Ref : AIG still facing huge credit losses
By Henny Sender in New York Financial Times, March 3 2009
AIG has declared a $62bn fourth-quarter loss and confirmed that it would give the US government a stake in its two biggest divisions as part of a fresh $30bn rescue.
Meanwhile more losses may follow. AIG retains $12bn in exposure to credit insurance on positions mostly involving subprime mortgages. As of February 18, AIG could have to pay counterparties up to $8bn on these positions.
Ben Bernanke, Federal Reserve chairman, expressed his strong sentiments in an appearance before the Senate budget committee: "If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG.There was no oversight of the financial products division. This was a hedge fund basically that was attached to a large and stable insurance company.”
AIG burnt its fingers badly when it moved agggressively into selling credit default swaps to provide credit protection for collateralised debt obligations.AIG ran into trouble when its credit rating was downgraded and the value of the CDOs it insured fell, This forced it to post tens of billions of dollars in additional collateral with its counterparties. Pushed to the wall, AIG had no option but appeal to the government for a bailout in September.
In November, the Federal Reserve Bank of New York set up a limited liability company called Maiden Lane III – backed by $5bn from AIG and borrowings of up to $30bn from the Fed – to deal with the crisis. Maiden Lane III would buy CDOs from AIG’s counterparties and then tear up the credit insurance issued by AIG.
In the days after the creation of Maiden Lane III, AIG and the Fed approached about 20 counterparties with an offer to buy CDOs. By the end of the year, Maiden Lane III had paid nearly $30bn for CDOs with a face value of $62bn. AIG paid $32.5bn to terminate the credit insurance on the CDOs, recognising a 2008 loss of $21bn. Counterparties received 100 cents on the dollar for the CDOs, but the prices paid by Maiden Lane III suggested that the CDOs were worth 47 cents on the dollar.
Showing posts with label Sub Prime Crisis. Show all posts
Showing posts with label Sub Prime Crisis. Show all posts
Wednesday, March 04, 2009
Monday, March 02, 2009
Explaining the role of central banks in the sub prime crisis
Ref The Economist dt Sep 11, 2008
According to George Cooper of JP Morgan, one of the main reasons for the global financial melt down is that central banks have subscribed to one economic philosophy in an expanding economy and quite another when the economy is contracting. When things are going well, central banks leave the markets alone. But at the merest hint of crisis, central bankers cut interest rates to stimulate their economies and prevent asset prices from falling. Indeed, this is what the Fed under Greenspan did. Greenspan argued that it was impossible to spot bubbles while they were inflating. Instead, he felt that central banks should quickly respond once the bubble had burst.
This school of thought believes that prices reflect all available information. On that basis, asset prices are always “right”, there can be no bubbles and central banks should not intervene to restrain speculative excess. Even if there is a temporary mispricing, the market will correct itself.
Cooper argues that markets are far from efficient. Investors may simply be unable to get enough information to make correct judgments about the value of securities, or indeed may be given misleading information by insiders such as company executives or salesmen from the financial-services industry.
During a market crash, central-bank intervention to prop up markets is often popular. There are few people who relish banking collapses or recessions. But it creates problems in the long run. The first is that consumers (and companies) are encouraged to borrow, not save, thanks to the low level of interest rates and a belief that central banks and governments will always rescue them if things go wrong.
The second danger is that the system becomes progressively less stable as risk-taking is encouraged. Instead, central banks should permit some short-term cyclicality in order to purge the system of excesses. They can do this by preventing excessive credit creation. This means that credit growth should not be far ahead of economic growth.
Letting the markets have their way would risk a repeat of the Great Depression. But the danger of bailouts is that central banks may inflate another credit bubble, saving the economy from disaster in the short term but raising the stakes still further when the next crisis comes around. The Bear Stearns, Fannie Mae, Freddie Mac and AIG rescues, suggests the world is heading in that direction.
According to George Cooper of JP Morgan, one of the main reasons for the global financial melt down is that central banks have subscribed to one economic philosophy in an expanding economy and quite another when the economy is contracting. When things are going well, central banks leave the markets alone. But at the merest hint of crisis, central bankers cut interest rates to stimulate their economies and prevent asset prices from falling. Indeed, this is what the Fed under Greenspan did. Greenspan argued that it was impossible to spot bubbles while they were inflating. Instead, he felt that central banks should quickly respond once the bubble had burst.
This school of thought believes that prices reflect all available information. On that basis, asset prices are always “right”, there can be no bubbles and central banks should not intervene to restrain speculative excess. Even if there is a temporary mispricing, the market will correct itself.
Cooper argues that markets are far from efficient. Investors may simply be unable to get enough information to make correct judgments about the value of securities, or indeed may be given misleading information by insiders such as company executives or salesmen from the financial-services industry.
During a market crash, central-bank intervention to prop up markets is often popular. There are few people who relish banking collapses or recessions. But it creates problems in the long run. The first is that consumers (and companies) are encouraged to borrow, not save, thanks to the low level of interest rates and a belief that central banks and governments will always rescue them if things go wrong.
The second danger is that the system becomes progressively less stable as risk-taking is encouraged. Instead, central banks should permit some short-term cyclicality in order to purge the system of excesses. They can do this by preventing excessive credit creation. This means that credit growth should not be far ahead of economic growth.
Letting the markets have their way would risk a repeat of the Great Depression. But the danger of bailouts is that central banks may inflate another credit bubble, saving the economy from disaster in the short term but raising the stakes still further when the next crisis comes around. The Bear Stearns, Fannie Mae, Freddie Mac and AIG rescues, suggests the world is heading in that direction.
Friday, February 27, 2009
The Citi bailout
On February 27th, Citigroup and the Treasury reached a deal that took a big step towards partial nationalisation. Through conversions of preferred stock, the government will own 36% of Citi, though the final figure will depend on how many preferred shares private holders agree to swap.
As the Economist mentioned today, the latest bail-out will give the government real control of Citi. The government does not need to own a majority of the shares in a bank to wield whatever influence it likes. With somewhere near 36% of Citi, control of decision-making will be complete—if it is not already. Citi already has to clear strategic decisions with regulators.
Citi approached regulators about the conversion, worried that further losses would as the recession and housing crisis deepen. Citi will need more capital in the coming months. And its current market cap of about $ 14 billion looks really puny indeed.
As the Economist mentioned today, the latest bail-out will give the government real control of Citi. The government does not need to own a majority of the shares in a bank to wield whatever influence it likes. With somewhere near 36% of Citi, control of decision-making will be complete—if it is not already. Citi already has to clear strategic decisions with regulators.
Citi approached regulators about the conversion, worried that further losses would as the recession and housing crisis deepen. Citi will need more capital in the coming months. And its current market cap of about $ 14 billion looks really puny indeed.
The crisis in Iceland
Ref The Economist dt Dec 13, 2008
The collapse of the krona and nationalisation of the country’s three largest banks in early October, 2008 have left Iceland facing a huge financial crisis.This is probably the biggest banking failure in history relative to the size of an economy. How did this happen?
Iceland ilustrates the dangers of a large globalised banking system in a small domestic economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003. Only about one-fifth of those loans were in kronur; interest rates on these were very high. SO many Icelanders instead borrowed from their banks in cheaper currencies such as yen and Swiss francs.
But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply. Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency.
The IMF forecasts that the economy will contract by 9.6% next year. Many workers have been laid off. Many young Icelanders, who have never known unemployment, are expected to lose their jobs.
