ENB NEWS : WORLD ECONOMY

Risk and the new financial orderSurviving the markets

Aug 16th 2007From The Economist print edition

The new financial order is undergoing its harshest test. It will not be pretty, but it is necessary
THE lifeguards had been scanning the horizon for an oil-price shock, a bankrupt buy-out or a terrorist attack. But when the big wave struck last week it surprised them by coming from inside the financial system and threatening to swamp an unlikely shore, the money markets where banks lend to each other to help cover their daily operations. Investors have been asking for years if the frantic innovation in finance, especially the securitisation of just about every form of debt into a tradable asset, was a way to spread risk efficiently, or whether this left the financial system prone to rare—but cataclysmic—failures. It looks as if investors are about to find out.
Over the past week central banks have lent tens of billions of dollars to restore confidence to the markets. But it is already clear that this mess is about more than a bit of rash mortgage lending to Americans who were in the habit of falling behind with their monthly payments. Hedge funds and private-equity firms, kings of the boom, are nursing big losses. Debt markets that once handed out cash to all comers are tight or closed altogether. In almost every asset market, investors are scurrying to reprice risk—which mostly means to reduce it.
The gravest and most immediate threat is to the banking system. For the time being, banks no longer trust other banks enough to lend them money except on onerous terms; equally worryingly, they lack confidence that other banks will trust them if they want to borrow. It is alarming when the very outfits that exist to supply the economy with credit start to hoard it from each other. At best this tightens monetary policy; at worst, a shortage of cash will cripple the payments system and cause runs on otherwise solvent banks and businesses that cannot rapidly raise funds.
Underneath all the new technology and the fancy derivatives with strange acronyms is a dilemma as old as banking itself. Anyone who thinks that lending has been too loose—and many bankers do—should welcome a purge: better now than later when the imbalances would be bigger and the economy probably weaker. But if good banks fail and money for good companies dries up, the purge will wreak huge and wasteful damage on healthy parts of the economy. How likely is that?
Fear of the deepFinancial crises are always about the way people do business, and not just the deals they have struck. Yet this one goes deeper than most. The spreading panic has shown up weaknesses in some of the foundations of modern finance. The past 20 years have created untold wealth. As securities and markets have steadily taken the place of old-style bank managers, the number of potential investors has grown and the cost of capital has fallen. Much good has come of that.
But there is a price that is only now becoming apparent. Because lenders expected to be able to sell on the risk of default to someone else, they lent too easily. After all, they would not have to pick up the pieces. In theory, that risk should have been borne by the people best able to carry it. But with everybody having sold on the risk to everyone else—and the risk often being carved up, repackaged and sold again—nobody is sure where the losses are. The fear is that some risks ended up with those who least understood what they were getting into, and fear is a potent force in this disintermediated world. In the interbank market, every counterparty was potentially vulnerable. Even small amounts of bad credit can drive out good.
In theory, ratings agencies and mathematical models help investors price the risk they are taking on, even if the securities they are buying are scarcely traded. Yet when some supposedly good-quality assets proved to be worth little, people lost faith in the models and the ratings. Across the board, investors had failed to take account of how fast and how far asset prices fall when everyone wants to sell at the same time. Hard-to-sell long-term securities had been bought with short-lived debt, which left borrowers vulnerable to a change in sentiment every time the debt fell due. It does nothing to restore confidence when the biggest model-driven hedge funds had to get in new money. The people at Goldman Sachs lost a packet when something happened that their computers told them should occur only once every 100 millennia.
Reassess, reprice and then reboundThe retreat to a new level of risk was never going to be orderly or free of casualties. Neither should it be. Bankers and investors need to suffer precisely because the methods of modern finance have been found wanting. It sounds Darwinian, but the brutal demonstration that you pay for your sins is what leads the system to evolve. Markets learn from their mistakes. Only fear will spur investors to price risks better and get them to put more effort into monitoring their counterparties.
If these lessons are to sink in, central bankers must stand back—as, by and large, they have done. Every intervention now will be taken as a sign of what the regulators will do next time. If they bail out banks that have mispriced risk, the mispricing will continue. And when the central banks do step in, it should not be to save the financiers. The cost of intervention is warranted only to save the rest of the economy from the financiers' folly. By that test, central banks were right to lend money to the banks in recent days, because it ensured that a liquidity crisis did not become a solvency crisis. They may yet have to take over a failed bank, though only if that is needed to stop a run. It is still far too soon to cut interest rates.
Because this crisis taps so deeply into the newly devised structures of finance, anyone who says the worst is definitely over is either a fool or someone with a position to protect. As risk has become bewilderingly dispersed, so too has information. Nobody yet knows who will bear what losses from mortgages—because nobody can be sure what those loans are really worth. Nobody knows if tighter lending standards will oblige borrowers to raise more capital, triggering more sales in stockmarkets and more pain. Nobody knows how messy the inevitable bankruptcies will turn out to be. What markets need now is time to piece that information back together. Time before the next wave strikes.

