Archive for August, 2007
Fed Chief Vows to Protect the Economy
Friday, August 31st, 2007Fed Chief Vows to Protect the Economy
JACKSON, Wyo. (AP) — Federal Reserve Chairman Ben Bernanke vowed Friday to do all that is necessary to protect the national economy from the ill effects of a global credit crunch — but not to bail out investors and lenders “from the consequences of their financial decisions.”
President Bush confidently predicted the country would safely weather the financial storm.
Friday’s comments — made in separate appearances — by Bernanke here and the president in Washington, sought to send a reassuring but tough love message: Fed policymakers and the Bush administration are on top of the situation that has unnerved investors on Wall Street and around the world and raised anxiety on Main Street. But they’ll act in the best interests of the economy.
While Bush announced steps Friday to help homeowners struggling to make their mortgage payments, he made clear he has no interest in bailing out lenders, some of whom got cocky, took on too much risk and ended up with bad loans.
“The government’s got a role to play, but it is limited,” Bush said at the White House. “A federal bailout of lenders would only encourage a recurrence of the problem.”
In anxiously awaited remarks, Bernanke suggested the Fed’s next move will be driven by economic considerations, not only in response to troubles of investors and lenders.
“It is not the responsibility of the Federal Reserve — nor would it be appropriate — to protect lenders and investors from the consequences of their financial decisions,” Bernanke said. “But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.”
Still, many believe the odds are growing that the Fed will cut its most important interest rate, now at 5.25 percent, by at least one-quarter percentage point on or before Sept. 18, its next regularly scheduled meeting. The Fed hasn’t lowered this rate in four years.
The Fed “will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets,” Bernanke told an economics conference here.
On Wall Street, stocks rose after Bernanke’s remarks. The Dow Jones industrials were up more than 150 points in early afternoon.
The fear is that if credit continues to become harder for people and businesses to get, spending and investment will be crimped. That could hurt overall economic growth. In a worst-case scenario, the country could slide into a recession. Credit is the economy’s life blood. It enables people to finance big-ticket purchases such as homes and cars and can help businesses bankroll expansions and other things that can boost hiring.
Bush, however, predicted the economy would get through the financial crisis and urged patience.
“The markets are in a period of transition as participants reassess and reprice risk,” the president said. “This process has been unfolding for some time, and it’s going to take more time to fully play out. As it does, America’s overall economy will remain strong enough to weather any turbulence.”
Before the financial crisis erupted, the economy had a full head of steam, growing at a robust pace of 4 percent in the April-to-June quarter. But growth is expected to slow to half that pace in the current quarter and lose more speed in the final quarter of this year.
The unemployment rate, now at 4.6 percent, is expected to creep up to around 5 percent by the end of this year.
To guide the Fed in terms of what its next move will be, Bernanke said policymakers will pay especially close attention to the “timeliest indicators” as well as information gleaned from businesses and banks around the country. Economic data that was taken before the credit markets really seized up in August will be much less useful to policymakers to assess the country’s economic health, he explained.
It was his first speech — and his most extensive comments — since the credit crunch took a turn for the worst in August. The carnage in credit markets and the turmoil on Wall Street pose the biggest test of Bernanke’s skills since taking the Fed helm 19 months ago.
The Fed’s most important interest rate, called the federal funds rate, has been at 5.25 percent for more than a year. Any reduction to this rate would mean lower interest rates for millions of people and businesses. That’s why it is the Fed’s main tool for influencing economic activity.
After listening to Bernanke’s speech, John Makin, principal at Caxton Associates Inc., believed the Fed was moving “a tiny bit closer” to a rate cut.
In his remarks to a high-profile conference here on housing sponsored by the Federal Reserve Bank of Kansas City, Bernanke discussed some of the steps the Fed has taken so far to deal with the credit crunch.
While problems were triggered largely by heightened concerns about higher-risk “subprime” mortgages made to people with blemished credit histories or low incomes, Bernanke said “global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans.”