With unemployment rising, citizens talk openly about defaulting on their home and car loans. Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. This and their foreign-currency exposure means many households’ debts have roughly doubled in krona terms.
The failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy’s size, that would be about 20 times the Swedish government's banking rescue act in the early 1990s. The cost would also be several times that of Japan’s serious banking crisis a decade ago.
The crisis was fulelled by the aggressive business model of Iceland’s two largest banks, Landsbanki and Kaupthing Bank. These banks could attract only paltry sums in the domestic market. In 2006, they decided to use the internet to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. These banks were soon sucking deposits away from bricks-and-mortar banks across Europe. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, or about half of Iceland’s entire GDP.
Now the debate has intensified whether Iceland should join the Euro. Here opinion is divided among Icelanders. And even if the country decides to join the Euro zone, it will take quite sometime.
The collapse of the krona and nationalisation of the country’s three largest banks in early October, 2008 have left Iceland facing a huge financial crisis.This is probably the biggest banking failure in history relative to the size of an economy. How did this happen?
Iceland ilustrates the dangers of a large globalised banking system in a small domestic economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003. Only about one-fifth of those loans were in kronur; interest rates on these were very high. SO many Icelanders instead borrowed from their banks in cheaper currencies such as yen and Swiss francs.
But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply. Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency.
The IMF forecasts that the economy will contract by 9.6% next year. Many workers have been laid off. Many young Icelanders, who have never known unemployment, are expected to lose their jobs.
With unemployment rising, citizens talk openly about defaulting on their home and car loans. Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. This and their foreign-currency exposure means many households’ debts have roughly doubled in krona terms.
The failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy’s size, that would be about 20 times the Swedish government's banking rescue act in the early 1990s. The cost would also be several times that of Japan’s serious banking crisis a decade ago.
The crisis was fulelled by the aggressive business model of Iceland’s two largest banks, Landsbanki and Kaupthing Bank. These banks could attract only paltry sums in the domestic market. In 2006, they decided to use the internet to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. These banks were soon sucking deposits away from bricks-and-mortar banks across Europe. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, or about half of Iceland’s entire GDP.
Now the debate has intensified whether Iceland should join the Euro. Here opinion is divided among Icelanders. And even if the country decides to join the Euro zone, it will take quite sometime.
Thursday, August 30, 2007
The sub prime crisis : Will cuts in interests rates restore risk appetite?
Will cuts in interests rates restore risk appetite and encourage entities to take up new debt. Or will growth slow down? According to George Magnus, writing in the Financial Times, the reduced availability of cheap credit will lead to a sharp reverse in spending. Magnus also mentions that the current crisis is different from 1998 when liquidity was the main concern. This time the problem is about solvency. The rapid deterioration in financial conditions and rising cost of capital will almost certainly lead to higher default rates. Magnus expects that in the near future, the price of capital will depress borrowing, capital mobilization, capital spending and employment. While the US will be the worst hit, Europe and Japan will slow down though not so much. But overall, the world economy may lose momentum and the business cycle may get rough.
Meanwhile, there have been wild swings in prices of some of the safest and most liquid government securities. After a flight to quality, there has been a massive sell off of T Bills. On August 22, the yield on one month treasury bill rose 83 basis points to 3.15%, while the 3 month T bill yield increased by 17 basis points to reach 3.44%. Swings of 50-100 basis points in T bill yields have become quite common. These fluctuations are of course the result of serious concerns about the $2130 billion commercial paper market, 50% of which is estimated to be backed by assets such as consumer loans, including mortgages and complex structured securities such as CDOs (Collateralised Debt Obligations) Money market funds, which are usually major buyers of such paper have shifted to the much safer T Bills. Till the markets become more confident that the skeletons are out of the cupboard, uncertainty and mistrust will continue. So will the market fluctuations.
Meanwhile, a more optimistic view has been expressed by Ken Fisher again writing in the Financial Times. According to him, while credit spreads have widened, they have not widened all that much compared to credit crunches of the past. Fisher also argues that a lot of cash hoarding is taking place, a clear signal that these are the late stages of a panic or correction, not the early stages of a bear market. Even today, interest rates remain low and debt is attractive. Firms can borrow globally and buy back shares to increase EPS. If that continues, the supply of equity will shrink and the bull market will resume.
Meanwhile, shakeouts continue. On August 23, Lehman Brothers announced plans to shutdown its sub prime mortgage unit, BNC Mortgage. Lehman will take a charge of about $52 million. According to company sources, sub prime lending activities account for less than 3% of revenues in recent quarters. Some 1200 people are expected to lose their jobs.
Meanwhile, Accredited Home lenders, a sub prime lender and HSBC have announced combined job losses of more than 2000. Accredited will cut 1600 jobs while HSBC will slash 600.
On the other hand, Bank of America has plans to invest $2 billion in country wide financial, the troubled mortgage company’s current market cap of about $12.6 billion. Bank of America’s move indicates that some companies are seeing a big opportunity to pick up undervalued stocks even as the market turmoil continues.
Meanwhile, there have been wild swings in prices of some of the safest and most liquid government securities. After a flight to quality, there has been a massive sell off of T Bills. On August 22, the yield on one month treasury bill rose 83 basis points to 3.15%, while the 3 month T bill yield increased by 17 basis points to reach 3.44%. Swings of 50-100 basis points in T bill yields have become quite common. These fluctuations are of course the result of serious concerns about the $2130 billion commercial paper market, 50% of which is estimated to be backed by assets such as consumer loans, including mortgages and complex structured securities such as CDOs (Collateralised Debt Obligations) Money market funds, which are usually major buyers of such paper have shifted to the much safer T Bills. Till the markets become more confident that the skeletons are out of the cupboard, uncertainty and mistrust will continue. So will the market fluctuations.
Meanwhile, a more optimistic view has been expressed by Ken Fisher again writing in the Financial Times. According to him, while credit spreads have widened, they have not widened all that much compared to credit crunches of the past. Fisher also argues that a lot of cash hoarding is taking place, a clear signal that these are the late stages of a panic or correction, not the early stages of a bear market. Even today, interest rates remain low and debt is attractive. Firms can borrow globally and buy back shares to increase EPS. If that continues, the supply of equity will shrink and the bull market will resume.
Meanwhile, shakeouts continue. On August 23, Lehman Brothers announced plans to shutdown its sub prime mortgage unit, BNC Mortgage. Lehman will take a charge of about $52 million. According to company sources, sub prime lending activities account for less than 3% of revenues in recent quarters. Some 1200 people are expected to lose their jobs.
Meanwhile, Accredited Home lenders, a sub prime lender and HSBC have announced combined job losses of more than 2000. Accredited will cut 1600 jobs while HSBC will slash 600.
On the other hand, Bank of America has plans to invest $2 billion in country wide financial, the troubled mortgage company’s current market cap of about $12.6 billion. Bank of America’s move indicates that some companies are seeing a big opportunity to pick up undervalued stocks even as the market turmoil continues.