Banks in trouble

The game is up
Aug 16th 2007From The Economist print edition

In a special section, we look at how trouble in the credit markets has led to a crisis of confidence in global financeIllustration by Satoshi KambayashiTHE old-fashioned financial system was like Old Maid, a parlour game once beloved of small children. The banks were like players, dealt hands from a pack of cards, which they swapped among each other. At the end, one player was left holding a lonely queen—a bad debt, if you will—and lost. Over the past few decades the game has changed. Securitisation has snipped the old maid into pieces; new faces, such as hedge funds, have joined the party, enabling the banks to distribute those pieces among a larger number of players. When the game is over, lots of players are left holding small losses instead of one player holding a big one.
During two exceedingly prosperous decades, that theory seemed to work just fine. But the swings in almost all financial markets this month have made dispersed risk suddenly morph into dispersed mistrust. The uncertainty has been magnified by the way that bad risks have become so hard to value. Investors have bought asset-backed securities that use shaky subprime mortgages in America as collateral, but as defaults have risen, the value of that collateral has tumbled. Meanwhile, collateralised-debt obligations (CDOs), made up of clumps of those securities and laced with leverage, have become almost impossible to trade. So none of the players really knows how much he has lost. While this uncertainty lasts, investors are taking it out on the banks that peddled the securities by dumping their shares; and the banks are taking it out on those they sold them to by demanding more collateral on their loans. The banks have even grown cagey about lending to each other.
The doubts burst into the open on August 9th when central banks were forced to inject liquidity into the overnight money markets because banks were charging punitive rates to lend to each other. At first, the problems appeared more serious among European banks, especially in Germany, where low profitability among state banks led them to take risky bets in subprime markets. The pain in America was concentrated in the largest hedge funds, including those run by Wall Street's biggest name, Goldman Sachs. Increasingly, however, analysts worry about the exposure of American, Canadian and Asian banks to mortgage-backed securities and especially those funded by short-term commercial paper that is becoming increasingly hard to roll over. On August 15th shares in Countrywide Financial, a large American mortgage lender, fell 13% after a Merrill Lynch analyst abruptly changed his buy rating on the stock to a sell, warning of possible funding difficulties. Despite a large liquidity injection by the Federal Reserve on August 15th, the S&P 500 index fell 1.4%. The heavy selling spread to Asian stocks on August 16th.
Every crisis begets finger-pointing, and the blame now is falling on the rating agencies that helped structure these exotic instruments. The European Commission is understood to be reviewing why rating agencies failed to move more quickly in response to the growing crisis in subprime mortgages. Currently, they are guided by a voluntary code that aims to tackle potential conflicts of interest. The biggest is that the agencies are paid by the firms they rate. Rating CDOs was a profitable business.
To understand why so much blame is being heaped on the rating agencies, consider how CDOs and collateralised-loan obligations (CLOs) came into vogue. In the mid-1990s individual loans looked appealing to investors, but their ratings (often below investment grade) made them too risky for conservative types. So whole forests of asset-backed securities were put together into a single CDO. These were structured so that the first losses would be taken by whoever had bought the riskiest, highest-yielding piece of the package. That piece had a low rating. But the piece at the top, which would take the last losses, was rated AAA—a reflection of how unlikely it was that all the loans in the CDO would default at once.
Rather than standing back and observing this from the sidelines, the rating agencies got involved in structuring these products. Like schoolgirls asking for help with their homework, the banks would go to the agencies and ask how the different slices of the CDOs they were putting together would score. The agencies would suggest improvements based on their models. And lo, the senior tranches were given the ratings required to market them to banks, which liked the security the triple-A ratings conferred, especially because their yields were higher than those of American Treasuries.
If these securities are now downgraded, the same banks could be forced to offload lots of illiquid instruments into a falling market—one of the fastest ways to lose money yet devised. But if there are no buyers, banks may have to sell something else to shore up their balance sheets.
Something like this indiscriminate selling has been affecting hedge funds over the past couple of weeks. Faced with more demanding standards from their banks and investors, some have been forced to unwind positions in order to realise cash. That has led to unusual movements in debt and equity markets, which have only got some funds deeper into trouble. Quantitative funds have been hardest hit, as investment models that had made money for ages briefly proved worse than useless.
Goldman Sachs admitted as much when it said that its funds had been hit by moves that its models suggested were 25 standard deviations away from normal. In terms of probability (where 1 is a certainty and 0 an impossibility), that translates into a likelihood of 0.000...0006, where there are 138 zeros before the six. That is silly.
Since banks lend to hedge funds, any problems there quickly become their concern. On top of this, both Bear Stearns and Goldman Sachs have found that when funds bearing their name get into trouble the desire to preserve their reputations soon leads to a rescue. Sometimes risk is not as far away from the banks as it seems.
At the end of Old Maid as banks used to play it, the loser would take a big write-off and then everyone could start playing again. In the new version, the use of leverage means the game is being played with hundreds of packs of cards and by thousands of different players. “Securitisation,” says Avinash Persaud of Intelligence Capital, a financial adviser, “has meant that credit risks have moved from knowledgeable, long-term hands, to fast hands, where the principal risk-management strategy is to sell before prices fall more”. Working out who has won and who has lost in this round will take a long time.

