truly systemic problem is

It is not, however, surprising to the
central bankers or close observers of the markets. The looming conflagration
over excessive leverage was signalled repeatedly earlier this year; warnings
that were routinely ignored. The market’s failure to inculcate the value of
restraint appears to demonstrate, as Strange predicted, pathological
tendencies. Diagnosis of the malaise leaves two critical questions unresolved.
How could the markets get the fundamentals of risk so wrong? How could a system
designed to minimise risk actually spread it?

At the operational level, a profound
miscalculation of the likelihood or salience of risk factors resulted in
suboptimal design. The producers, financiers and consumers of a highly
leveraged variant of the American dream failed to appreciate the dynamics of
integrating desire, delusion and greed with lower opportunity costs. Excess
liquidity generated huge risk distortions. Arbitraging the difference between
the cost of debt and rising house and commodity prices along with manufacturing
profits led to abnormal returns that were enhanced exponentially by the power
of leverage.

The process and its rationale percolated
throughout society. From the boardrooms of Manhattan to the inner cities of the
United States no barrier to lending was imposed. Just as low-documentation
loans became pervasive in the sub-prime market, multi-billion dollar lines of
credit were extended with little or no covenants. In part, this could be
justified because the underlying debt was securitised and on-sold in the form
of esoteric financial instruments known as ‘collateralised debt obligations’
(CDOs). The debt repackaging was, in turn, fundamentally mis-priced by rating
agencies. Despite the inherently unstable nature of its core ingredients, the
reconfigured parcels were provided with implausible and unsustainable credit

Institutional actors, precluded by
governance mandates from holding products with a less than investment-grade
valuation, followed hedge funds into products in which the ownership of
economic risk was, at best, unclear. The faith placed in these products and the
ratings system now appears unwarranted. The partial internal and external
collapse of the CDO market is prompting increasing margin calls that can only
be met by parting with liquid assets, particularly corporate equities, thus
completing a vicious circle.

The credit freeze symbolises a profound
climate change in global markets. Only a matter of months ago traders and those
providing corporate advisory services were speculating (and salivating at) the
possibility of a US $100 billion buyout. Recent data from UBS suggests that
more than US $218 billion in committed funds remain non-securitised from the
top five investment banks. Major deals, such as the planned acquisition of a
Texas-based utility, TXU, which was trumpeted as the world’s largest ever
private buyout, are unravelling with alarming speed.

Investment banks are more willing to pay
break-up fees than proceed with non-economic loans for which no secondary
competitive market currently exists. In the United Kingdom debt offerings for
fundamentally sound corporations, such as the pharmaceutical chain Boots have
been pulled amid increasingly fraught attempts to renegotiate terms. With
corporate valuations slipping, reliance on much vaunted financial skills to
manufacture the appearance of good performance will be treated with much
greater scepticism. Engineering a winning strategy in the global financial
casino has just become much more problematic.

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