Friday, August 24, 2007
The Sub Prime Crisis: The Fed’s impact on money markets
(Ref: Wall Street Journal, August 21, Financial Times August 21)
About a week back (August 17th) the Fed reduced the discount rate, the interest rate at which the Fed provides funds to banks, as a lender of last resort. The Federal funds rate, the interest rate at which banks led to each other, has still not been cut. But the stock markets, in anticipation of such a cut, have bounced back a little. In contrast, the money markets, for whom the message was intended, have reacted in a negative way. Money market investors have retreated to safety, investing heavily in short term US government debt. On August 20, the yield on the one month treasury bills fell to 1.34% (about 160 basis points) while that on three month treasury bills fell to 2.51% (123 basis points). This retreat to safety is a clear indication that risk aversion has seized the markets. There is now speculation that the Fed will cut the Federal Funds rate on September 18, the date of the next policy meeting. Meanwhile, yesterday (August 20), major central banks continued to pump funds into money markets. The ECB has so far injected liquidity to the tune of Euro 95 billion on August 9, Euro 61 billion in Aug 10, Euro 47.7 billion on August 13, and Euro 7.7 billion on August 14. Yesterday (August 20) the Fed pumped in $3.5 billion of overnight funds while the Bank of Japan added $8.76 billion to short term money markets.
About a week back (August 17th) the Fed reduced the discount rate, the interest rate at which the Fed provides funds to banks, as a lender of last resort. The Federal funds rate, the interest rate at which banks led to each other, has still not been cut. But the stock markets, in anticipation of such a cut, have bounced back a little. In contrast, the money markets, for whom the message was intended, have reacted in a negative way. Money market investors have retreated to safety, investing heavily in short term US government debt. On August 20, the yield on the one month treasury bills fell to 1.34% (about 160 basis points) while that on three month treasury bills fell to 2.51% (123 basis points). This retreat to safety is a clear indication that risk aversion has seized the markets. There is now speculation that the Fed will cut the Federal Funds rate on September 18, the date of the next policy meeting. Meanwhile, yesterday (August 20), major central banks continued to pump funds into money markets. The ECB has so far injected liquidity to the tune of Euro 95 billion on August 9, Euro 61 billion in Aug 10, Euro 47.7 billion on August 13, and Euro 7.7 billion on August 14. Yesterday (August 20) the Fed pumped in $3.5 billion of overnight funds while the Bank of Japan added $8.76 billion to short term money markets.
The Sub Prime Crisis: Some investors see an opportunity
(Ref: The Financial times dt August 21)
Wilbur Ross, the US financier specializes in distressed businesses. In 2000 he bought a bankrupt lender, Kofuku Bank of Osaka and sold it three years later for a profit. Planning to invest in the sub prime segment in a big way, Ross recently remarked, “We are going to be in sub prime. It is a valid business. There is nothing wrong with lending sub prime, what is wrong is doing it recklessly.” Having lent $50 million to American Home Mortgage, a move which he equates to getting his feet wet, Ross has much bigger plans ahead.
Ross’s move is reflection of the maturity and dynamism of the US financial markets. True there is currently a crisis. But even in a crisis, people are seeing opportunities. There is a lot of soul searching going on out there. No one is trying to downplay the magnitude of the crisis. The only debate is on what is the best policy measure under the circumstances. And what are the structural measures needed in the long run? If such a crisis had happened in India, the country’s leaders would have almost certainly gone into a state of denial, arguing that the crisis had been exaggerated. In contrast, the crisis is being discussed in a very transparent way in the US. Even Henry Paulson the highly respected Treasury Secretary and former Goldman Sachs CEO has admitted that the US economy will take a hit. The strength of the global economy, less dependence on the US, pragmatic measures by the Fed and the arrival of bargain hunters like Ross mean that there is still a silver lining in the cloud. The markets may stablise faster than expected.
Wilbur Ross, the US financier specializes in distressed businesses. In 2000 he bought a bankrupt lender, Kofuku Bank of Osaka and sold it three years later for a profit. Planning to invest in the sub prime segment in a big way, Ross recently remarked, “We are going to be in sub prime. It is a valid business. There is nothing wrong with lending sub prime, what is wrong is doing it recklessly.” Having lent $50 million to American Home Mortgage, a move which he equates to getting his feet wet, Ross has much bigger plans ahead.
Ross’s move is reflection of the maturity and dynamism of the US financial markets. True there is currently a crisis. But even in a crisis, people are seeing opportunities. There is a lot of soul searching going on out there. No one is trying to downplay the magnitude of the crisis. The only debate is on what is the best policy measure under the circumstances. And what are the structural measures needed in the long run? If such a crisis had happened in India, the country’s leaders would have almost certainly gone into a state of denial, arguing that the crisis had been exaggerated. In contrast, the crisis is being discussed in a very transparent way in the US. Even Henry Paulson the highly respected Treasury Secretary and former Goldman Sachs CEO has admitted that the US economy will take a hit. The strength of the global economy, less dependence on the US, pragmatic measures by the Fed and the arrival of bargain hunters like Ross mean that there is still a silver lining in the cloud. The markets may stablise faster than expected.
The structural reasons behind the Sub Prime Crisis
(Ref Financial Times dt August 22)
In a recent article in the Financial Times, Martin Wolf, the well known columnist has dug deeper into the sub prime crisis. Many of the articles written on the subject have focused on the linkages between different markets. But this one looks at broad macro economic factors contributing to the crisis. We all know the US has been running a major current account deficit in the recent past. A current account deficit essentially means the country is spending more that it is saving. According to Wolf, there is an excess of savings over investment (and consumer spending) in much of the world. This has been offset by an excess of investment (and consumer spending) over savings in a smaller part of the world. In 2006, the countries with surplus savings generated a current account surplus of about $1300 billion. The US current account deficit absorbed about two thirds of this surplus.
In simple terms, foreigners have been buying US assets on a vast scale. The funds provided by foreigners have been absorbed by the US government and households since the stock market bubble burst in 2000. Between the first quarter of 2000 and the third quarter of 2003, there was a negative swing in the US budget balance of 7% of GDP. Household spending has also been on the rise since the 1990s. By 2006, households had accumulated a financial deficit of close to 4% of GDP. This household deficit has absorbed the financial surpluses of the business sector. This rise in household indebtedness has worked through asset backed borrowing. Or more precisely mortgages. This had to happen because with the US absorbing so much of capital, the government already having piled up a huge fiscal deficit and businesses showing surpluses, somebody had to spend to prevent the economy from going into recession. That is also why the Fed is likely to cut interest rates and sort of prolong the party. The other alternative which the Fed has, cutting the current account deficit or increasing the budget deficit, are not that practically feasible.
Wolf concludes on a poignant note: “Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?”
In a recent article in the Financial Times, Martin Wolf, the well known columnist has dug deeper into the sub prime crisis. Many of the articles written on the subject have focused on the linkages between different markets. But this one looks at broad macro economic factors contributing to the crisis. We all know the US has been running a major current account deficit in the recent past. A current account deficit essentially means the country is spending more that it is saving. According to Wolf, there is an excess of savings over investment (and consumer spending) in much of the world. This has been offset by an excess of investment (and consumer spending) over savings in a smaller part of the world. In 2006, the countries with surplus savings generated a current account surplus of about $1300 billion. The US current account deficit absorbed about two thirds of this surplus.
In simple terms, foreigners have been buying US assets on a vast scale. The funds provided by foreigners have been absorbed by the US government and households since the stock market bubble burst in 2000. Between the first quarter of 2000 and the third quarter of 2003, there was a negative swing in the US budget balance of 7% of GDP. Household spending has also been on the rise since the 1990s. By 2006, households had accumulated a financial deficit of close to 4% of GDP. This household deficit has absorbed the financial surpluses of the business sector. This rise in household indebtedness has worked through asset backed borrowing. Or more precisely mortgages. This had to happen because with the US absorbing so much of capital, the government already having piled up a huge fiscal deficit and businesses showing surpluses, somebody had to spend to prevent the economy from going into recession. That is also why the Fed is likely to cut interest rates and sort of prolong the party. The other alternative which the Fed has, cutting the current account deficit or increasing the budget deficit, are not that practically feasible.
