Financial shell games

The gigantic liquidity bubble is now deflating. The sub-prime problems were merely the trigger for a major adjustment in the availability and cost of borrowings globally.

By Satyajit Das

 

The end of the world?

In Indian mythology, we are in the Age of Kali – the last age, in which the world ends when Kali dances the dance of death. With the sub-prime crisis in the US, which started in 2006, creating a ripple effect in global markets, has Kali begun her dance for financial markets? American television personality Jim Cramer, who launched a ‘we’re in Armageddon’ tirade, seems to think so; while Samuel Molinaro, Chief Operating Officer of a leading global investment bank, pleaded ‘I’ve been out here for 22 years, and this is as bad as I’ve seen it in the fixed-income markets.’ It’s clear that the credit bubble is finally deflating.

The new liquidity factory

Where did it all start? The early 2000s was a period of ‘too much’ and ‘too little’ – too much money, too much borrowing, too much complex financial engineering, too little return for risk, and too little understanding of the risks. Steven Rattner (from hedge fund Quadrangle Group) summed it up in the Wall Street Journal: ‘No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since US financial markets reached full flower.’

Liquidity is the amount of money and credit available. In the ‘new liquidity factory’, investors borrowed – hedge funds borrowed against investments; traders borrowed cheap money (especially Japanese yen at zero interest rates) to fund high yielding assets. Bankers became adept at stripping money out of homes where prices had risen to fund a frantic personal debt addiction in the fast debt nations – US, UK and Australia. Traditional money, fueled by loose monetary policy, low interest rates, large capital flows from the savers of Europe and Asia, was turbo-charged by ‘financial engineering’. It was this engineering – otherwise known as derivatives – that laid the foundation for the current credit crisis.

Derivatives – highly leveraged commercial bets on movements in prices of financial assets – can be used to manage or create risk. In recent years, more and more investors were turning to derivatives to increase risk for higher returns. One example we have seen is the Collateralised Debt Obligation (CDO), a mortgage loan secured on steroids. It works like this. A portfolio of loans, bonds or mortgages is assembled. CDO securities, secured over the portfolio, are sold to investors. Interest and principal from the underlying portfolio is used to make payments on the CDO securities issued. The investors receive higher returns than from traditional investments.

CDOs and their kin – structured credit – have helped supersize debt levels using techniques of staggering complexity, incomprehensible to all but a small group of practitioners. The market was so heated that one professional confessed that even his headhunter had been recruited into a structured credit role at an investment bank. Buyers from Switzerland to Slovakia, Boston to Beijing bought up credit risk. A feature of the market was that the investor did not understand the complexity and risk of structures.

The new liquidity machine created a money pyramid that has no parallel in history, as shown in Figure 1. [view enlarged image]

Figure 1
Source: Independent Strategy – this version is adapted from Andrew Cornell’s “The Year of Easy Money” from the Weekend Australian Financial Review, 27 December – 1 January 2007

Now, this gigantic liquidity bubble is deflating. The sub-prime problems were merely the trigger for a major adjustment in the availability and cost of borrowings globally. Investors, including hedge funds, who borrowed heavily against assets that have gone down in value, have been forced to sell to repay borrowings. However, in the highly leveraged world of the new liquidity factory, the amount that needs to be sold is exaggerated.

This process of deflation will not be quick or painless. A veteran commentator, Ian Kerr compared the current credit crunch to death from radiation – CDO, particularly those with sub-prime exposure, now stands for Chernobyl Death Obligations!

Financial ‘shell games’ or the ‘pea and thimble’ trick

Markets exaggerate the short-term impact and underestimate the long run impact of events, and the liquidity factories were based on the New Age idea of ‘risk transfer’. Traditionally, banks made loans and then held them on their balance sheets till maturity. In the new money game, banks ‘originate’ (sell) loans, ‘warehouse’ (hold) them on their balance sheet for a short time and then use CDO technology to ‘distribute’ (transfer) them to investors such as insurance companies, pension funds and ubiquitous hedge funds. Central banks believe that if banks sell off their loans in this way, the risk is distributed widely, thus reducing the chance of a crash.

Yet risk transfer is a short con, quick and easy to pull off. It’s like the ‘shell game’, which involves three shells and a small, round ball about the size of a pea. The trickster places the ball under one of the shells, then shuffles the shells around quickly. Bets are taken from the audience on the location of the ball. By sleight of hand, the operator easily hides the ball, undetected by the victims. Like the shell game, risk transfer via the structured credit market is a confidence trick used to perpetrate fraud. And in the current credit crunch, the shortcomings of the new money game are being exposed.

Banks do not sell off their real risks very often, mainly for regulatory reasons. In a CDO, the bank typically takes some of the riskiest securities created. This is ‘hurt money’ or the ‘skin in the game’ to reassure other investors, which the banks must hold until they can be sold. If there is a market disruption and the bank is unable to sell the risk into the market, then the risk remains with the bank.