To stabilize wobbly markets, the Fed on Aug. 17 sliced its lending rate to banks by a half percentage point to 5.75 percent. It also has pumped billions of dollars into the financial system to help banks and other institutions get through the credit hump and carry out their business.
The Fed’s main concern, however, is the extent to which these problems might short-circuit economic growth.
“The further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effect on consumer spending and the economy more generally,” Bernanke said.
After a five-year boom, the housing market went bust last year; problems are expected to persist well into next year as builders try to whittle down a glut of unsold homes.
During the housing slump, a combination of higher interest rates and weaker home values clobbered homeowners, especially those with blemished credit histories or low incomes holding higher-risk “subprime” loans.
With squeezed homeowners finding it impossible to make their mortgage payments or pay them in a timely fashion, foreclosures and delinquencies are soaring and are expected to get worse. Lenders have been forced out of business, and hedge funds and other big investors in subprime mortgage securities also have taken a big financial hit.
Very low initial “teaser” rates jumping to much higher rates as they reset are socking some homeowners. Analysts estimate 2 million adjustable-rate mortgages will reset this year and next. Steep prepayment penalties have made it difficult for some to get out of their mortgages. Some overstretched homeowners can’t afford to refinance or even sell their homes.
A key element of Bush’s plan would allow homeowners with a good credit history, but who cannot afford their mortgage payments, to refinance into mortgages insured by the Federal Housing Administration to keep from defaulting.
Most of the carnage has been in the subprime market, but problems have spread to other more creditworthy borrowers. That has sent investors into periods of panic in recent weeks, causing stocks on Wall Street to careen wildly.
On the Net:
- Federal Reserve: http://www.federalreserve.gov
Federal Reserve Bank Chairman Ben Bernanke, right, shares a light moment with vice-chairman Donald Kohn as they appear before television cameras during a break in the Federal Reserve Bank of Kansas City Economic Symposium, Friday, Aug. 31, 2007, at the Jackson Lake Lodge at Grand Teton National Park, Wyo. (AP Photo/Ted S. Warren)
http://ap.google.com/article/ALeqM5gbB-yBIGYGpOLykwIKDn5wZrVP5w
“Bernanke Put” slammed holders of “put options”
Thursday, August 30th, 2007How the Friday “Bernanke Put” Slammed Holders of “Put Options” Betting on a Market Fall
Nouriel Roubini | Aug 20, 2007
Whether the surprise discount rate cut and FOMC easing bias last Friday is the first example of a moral-hazard related “Bernanke Put” is being widely discussed. But it was certainly the case that the Fed action sharply hurt those who had bought “put” options on the S&P that were expiring last Friday almost immediately after the opening bell. Given the spike in the S&P at the start of the day those put options that were in the money before the Fed Statement lost their value right after the opening bell. So quite paradoxically the “Bernanke Put” slammed holders of “put options”. Market Beat reported this by citing a report by Scott Peterson:
While the Fed’s move helped many investors last Friday, it slammed a handful who’d wagered that the market would continue to decline. It was especially painful to those who had purchased certain monthly “put” options tied to the Standard & Poor’s 500-stock index, which are contracts that pay off if the index declines below a certain level. Those options expired almost immediately after the opening bell Friday.
Holders of many of these August puts — which are often purchased as a form of insurance against a declining market — went to sleep Thursday evening expecting to cash in Friday morning. Instead, since the Fed’s announcement came before the opening bell, sending stock futures sharply higher, they were left empty-pocketed. Investors holding S&P puts that would pay off if the index opened Friday below 1450, for instance, would have made money without the Fed’s action, since the index closed at 1411 Thursday and was moving lower in overnight trading. Instead, the index shot up at the open, pushing the exercise settlement value of the contract above 1450 (1450.11, to be exact — see chart of S&P futures at right).
On Thursday, when stocks were in free-fall, S&P August puts that would have paid off if the contract opened at or below 1450 were at times changing hands for nearly $80 a piece, according to OptionMonster.com. Since roughly 110,000 of those contracts were still open at the start of trading Friday, that represents a theoretical loss of about $800 million for that single contract.