Wolf concludes on a poignant note: “Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?”
The Sub Prime Crisis: The dollar as a safe haven
(Ref: Wall Street Journal, August 20)
Whenever there is a crisis or a major instability in the global markets, the dollar attracts investor attention. As the saying goes, when the going gets tough, the tough get going. And the dollar is indeed a tough currency despite occasional see saws. During the Sub Prime crisis, with many market participants getting into serious trouble, the dollar has actually risen against the Euro. The yields the US government pays on its debt have fallen. The Wall Street Journal quotes Michael Dooley of the University of California at Santa Cruz: “The collapse of the yield on the 10 year treasury is probably the best indication of how quality is defined in people’s minds. The fact that the US still produces by far the best assets in the world, will as things settle down, be very good for the US.”
The fact that the ECB had to intervene with much bigger chunks of liquidity is an indication that the European markets are less able to adjust to rapid price movements than the US. The US has some structural problems to address but these are in a relative sense not all that daunting. Professor Catherine Mann of Brandeis University feels that the US current account deficit can be easily financed by investors unless an alternative investment emerges.
Whenever there is a crisis or a major instability in the global markets, the dollar attracts investor attention. As the saying goes, when the going gets tough, the tough get going. And the dollar is indeed a tough currency despite occasional see saws. During the Sub Prime crisis, with many market participants getting into serious trouble, the dollar has actually risen against the Euro. The yields the US government pays on its debt have fallen. The Wall Street Journal quotes Michael Dooley of the University of California at Santa Cruz: “The collapse of the yield on the 10 year treasury is probably the best indication of how quality is defined in people’s minds. The fact that the US still produces by far the best assets in the world, will as things settle down, be very good for the US.”
The fact that the ECB had to intervene with much bigger chunks of liquidity is an indication that the European markets are less able to adjust to rapid price movements than the US. The US has some structural problems to address but these are in a relative sense not all that daunting. Professor Catherine Mann of Brandeis University feels that the US current account deficit can be easily financed by investors unless an alternative investment emerges.
The Sub Prime Crisis: The impact on Asia
(Ref: Wall Street Journal, August 20)
If consumption in the US weakens, Asian economies will get affected. While ruling out an Asian financial crisis, Singapore PM Lee Hsien Loong admitted that economic growth could be affected if uncertainty continues and the US economy slows down. South Korea’s Kospi index fell 10.4% last week. Shares in big Japanese companies like Toyota and Canon also fell sharply on August 17th due to concerns that the rising Yen would affect export performance. The rising Yen is due to the unwinding of carry trade positions by investors who are scrambling for liquidity. IPOs are being postponed in Japan. More and more analysts feel that the Bank of Japan will not raise interest rates in the near future. This is a reversal of earlier expectations. Malaysian company MISC and South Korean car maker Kia are postponing their bond issue.
If consumption in the US weakens, Asian economies will get affected. While ruling out an Asian financial crisis, Singapore PM Lee Hsien Loong admitted that economic growth could be affected if uncertainty continues and the US economy slows down. South Korea’s Kospi index fell 10.4% last week. Shares in big Japanese companies like Toyota and Canon also fell sharply on August 17th due to concerns that the rising Yen would affect export performance. The rising Yen is due to the unwinding of carry trade positions by investors who are scrambling for liquidity. IPOs are being postponed in Japan. More and more analysts feel that the Bank of Japan will not raise interest rates in the near future. This is a reversal of earlier expectations. Malaysian company MISC and South Korean car maker Kia are postponing their bond issue.
The Sub Prime Crisis: Strange developments in Asian currency markets
(Ref: Wall Street Journal, August 20)
Strange developments are being reported in the Asian currency markets. These are related to the carry trade, a favourite strategy among forex dealers for the past few years. The carry trade consists of borrowing the low interest rate Yen, and selling it and investing in high interest rate currencies like the Aussie $ and the New Zealand $.
In the wake of the sub prime crisis, with many investors scrambling for liquidity, there has been unwinding of these positions. That means people have sold the Australian and New Zealand currencies and bought Yens and squared off their positions to book profits. Consequently, the Yen rose 9% against the Aussie Dollar last week.
Indeed, trading in these Asian currencies has become so one sided that traders have been struggling to find buyers. In Australia, the trading reached panic levels on 17th August. Because of illiquid positions in London and New York, the Reserve Bank of Australia had to intervene. This is the first time in 6 years that the Reserve Bank has intervened. The Bank has indicated that it is ready to act again if needed.
Strange developments are being reported in the Asian currency markets. These are related to the carry trade, a favourite strategy among forex dealers for the past few years. The carry trade consists of borrowing the low interest rate Yen, and selling it and investing in high interest rate currencies like the Aussie $ and the New Zealand $.
In the wake of the sub prime crisis, with many investors scrambling for liquidity, there has been unwinding of these positions. That means people have sold the Australian and New Zealand currencies and bought Yens and squared off their positions to book profits. Consequently, the Yen rose 9% against the Aussie Dollar last week.
Indeed, trading in these Asian currencies has become so one sided that traders have been struggling to find buyers. In Australia, the trading reached panic levels on 17th August. Because of illiquid positions in London and New York, the Reserve Bank of Australia had to intervene. This is the first time in 6 years that the Reserve Bank has intervened. The Bank has indicated that it is ready to act again if needed.
Wednesday, August 22, 2007
The Sub Prime crisis : Impact on the real economy
(Ref: The Economist, dt. 18 August; The Financial Times, August 20)
Are the problems in the housing market affecting the real economy? Wal-Mart the bell whether of the US economy recently announced that spending by American consumers could fall in the coming months. The company gave a downward profit guidance.
As the pressure to generate liquidity increases, there have been sell offs in the oil market. Oil prices have fallen substantially from their peak of $79 per barrel reached in late July. The Economist’s metals index is 14% below the highs it reached in May.
Meanwhile, hundreds of US companies are facing significantly higher interest rates on the short term debt used to fund their day-to-day operations. Walt Disney, Heinz and Motorola are among the well known US companies which have major commercial paper borrowings. So far, however, the higher end of the CP market featuring issuers such as GE, IBM and AT&T, with higher credit ratings has been spared. The yields of these blue chips seem to be stable, at least for the time being.
Are the problems in the housing market affecting the real economy? Wal-Mart the bell whether of the US economy recently announced that spending by American consumers could fall in the coming months. The company gave a downward profit guidance.
As the pressure to generate liquidity increases, there have been sell offs in the oil market. Oil prices have fallen substantially from their peak of $79 per barrel reached in late July. The Economist’s metals index is 14% below the highs it reached in May.
Meanwhile, hundreds of US companies are facing significantly higher interest rates on the short term debt used to fund their day-to-day operations. Walt Disney, Heinz and Motorola are among the well known US companies which have major commercial paper borrowings. So far, however, the higher end of the CP market featuring issuers such as GE, IBM and AT&T, with higher credit ratings has been spared. The yields of these blue chips seem to be stable, at least for the time being.
The Sub Prime Crisis: What next from Fed?