Fed brings relief to the markets
FT.Com
By Krishna Guha in Washington
Published: August 17 2007 14:27

The US Federal Reserve took radical steps to combat financial market contagion on Friday, making direct loans available to cash-strapped banks on more favourable terms and signalling it would cut its main interest rate if necessary.
The US central bank said financial market conditions had deteriorated to the point where “the downside risks to growth have increased appreciably”. It said it was monitoring the situation and was “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”.
The Fed cut its so-called discount rate – the rate at which banks can borrow directly from the central bank against a wide range of collateral, including subprime mortgages – from 6.25 per cent to 5.75 per cent. That is only 50 basis points above its main interest rate, the federal funds rate.
Also, the Fed said it was extending the period for which these loans would be available from one day to up to 30 days, renewable at a bank’s request.
The New York Fed convened an extraordinary conference call for leading Wall Street banks to explain its move and encourage them to use the so-called discount window, saying to do so would be a “sign of strength”.
In recent years, few banks have used the discount window, fearing that going to the Fed for cash might be interpreted as a sign that they were in trouble.
The Fed hopes that if banks know they can always access cash at not-too-punitive terms against mortgage and other securities, they will jumpstart the frozen markets for asset-backed commercial paper and securities backed by “jumbo” mortgages.
Neal Soss, chief economist at Credit Suisse, said: “This is a masterful move because it doesn’t actually feed some of the concerns about moral hazard’’ of bailing out investors who took risks.
The Fed announced the changes in its policy statement following a video conference of its open market committee on Thursday.
The action was unanimously endorsed by committee members, although Bill Poole, president of the St Louis Fed, who has argued publicly against an emergency rate cut, did not take part in the vote.
John Lonski, chief economist at Moody’s Investors Service, said the discount rate cut was “welcome news for a jittery credit market” but added: “It would be premature to state with confidence that cutting the discount rate will serve to stabilise markets.”
Stocks around the world rose on news, with the Dow Jones Industrial Average gaining 233.30 points, or 1.8 per cent, to 13,079.08. The yield on the two-year US Treasury note fell 4 basis points to 4.18 per cent, signalling continuing risk aversion in the credit markets.
Fed funds futures still indicated that investors expect several quarter-point cuts from the current 5.25 per cent by the end of the year.
“It’s not over yet,” said Marco Annunziata, chief economist at UniCredit in London, “but the Fed has started to lay the basis for a gradual return to sanity, and to more realistic and discriminating asset valuations.”
Additional reporting by Richard Beales in New York and Eoin Callan in Washington