The Hindu Business Line : The wages of financial innovation

The current sub-prime triggered financial crisis is quite different from what the world had witnessed in the past. It is not one-dimensional or confined to a specific sector. It has intertwined banks with an array of other institutions.

K. Subramanian

It is a cliché to attribute the Crash of 2007-08 to the woes arising from the subprime lending in the US. It broke out within days after the meeting of the US Federal Reserve on August 7.

Fear seized credit markets, bred risk aversion and liquidity froze. Warriors (read, investment bankers) who could shuffle billions of dollars across computers in seconds in what was described as “statistical arbitraging” were scurrying for liquidity to bolster the value of their assets.

More than fear, it was the distrust of the value of the assets held by their peers that curdled cash flows.

Not one-dimensional

Pink papers bring out newer interpretations of the causes, turn of events and their linkages. Unlike in the past, the latest crisis is not one-dimensional or confined to a specific sector.

It has intertwined banks with an array of other institutions ranging from investment banks, hedge funds, non-banking financial institutions and other entities.

Banks in many countries face bankruptcy. The European Central Bank (ECB) was quick to act and pump in liquidity. The US Fed fell in line days later and also reduced the Fed rate by half a percentage point.

In Germany, IKB Deutsche Industriebank was shielded by KfW (German government-owned development bank). Deutschebank itself is said to be under attack.

The French bank BNP Paribas suspended operations of three of its funds. Macquarie Bank, a high flying Australian securities bank, declared a loss of 25 per cent in its Fortress Fund.

What shocked many, including the Bank of England and FSA (Financial Services Authority), a UK-based independent non-governmental body, was the run on Northern Rock, the leading mortgage bank.

Focus on CDO

In the current state of uncertainty, it is difficult to predict who the next victim would be. It depends on the value of the collateralised debt obligations (CDO) it holds and how much of it is ‘toxic.’

The CDO is the umbilical cord that binds subprime lenders, banks, hedge funds, investment banks and all others.

CDOs are derivatives seeking to diversify risks attached to loans and securities. They originated modestly in the early 1990s. It was a method which enabled banks to package loans in their portfolio into securities and trade them. The shift was from the model of “originate and hold” to one of “originate and distribute.” It shifted the risk to the buyer and enabled the amount to be taken off its balance sheet.

Within a few years, securitisation morphed into CDOs through bundling pools of securities.

The bundles were further carved into tranches with rating related to different levels of risk and return. Riskier tranches suffer the first losses if the underlying loans sour. Other tranches offer lower returns as riskier tranches take the first hit.

The mortgages and sub-prime loans were hidden under CDOs and also facilitated their proliferation.

In recent years, CDO volumes have been rising astronomically. In its 77th Annual Report released in June 2007, the Bank for International Settlements (BIS) referred to the toxic effect of the “$170 billion collateralised debt obligations (CDO), and a further $524 billion in ‘synthetic’ CDOs, which have been spread through hedge funds.”

As the magic of CDOs unfolded, banks handled more of them earning larger commissions and nearly abdicated their conventional role of taking deposit and lending.

The newer methods of structuring CDOs and their exotic variants were glamourised as financial innovations which, by diversifying risk, provided stability to the financial system. Mr Alan Greenspan made repeated and adulatory references to them, especially in promoting financial stability. Mr Ben Bernanke, the current Chief of the Fed, holds similar views. The enthusiasm of US authorities over these innovations is not shared by non-US economists.

In its Annual Report for 2005, the BIS expressed worries over the sharp rise in the volume of CDOs and their nature. As it explained, “The covenant on many CDO contracts can be difficult to comprehend and deal complexity has posed many modelling challenges….. progress still needs to be made in understanding the nature of portfolio distributions, the profile of CDO tranches and their sensitivity to credit risk correlations.”

In a very detailed report, Bloomberg narrated the structuring of CDOs and the role of rating agencies (‘The Rating Charade’, July 27, 2007, at http://www.bloomberg.com/news/marketsmag/ratings.html ). It offers a shocking revelation of the collusion between banks and rating agencies. The bundles are put through by rating agencies and also rated by them. They are supposed to follow highly mathematical models.

The models had the trappings of certitude and, as later events established, were dubious. The regulators in the US had given full freedom to rating agencies and the reason adduced was that they were unable to go behind the sophisticated models for regulatory reach!

Analysts draw attention to the fact that they were ‘marked to model’ and not ‘marked to market.’ Unfortunately, in recent years CDOs became big business between banks, non-banks and brokers and grew in volume. Reuters reported it around $2.6 trillion for 2006.

Inherently risky

By their origin, sub-prime loans were high risk and extended to persons who were not eligible for loans under Federal guidelines. They were NINJA (no-income-no-job-no-asset) loans and could be traced to the years 2003-05 when the Fed kept the rate at 1 per cent. Low interest and easy credit planted the seeds of the crisis. Further, capital adequacy norms on banks tilted the balance in favour of unregulated lenders.

They, in turn, financed their operations not from deposits but through Wall Street lines and securitisation.

Thus, sub-prime loans got embedded into CDOs. This alliance between sub-prime loans and other variants subsumed under “structured investment vehicles” would cause collateral damage in due course unbeknownst to US Fed and other regulators.

By June, the rating agencies came out with downgrades for some banks and institutions creating mayhem in the market. Suddenly, the financial community woke up to realise that it was holding worthless bundles that could not be traded or were ‘illiquid.’

Wall Street bankers were trading CDOs with banks abroad and it was explained as a way of sharing risk with others. With AAA rating, many banks were attracted to hold those assets. Sadly, they did not know what they were buying or how to handle them when the crisis struck. The computerised models and pricing formulae had run aground and “this predilection for lemming style buying or selling from investors using similar models could turn what would be a market setback into a wider contagion.” (New York Times, August 13, 2007.)

Uneasy calm

It is not clear how far the contagion would spread. There is an uneasy calm prevailing among bankers. It is equally unclear how or how soon the assets tangles may be resolved or who would bear the costs. Central banks, including the venerated ones, are clueless. Sadly, “Recent events show that financial innovations meant to distribute risk can end up multiplying instead in ways neither regulators nor investors fully understand.” (The Wall Street Journal, August 7, 2007.) Avinash Persaud has analysed it more trenchantly: “Securitisation has in fact led to more concentrated behaviour. It raises, not lowers, systemic risk.” (Economic and Political Weekly, August 25, 2007.)

This crisis is quite different from what the world had witnessed in the past. It cannot be solved by pumping more and more money unless the Augean mess is cleaned up.

They are the detritus left behind by financial innovation. It is a daunting task and would require international coordination among all central banks of developed and developing countries and the formulation of a new framework for banks, hedge funds, etc.

(The author, a former Finance Ministry official, has extensive experience in trade and finance issues.)

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