(Ref: The Economist, dt. 18 August; The Financial Times, August 20)
How will the Fed respond to the recent turn of events? Many analysts are recalling what happened in 1998, as they try to predict what might happen now. In 1998, against the backdrop of the Asian currency crisis, the collapse of the Russian rouble and the Long Term Capital Management (LTCM) bankruptcy, the Fed cut interest rates by 25 basis points each, three times, beginning on September 29. Accordingly some analysts are predicting that the Fed will cut interest rates by 25 basis points on September 18 and again in October if required.
Expectations from the Fed are high keeping in view that the venerable financial institution played a key role in restoring sentiments both after the 1987 stock market crash and the 1998 LTCM collapse. Knowledgeable observers argue that the Fed, however, will be careful to avoid moral hazard. It will send signals based on the possible impact of market events on the real economy, not because of the plight of the financial intermediaries alone.
Meanwhile, the Economist in its recent issue has examined the kind of role that a Central bank should play during such crises. The Economist recalls how in 1873, the famous writer Walter Bagehot urged the Bank of England to stave off financial panics by “lending quickly, feely, readily at a penalty rate of interest to any bank that can offer good securities as collateral.” By lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central banks can distinguish insolvent banks from illiquid ones and by charging a penal rate of interest, they ensure that they are truly the lenders of last resort.
What Bagehot mentioned in 1873 is exactly what the Fed (and the European Central Bank) seems to have done in the past few days. The only difference (but a big one) is that the Fed did not charge a penal rate of interest. Meanwhile, William Buiter and Anne Sibert, two London based academics argue that central bankers must become the “market makers of last resort,” by setting a price for securities that can no longer be sold on orderly markets. This will prevent distress sales that can further aggravate the market turmoil. For example, the central bank could make a market in CDOs, either by accepting them as collateral or by buying them out right. But Buiter also makes it clear that hedge funds should not receive from central banks the same kind of protection as banks, unless they accept similar restrictions (i.e., like those applicable to banks) in the way they conduct their operations
How will the Fed respond to the recent turn of events? Many analysts are recalling what happened in 1998, as they try to predict what might happen now. In 1998, against the backdrop of the Asian currency crisis, the collapse of the Russian rouble and the Long Term Capital Management (LTCM) bankruptcy, the Fed cut interest rates by 25 basis points each, three times, beginning on September 29. Accordingly some analysts are predicting that the Fed will cut interest rates by 25 basis points on September 18 and again in October if required.
Expectations from the Fed are high keeping in view that the venerable financial institution played a key role in restoring sentiments both after the 1987 stock market crash and the 1998 LTCM collapse. Knowledgeable observers argue that the Fed, however, will be careful to avoid moral hazard. It will send signals based on the possible impact of market events on the real economy, not because of the plight of the financial intermediaries alone.
Meanwhile, the Economist in its recent issue has examined the kind of role that a Central bank should play during such crises. The Economist recalls how in 1873, the famous writer Walter Bagehot urged the Bank of England to stave off financial panics by “lending quickly, feely, readily at a penalty rate of interest to any bank that can offer good securities as collateral.” By lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central banks can distinguish insolvent banks from illiquid ones and by charging a penal rate of interest, they ensure that they are truly the lenders of last resort.
What Bagehot mentioned in 1873 is exactly what the Fed (and the European Central Bank) seems to have done in the past few days. The only difference (but a big one) is that the Fed did not charge a penal rate of interest. Meanwhile, William Buiter and Anne Sibert, two London based academics argue that central bankers must become the “market makers of last resort,” by setting a price for securities that can no longer be sold on orderly markets. This will prevent distress sales that can further aggravate the market turmoil. For example, the central bank could make a market in CDOs, either by accepting them as collateral or by buying them out right. But Buiter also makes it clear that hedge funds should not receive from central banks the same kind of protection as banks, unless they accept similar restrictions (i.e., like those applicable to banks) in the way they conduct their operations
The Sub Prime Crisis: Hedge funds in trouble
(Ref: The Economist, dt. 18 August; The Financial Times, August 20)
One of the first groups of market participants to find themselves in trouble when the sub prime crisis unfolded was hedge funds. Some of the hedge funds which have found themselves badly mauled by the market turmoil include the global equity fund of Goldman Sachs, Renaissance, a successful quant fund and various hedge funds in Japan. Basin Capital of Australia has also lost heavily.
Both human factors and computer driven models have contributed to the sad plight of these hedge funds. Banks started putting pressure on hedge funds to increase their collateral forcing them to take desperate measures to generate liquidity. At the same time, long-short equity neutral funds which assume that some stocks will rise while others fall, found that underlying assumptions behind their computer based trading strategies were faulty.
On August 13th, Goldman announced its leading global equity fund had lost more than 30% of its value within a week. The bank had to put in $2 billion of its own money and $1 billion contributed by investors. Renaissance, founded by James Simons, a prize wining mathematician also suffered big losses. Quantitative hedge funds in Japan seem to be among the worst affected. Whether hedge funds will stage a comeback in the foreseeable future depends on a big question. Will the pension funds, endowments and rich individuals investing in hedge funds hold their nerve?
As hedge funds find themselves in serious trouble, quantitative models are again coming under close scrutiny. Recall that they were the undoing of the celebrated Long Term Capital Management (LTCM) in 1998. Quantitative models try to find minute market inefficiencies and exploit them. Computers help in finding these inefficiencies quickly so that the traders can take advantage of them before they disappear. As many people start using similar models, such opportunities disappear.The only way to get ahead is to come up with more complex and sophisticated models. Long-short funds, for example generated profits as recently as February/March 2007, using this approach. But to get really good returns, leverage is needed. And as we have seen, leverage can be a risky proposition.
One major lesson which seems to be emerging from the crisis is that quantitative models also cannot overlook the behavioural factors involved in trading. As John Authers has mentioned in the FT (Aug 20), “ …human judgement when it comes to investment is flawed in predictable ways that lead to predictable mis-pricings in the market. A quantitative model that will follow rules set for it by humans, without the risk of human judgment subsequently messing things up, is needed to take advantage of those mispricings.”
In recent weeks, these models have come to naught. The models wanted the funds to hold certain positions. But the need to generate liquidity forced funds to sell their good investments. As many quants followed suit, what we saw were 25 standard deviation events which in normal circumstances, would happen only once in 100,000 years. Leverage amplified these losses. In other words, the models failed to account for the “fat tails.”
Authers mentions that mathematical models will need to improve significantly in the months to come. The quants must take into account:
The herding effects, i.e., other funds taking similar positions
Impact of their own actions on the market
Need to use leverage to magnify returns.
If the regular steam of profits based on the models, comes up with huge losses occasionally, the combination of rigid quantitative strategies with leverage may not be all that appealing.
In short it looks as though there may not be that many leveraged active quant funds we will see going forward. Quite likely the ones that remain will belong to the large well capitalized investment banks.
One of the first groups of market participants to find themselves in trouble when the sub prime crisis unfolded was hedge funds. Some of the hedge funds which have found themselves badly mauled by the market turmoil include the global equity fund of Goldman Sachs, Renaissance, a successful quant fund and various hedge funds in Japan. Basin Capital of Australia has also lost heavily.
Both human factors and computer driven models have contributed to the sad plight of these hedge funds. Banks started putting pressure on hedge funds to increase their collateral forcing them to take desperate measures to generate liquidity. At the same time, long-short equity neutral funds which assume that some stocks will rise while others fall, found that underlying assumptions behind their computer based trading strategies were faulty.