However, the risk may also return to the bank via the back door. Where it acts as a prime broker – this is where banks execute trades, settle transactions and lend to hedge funds – the bank lends to investors using the CDO securities created as collateral. If the value of the securities falls and the hedge fund is unable to post additional margin to cover the loss, the bank is exposed to the risk of the securities. The bank assumes that it can sell the securities it is holding to pay itself back. As there are few prime brokers – three dominate the business – the risk is concentrated.

Banks have also created a plethora of off-balance sheet structures – arbitrage or conduit vehicles – known as structured investment vehicles (SIVs). The vehicles purchase high quality securities like AAA or AA rated CDOs and fund them with short-term borrowing, usually commercial paper (CP) issued to money market funds. Banks provide standby lines of credit to the vehicles to cover funding shortfalls. If CP cannot be issued, the banks may be forced to lend against the assets that they have supposedly sold off. In the current crisis, some banks refused to lend, arguing material changes in circumstances. Others foraged down the back of the sofa for any loose change to add to their dwindling liquidity to meet their commitments. Some bowed to the inevitable and took the assets back onto their balance sheets.

The new money game assumes that the risk moves to stable investors. In fact, credit risk moves from a place where it is regulated and observable to a place where it is less regulated and more difficult to identify. Around 60 per cent of all credit risk is transferred to leveraged hedge funds that may be inadequately capitalised to bear the risk – around one dollar of ‘real’ capital supports between $20 and $30 of loans. In contrast, banks are required to hold $1 of capital for every $12.50 of loans.

When we see banks setting up hedge funds, and investing in them, the trouble begins. Hedge fund investors can withdraw funds at relatively short notice, typically, one to three months. The hedge fund’s borrowings are also short-term, and this money finances long-term assets, making the hedge funds vulnerable to a credit crisis. When a hedge fund gets into trouble, as we have seen, there is commercial and reputation pressure to support the fund, bringing the risk back into the bank. As one humorist wryly suggested, with more and more funds facing margin calls, they should meet capital calls by using nickels, pennies and quarters.

The same model as sub-prime is used, worryingly, for funding highly leveraged private equity, infrastructure and property transactions. As of August 2007, $300 billion of leveraged finance loans made by banks have been effectively orphaned. In other words, they cannot be sold off. One bank recently offered $1 billion to a client to walk away from an underwriting commitment where it stood to lose more if the transaction proceeded. Another bank, active until recently in making multi-billion dollar commitments to private equity transactions, told clients that ‘they were not in leveraged lending business any more.’ It smacked of the day in the late 1980s when the then all-powerful Japanese banks refused to participate in leveraged financing to meet the cost of acquiring United Airlines. This ushered the end of that era.

Truth in labelling

There is a lack of transparency in many of these activities. One trader summed it up using Donald Rumsfeld’s immortal words: the known known was that there were losses in sub-prime mortgages and anything related to them; the known unknown was that everybody knew that they did not know the full extent of the problem; the unknown unknown was that there could be other problems about which we did not then know. Investment banks and hedge funds believe in transparency and disclosure for everybody, except for themselves. One central banker observed that in the good old days, there would have been no problem as the risk would be where it always was – at the banks.

There are also problems about the models used to value these complex securities, assumptions about being able to buy and sell them, and the role of rating agencies in certifying them.

The current crisis points to the need for significant and important changes in financial markets. In its 2007 annual report, the Bank of International Settlements (BIS), the central bank to the world’s central banks, admitted that ‘our understanding of economic processes may be even less today than it was in the past.’

The temptation to seek a scapegoat – such as the brokers that sold sub-prime mortgages and rating agencies – looms large. And the temptation for a quick fix – lower interest rates – is ever-present. The Federal Reserve System has cut the discount rate. It has also clarified the rules, stating that banks can pledge asset backed commercial paper as collateral for funding at its discount window. Usually, only government securities are eligible. The Fed is effectively underwriting the credit risk, and is arguably reverting to type, bailing out banks and investors from poor decisions or irrational exuberance in underwriting excessive risk-taking.

John Maynard Keynes knew the problem well: ‘the difficulty lies not so much in developing new ideas as in escaping from old ones.’ But as John Kenneth Galbraith observed: ‘faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.’

There are unknown knowns in financial markets – what we did not know we knew. These are things we never admit to ourselves. Ordinary, decent people always pay for financial excesses with their hard-earned money and taxes. We all knew that somewhere along the road, the financial shell game would end this way.

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A condensed version of a lecture given at the Melbourne Centre for Financial Studies and the Financial Services Institute of Australasia on 26 February 2008.

Mr Satyajit Das is a risk consultant and author of a number of key reference works on derivatives, including Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider’s account of derivatives trading and the financial products business.


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