On August 13th, Goldman announced its leading global equity fund had lost more than 30% of its value within a week. The bank had to put in $2 billion of its own money and $1 billion contributed by investors. Renaissance, founded by James Simons, a prize wining mathematician also suffered big losses. Quantitative hedge funds in Japan seem to be among the worst affected. Whether hedge funds will stage a comeback in the foreseeable future depends on a big question. Will the pension funds, endowments and rich individuals investing in hedge funds hold their nerve?
As hedge funds find themselves in serious trouble, quantitative models are again coming under close scrutiny. Recall that they were the undoing of the celebrated Long Term Capital Management (LTCM) in 1998. Quantitative models try to find minute market inefficiencies and exploit them. Computers help in finding these inefficiencies quickly so that the traders can take advantage of them before they disappear. As many people start using similar models, such opportunities disappear.The only way to get ahead is to come up with more complex and sophisticated models. Long-short funds, for example generated profits as recently as February/March 2007, using this approach. But to get really good returns, leverage is needed. And as we have seen, leverage can be a risky proposition.
One major lesson which seems to be emerging from the crisis is that quantitative models also cannot overlook the behavioural factors involved in trading. As John Authers has mentioned in the FT (Aug 20), “ …human judgement when it comes to investment is flawed in predictable ways that lead to predictable mis-pricings in the market. A quantitative model that will follow rules set for it by humans, without the risk of human judgment subsequently messing things up, is needed to take advantage of those mispricings.”
In recent weeks, these models have come to naught. The models wanted the funds to hold certain positions. But the need to generate liquidity forced funds to sell their good investments. As many quants followed suit, what we saw were 25 standard deviation events which in normal circumstances, would happen only once in 100,000 years. Leverage amplified these losses. In other words, the models failed to account for the “fat tails.”
Authers mentions that mathematical models will need to improve significantly in the months to come. The quants must take into account:
The herding effects, i.e., other funds taking similar positions
Impact of their own actions on the market
Need to use leverage to magnify returns.
If the regular steam of profits based on the models, comes up with huge losses occasionally, the combination of rigid quantitative strategies with leverage may not be all that appealing.
In short it looks as though there may not be that many leveraged active quant funds we will see going forward. Quite likely the ones that remain will belong to the large well capitalized investment banks.
The Sub Prime Crisis: Trouble at banks
(Ref: The Economist, dt. 18 August)
Many banks and financial institutions have been affected by the sub prime crisis. These include HSBC, Lloyds, HBOS (England), Coventree (Canada), Citi (USA), IKB, West LB, Sachsen LB (Germany). Some of these banks have used off balance sheet investment vehicles popularly called “conduits”. These vehicles are typically funded in the asset backed commercial paper market. The loans are cheap but of short maturity and are rolled over every few months. The conduits use the money to buy Collateralised Debt Obligations (CDOs), which are much higher yielding securities. But as market conditions have worsened, the source of funds has dried up and the problem has spread to banks who typically provide the conduits back up credit. The global asset based commercial paper market is estimated at $1.2 trillion, up from $650 billion three years ago. These are not trivial numbers and the rapid growth confirms that greed can drive markets crazy.
Banks have also gone beyond conduits and set up the more leveraged structured investment vehicles (SIV). Indeed, SIVs represent one of the fastest growing areas of structured finance. Some 23% of SIV assets seem to be in residential mortgage securities. Covenant-lite versions of SIVs (i.e., SIVs with less restrictions) are also floating around. These involve borrowings of up to 40-70 times the equity collateral. The SIV lites seem to have gone heavily into sub prime assets.
In an environment of mistrust, as these kinds of information come to the notice of the public, banks are being viewed increasingly with suspicion.
Many banks and financial institutions have been affected by the sub prime crisis. These include HSBC, Lloyds, HBOS (England), Coventree (Canada), Citi (USA), IKB, West LB, Sachsen LB (Germany). Some of these banks have used off balance sheet investment vehicles popularly called “conduits”. These vehicles are typically funded in the asset backed commercial paper market. The loans are cheap but of short maturity and are rolled over every few months. The conduits use the money to buy Collateralised Debt Obligations (CDOs), which are much higher yielding securities. But as market conditions have worsened, the source of funds has dried up and the problem has spread to banks who typically provide the conduits back up credit. The global asset based commercial paper market is estimated at $1.2 trillion, up from $650 billion three years ago. These are not trivial numbers and the rapid growth confirms that greed can drive markets crazy.
Banks have also gone beyond conduits and set up the more leveraged structured investment vehicles (SIV). Indeed, SIVs represent one of the fastest growing areas of structured finance. Some 23% of SIV assets seem to be in residential mortgage securities. Covenant-lite versions of SIVs (i.e., SIVs with less restrictions) are also floating around. These involve borrowings of up to 40-70 times the equity collateral. The SIV lites seem to have gone heavily into sub prime assets.
In an environment of mistrust, as these kinds of information come to the notice of the public, banks are being viewed increasingly with suspicion.
The Sub Prime Crisis: Trouble in the inter bank market
(Ref: The Economist, dt. 18 August)
The inter bank market is supposed to be one of the safest places in the financial system. After all, the borrowers are people with some of the best credit ratings gong around. But the sub prime crisis has challenged this assumption. On August 9th/10th, US rates hit 6%, 75 basis points over the Fed benchmark and in the Euro area, 4.7%, 70 basis points over the benchmark of 4%. Under normal market conditions, these spreads would have been much smaller. To ease the situation, the ECB provided funds to the tune of $131 billion on August 9th followed by about $85 billion on the following day. The Fed injected liquidity to the tune of $24 billion and $38 billion or the two days respectively. The Fed also allowed mortgage backed securities, though guaranteed by federal agencies, as collateral. The liquidity injection did succeed in pushing money market rates down. But it is not clear whether these moves have really dealt with the core of the problem – the absence of trust in the markets today. As the Economist summed up, “Markets are jumping at every shadow. Only when imagined bad news has been flushed out will inter bank markets return to obscurity.”
The inter bank market is supposed to be one of the safest places in the financial system. After all, the borrowers are people with some of the best credit ratings gong around. But the sub prime crisis has challenged this assumption. On August 9th/10th, US rates hit 6%, 75 basis points over the Fed benchmark and in the Euro area, 4.7%, 70 basis points over the benchmark of 4%. Under normal market conditions, these spreads would have been much smaller. To ease the situation, the ECB provided funds to the tune of $131 billion on August 9th followed by about $85 billion on the following day. The Fed injected liquidity to the tune of $24 billion and $38 billion or the two days respectively. The Fed also allowed mortgage backed securities, though guaranteed by federal agencies, as collateral. The liquidity injection did succeed in pushing money market rates down. But it is not clear whether these moves have really dealt with the core of the problem – the absence of trust in the markets today. As the Economist summed up, “Markets are jumping at every shadow. Only when imagined bad news has been flushed out will inter bank markets return to obscurity.”
The Sub Prime Crisis: Dispersed risk becomes dispersed mistrust
(Ref: The Economist, dt. 18 August)
Securitization has been one of the major financial innovations of modern times. Securitization has helped banks in the past two decades to repackage mortgage loans, convert them into liquid instruments and sell them in tranches with varying degrees of risk to other market participants. They in turn have sold securities to other investors. This way, the risk has spread across the system. But this seems to have created more problems than solved them.
As the Economist (August 18, 2007) mentions, the dispersal of risk should logically lead to many players holding small losses. “But the swings in almost all financial markets this month have made dispersed risk suddenly morph into dispersed mistrust.”
The magazine quotes Avinash Persaud, a respected financial analyst: “Securitisation 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 the prices fall more.”
Let me give my own take now. Think of a spicy Indian dish. If big chilly pieces are seen floating, one can easily pick them out and avoid getting into trouble. If on the other hand, we have cut them into small pieces or ground them nicely, and the dish becomes “too hot,” people are going to consume little of that and whole dish may have to be discarded. A very crude anology but that may well sum up the situation today.
Securitization has been one of the major financial innovations of modern times. Securitization has helped banks in the past two decades to repackage mortgage loans, convert them into liquid instruments and sell them in tranches with varying degrees of risk to other market participants. They in turn have sold securities to other investors. This way, the risk has spread across the system. But this seems to have created more problems than solved them.
As the Economist (August 18, 2007) mentions, the dispersal of risk should logically lead to many players holding small losses. “But the swings in almost all financial markets this month have made dispersed risk suddenly morph into dispersed mistrust.”
The magazine quotes Avinash Persaud, a respected financial analyst: “Securitisation 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 the prices fall more.”
Let me give my own take now. Think of a spicy Indian dish. If big chilly pieces are seen floating, one can easily pick them out and avoid getting into trouble. If on the other hand, we have cut them into small pieces or ground them nicely, and the dish becomes “too hot,” people are going to consume little of that and whole dish may have to be discarded. A very crude anology but that may well sum up the situation today.
The Sub Prime Crisis: Is it worse than we thought?
(Ref: The Economist, dt. 18 August)
If one were to go by the recent issue of The Economist (18 August 2007), things are much worse than we thought. The mess has gone well beyond rash mortgage lending. Banks no longer seem willing to provide liquidity to each other. As the magazine puts it, “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 systems and cause runs on otherwise solvent banks and businesses that cannot rapidly raise funds.”
The Economist has also neatly summed up the basic reasons contributing to the crisis. Lenders have indulged in reckless lending because they could easily securitise the loans and sell off the risk to someone else. Logically, risk should be borne by the party which is best equipped to understand and manage it. But thanks to slicing, repackaging and selling of risk, no one really knows where the risk has finally landed. There is fear all around that risks may have ended up with people who least understand them. Illiquid long term securities have been bought with short term debt, leaving borrowers vulnerable to a change in sentiment every time the debt falls due.
Now the markets seems to be adjusting and retreating to a new level of risk. The market jargon for this process is deleveraging. And going by past history that process may not be smooth. Yet, the Economist argues that central banks must resist the temptation to intervene. If at all they intervene, it must be not to save the financiers but to save the rest of the economy from the folly of the financiers. The Economist concludes on a note of warning: “ …anyone who says the worst is definitely over is either a fool or someone with a position to protect.”
A primer on the Sub Prime crisis
(Ref: Time, August 27, 2007)
Time Magazine recently gave a lucid account of the US sub prime crisis. For generations, U.S. home price appreciation largely tracked inflation. But since 1995, home prices began rising at an unprecedented pace. The boom created a lot of wealth but also created risks that spread far beyond the housing market.
To attract more home buyers, lenders began offering mortgages with only a cursory scrutiny of the borrower's qualifications. Many of these loans had low starting interest rates that would rise over time. As long as home values rose and interest rates stayed low, everyone was happy. But once prices flattened or fell and interest rates crept up, sub prime borrowers became vulnerable. They could not sell or refinance their loans because they owed more than what their home was worth.
In recent weeks, the scenario has changed for the worse and defaults by borrowers have increased. In the past, the trouble would end with a borrower in default and a bank foreclosing on the home. But today few banks hold onto mortgages until maturity. Most loans are securitized, ie bundled together and sold as mortgage-backed securities.
The new owners of the mortgages can use them as collateral to issue bonds to finance other deals. Money from thousands of homeowners covers the interest payments on those bonds. To attract investors, the bonds are rated by risk groups, called tranches. The more secure the bond, the lower the payoff for investors. Those who buy the riskiest pool of bonds - the ones backed by the riskiest home mortgages - are promised the highest return.
To further complicate the picture, some firms create structured finance products, called collateralized debt obligations (CDO), from pieces of other mortgage securities. These new bonds are re-rated, creating an illusion of safety even though the top-rated bonds may include very risky original loans. Last year nearly $500 billion in CDOs flooded the market. Many hedge funds invested heavily in them, often using borrowed money, and thus increasing their exposure.
In short, the entire process is based on using borrowed money (home mortgages) as collateral to borrow more money (mortgage-backed securities) to borrow yet more money (CDOs), and hoping the payment chain does not break. Once home-mortgage defaults started, the whole system began to unravel. Without the payments from homeowners, the issuers could not pay off the bonds. The bonds lost value, and the hedge funds that borrowed money to buy the bonds had to put up more collateral. Alternatively they had to try to sell the bonds, which caused their value to drop even more. The rout began. Banks tightened credit, raising the cost of financing corporate and private-equity deals. Other investors then wanted to reduce their risk. Stock prices fell, and bond prices rose. With global markets so closely linked, fear began to spread rapidly around the globe. Tighter credit meant fewer people getting home mortgages, further depressing the housing market and perpetuating the cycle.
Time Magazine recently gave a lucid account of the US sub prime crisis. For generations, U.S. home price appreciation largely tracked inflation. But since 1995, home prices began rising at an unprecedented pace. The boom created a lot of wealth but also created risks that spread far beyond the housing market.
To attract more home buyers, lenders began offering mortgages with only a cursory scrutiny of the borrower's qualifications. Many of these loans had low starting interest rates that would rise over time. As long as home values rose and interest rates stayed low, everyone was happy. But once prices flattened or fell and interest rates crept up, sub prime borrowers became vulnerable. They could not sell or refinance their loans because they owed more than what their home was worth.
In recent weeks, the scenario has changed for the worse and defaults by borrowers have increased. In the past, the trouble would end with a borrower in default and a bank foreclosing on the home. But today few banks hold onto mortgages until maturity. Most loans are securitized, ie bundled together and sold as mortgage-backed securities.
The new owners of the mortgages can use them as collateral to issue bonds to finance other deals. Money from thousands of homeowners covers the interest payments on those bonds. To attract investors, the bonds are rated by risk groups, called tranches. The more secure the bond, the lower the payoff for investors. Those who buy the riskiest pool of bonds - the ones backed by the riskiest home mortgages - are promised the highest return.
To further complicate the picture, some firms create structured finance products, called collateralized debt obligations (CDO), from pieces of other mortgage securities. These new bonds are re-rated, creating an illusion of safety even though the top-rated bonds may include very risky original loans. Last year nearly $500 billion in CDOs flooded the market. Many hedge funds invested heavily in them, often using borrowed money, and thus increasing their exposure.
In short, the entire process is based on using borrowed money (home mortgages) as collateral to borrow more money (mortgage-backed securities) to borrow yet more money (CDOs), and hoping the payment chain does not break. Once home-mortgage defaults started, the whole system began to unravel. Without the payments from homeowners, the issuers could not pay off the bonds. The bonds lost value, and the hedge funds that borrowed money to buy the bonds had to put up more collateral. Alternatively they had to try to sell the bonds, which caused their value to drop even more. The rout began. Banks tightened credit, raising the cost of financing corporate and private-equity deals. Other investors then wanted to reduce their risk. Stock prices fell, and bond prices rose. With global markets so closely linked, fear began to spread rapidly around the globe. Tighter credit meant fewer people getting home mortgages, further depressing the housing market and perpetuating the cycle.
The Sub Prime crisis-How legitimate are the fears of a crash?
(Ref: Gillian Tett, Financial Times August 17)
An insightful article by Gillian Tett in the Financial Times dt. 17 August 2007 mentions that the current market turmoil cannot really be called a crash. We have not seen a big drop like what we did after the dotcom boom of 2000, say. The article then goes on to cover the various concerns arising out of the market turmoil.
Is the turmoil a prelude to a bigger bear market? There is no doubt that the contagion is spreading. Initially, defaults were rising among American households with bad credit histories who had taken out mortgages – i.e., the “subprime” sector. This hit the debt markets because mortgage loans were repackaged into new securities and sold by banks to new investors. When US homeowners defaulted, the value of these related securities suffered.
Then came the hedge funds who bought sub prime securities. These hedge funds, typically borrowed money from investment banks. When these funds suffered losses on their sub prime securities earlier this year, banks asked them to funds post more “collateral”. At the same time, some hedge fund investors started to demand their money back. So hedge funds came under pressure to raise cash in a hurry. Some responded by cutting their risky strategies and conducting firesales of their assets. This is how the contagion is spreading to other markets.
When things go wrong, many things often go wrong at the same time. That is what seems to be happening now. In the past couple of weeks, the computer models that some hedge funds use to make trades have gone haywire. These models typically scan markets to spot tiny price discrepancies, and accordingly place large orders. Under normal market conditions, this technique often produces great results. But in recent weeks it appears to have triggered a flurry of equity sales, which has not only hurt the markets, but also created big losses at some hedge funds.
Now the concerns are shifting from hedge funds to banks. True banks have sold subprime securities to other investors, which means they are not directly affected. But banks have also promised to provide credit lines to other institutions with subprime exposure, such as mortgage lenders, if those institutions have problems raising finance in the financial markets. Right now, some of those secondary groups are facing funding woes, making it likely that they will soon demand credit lines from the banks.
True most of the global banks have very strong balance sheets. But what makes the situation very intriguing is that they are under pressure right now from several sources. For example, banks have arranged loans to risky companies, such as private equity buy-out groups. They are now finding it hard to sell these loans because investors are so nervous. That means an estimated $300bn worth of unsold loans are sitting on their balance sheets. And, these pressures are coming at a time when banks themselves are facing problems raising funding in the money markets.
Indeed, raising funds has suddenly become more difficult, creating serious liquidity problems. Investors in the money markets are very nervous about lending money to anybody who might be potentially exposed to subprime losses! And because of financial innovations and slicing and dicing of risks across the financial system, it is hard to know who is holding subprime exposure. So anyone looking for funds is being punished in an indiscriminate fashion without seriously examining the fundamentals.
Central banks are now getting involved. Last week, the European Central Bank pumped liquidity into Europe’s overnight money markets. The Fed, has also sprung into action cutting a key discount rate by 50 basis points. The Fed has promised to pump even more money into the market, to help the banks get access to funding. It has also signalled its willingness to take even more dramatic steps, in the future. But we don’t know yet whether all this will be enough to ensure that the money markets will work normally again or stop investors worrying about where the losses on subprime loans now lie.
One way to understand the market turmoil is to see it as a period during which investors and institutions cut their debt levels. De-leveraging a financial system is never easy, and financial history suggests this often leads to economic shocks. However, in many ways, de-leveraging is good news. For in recent years, debt levels have become unhealthily high in parts of the financial world, because the cost of borrowing money has been quite low.
What might make the current bout of de-leveraging less painful than before is that it is not mainstream companies that are burdened with excess debt. Instead, the pain is now being felt in hedge funds or private equity groups. Meanwhile, the “real” economy has been performing pretty well recently. In theory, this according to the optimists should provide some cushion against these market shocks. Will the optimists be proved right? That is the billion dollar question staring at the markets.
An insightful article by Gillian Tett in the Financial Times dt. 17 August 2007 mentions that the current market turmoil cannot really be called a crash. We have not seen a big drop like what we did after the dotcom boom of 2000, say. The article then goes on to cover the various concerns arising out of the market turmoil.
Is the turmoil a prelude to a bigger bear market? There is no doubt that the contagion is spreading. Initially, defaults were rising among American households with bad credit histories who had taken out mortgages – i.e., the “subprime” sector. This hit the debt markets because mortgage loans were repackaged into new securities and sold by banks to new investors. When US homeowners defaulted, the value of these related securities suffered.
Then came the hedge funds who bought sub prime securities. These hedge funds, typically borrowed money from investment banks. When these funds suffered losses on their sub prime securities earlier this year, banks asked them to funds post more “collateral”. At the same time, some hedge fund investors started to demand their money back. So hedge funds came under pressure to raise cash in a hurry. Some responded by cutting their risky strategies and conducting firesales of their assets. This is how the contagion is spreading to other markets.
When things go wrong, many things often go wrong at the same time. That is what seems to be happening now. In the past couple of weeks, the computer models that some hedge funds use to make trades have gone haywire. These models typically scan markets to spot tiny price discrepancies, and accordingly place large orders. Under normal market conditions, this technique often produces great results. But in recent weeks it appears to have triggered a flurry of equity sales, which has not only hurt the markets, but also created big losses at some hedge funds.
Now the concerns are shifting from hedge funds to banks. True banks have sold subprime securities to other investors, which means they are not directly affected. But banks have also promised to provide credit lines to other institutions with subprime exposure, such as mortgage lenders, if those institutions have problems raising finance in the financial markets. Right now, some of those secondary groups are facing funding woes, making it likely that they will soon demand credit lines from the banks.
True most of the global banks have very strong balance sheets. But what makes the situation very intriguing is that they are under pressure right now from several sources. For example, banks have arranged loans to risky companies, such as private equity buy-out groups. They are now finding it hard to sell these loans because investors are so nervous. That means an estimated $300bn worth of unsold loans are sitting on their balance sheets. And, these pressures are coming at a time when banks themselves are facing problems raising funding in the money markets.
Indeed, raising funds has suddenly become more difficult, creating serious liquidity problems. Investors in the money markets are very nervous about lending money to anybody who might be potentially exposed to subprime losses! And because of financial innovations and slicing and dicing of risks across the financial system, it is hard to know who is holding subprime exposure. So anyone looking for funds is being punished in an indiscriminate fashion without seriously examining the fundamentals.
Central banks are now getting involved. Last week, the European Central Bank pumped liquidity into Europe’s overnight money markets. The Fed, has also sprung into action cutting a key discount rate by 50 basis points. The Fed has promised to pump even more money into the market, to help the banks get access to funding. It has also signalled its willingness to take even more dramatic steps, in the future. But we don’t know yet whether all this will be enough to ensure that the money markets will work normally again or stop investors worrying about where the losses on subprime loans now lie.
One way to understand the market turmoil is to see it as a period during which investors and institutions cut their debt levels. De-leveraging a financial system is never easy, and financial history suggests this often leads to economic shocks. However, in many ways, de-leveraging is good news. For in recent years, debt levels have become unhealthily high in parts of the financial world, because the cost of borrowing money has been quite low.
What might make the current bout of de-leveraging less painful than before is that it is not mainstream companies that are burdened with excess debt. Instead, the pain is now being felt in hedge funds or private equity groups. Meanwhile, the “real” economy has been performing pretty well recently. In theory, this according to the optimists should provide some cushion against these market shocks. Will the optimists be proved right? That is the billion dollar question staring at the markets.
Subscribe to:
Posts (Atom)