Far more investors had been purchasing S&P puts than normal due to the recent jump in volatility. Roughly $4 billion in S&P puts changed hands Thursday, about four times the daily average during the last three month, according to Hamzei Analytics, a Los Angeles derivatives trading firm. “A lot of people were hurt,” said Fari Hamzei of Hamzei Analytics. “We just zoomed to a new level, there was nothing that anyone could do.”
On the flip side, holders of S&P “calls,” which pay off in a rising market, hit the jackpot. Far fewer investors had been purchasing calls than puts, however, since the market appeared to be heading lower.
The fact that the Fed’s move came on an option-expiration day raised some eyebrows on Wall Street. Not only did the discount-rate cut hurt holders of S&P puts, it also forced them to scramble to purchase index futures in order to balance out their losses — further fueling the market’s surge. “If you ask me, if you want to get bang for your buck, I’d say [the Fed had] excellent timing,” said financial author Michael Panzner.
And today another finance blogger - Adam Warner of Daily Options Report – explains how Bernanke &Co. implictly used their Friday actions to the maximum effect by short squeezing option sellers (hat tip to Market Beat again):
The Bernanke Short Options Squeeze
So how does putting a market-moving Fed action as close to expiration as humanly possible have the maximal turbo effect? One word: Gamma.
Consider a world where there is just one option, ATM SPY calls. They have a 50 delta, so let’s say there is an open interest of 100 where each call gives you the right to buy 100 SPY’s. If they are ATM, the calls have approximately a 50 delta, so presumably the call shorts own 5000 SPY’s, while the longs are short the SPY’s.
But the delta changes as the stock moves. That’s the gamma. Let’s say the gamma is 10, so in other words if SPY lifts a point, the calls now have a 60 delta. The longs can thus sell 1000 SPY’s up a point, while the shorts have to buy 1000 up a point in order to both stay flat. The quantities are always going to offset, options are a zero sum game, so it becomes all about the urgency of the two sides.
And who has more urgency lately? Clearly the options shorts. So it stands to reason that the higher gamma gets, the more turbo in the stock.
The closer you get to expiration, the higher the gamma. And the more pressure on the side that is squeezed. In other words with a few days to go, maybe that gamma is 20. So a one point move causes the scrambling shorts to buy 2000, while the longs can sell 2000, probably at prices more their liking.
And what if it turns back down to the strike? The option shorts now have to sell back those 2000 shares to flatten out again. And so on and so forth.
And then the next day maybe they have 30 gamma near the money. Even more pressure in each direction exerted by the shorts in this environment.
Which brings us to Friday. Gamma is essentially infinity in the SPX August options. They have stopped trading. They are merely cashed out at the “opening” price (defined as whatever the calculation formula spits out taking the opening tick from each component). The rate cut and market pop comes an hour and change ahead of the open. All a call short can do to defend his position is chase futures/ETF’s up. Some OTM calls he is short now have a 100 delta between now and the open. Sure there is an offsetting long that can sell the futures/ETF’s, but who has the urgency here? Clearly the squeezed short. And thus the kindling wood lit by the Bernanke match.
Throw in a similar dynamic on all other index/ETF options that expire at the end of the day, and Big Ben literally found the perfect minute to cause the most pain to options sellers.
So now holders of put options and other participants in the options markets will have to start to worry about another surprise “Bernanke Put” Fed actions in the next few weeks. Indeed, since credit markets do not seem to have stabilized after the Friday Fed actions, investors are considering whether the Fed may be forced to cut the Fed Funds rate target before the next formal FOMC meeting on September 18th. I will not rule out such a surprise emergency Fed Funds rate cut since I expect (see my forthcoming blog) that the Fed actions last Friday will not succeed to reliquify markets seized by a severe credit and liquidity crunch.
Like chocolate soldiers
Thursday, August 30th, 2007
Say hello to the ‘market dislocation vehicle’
Aug 30 16:29
by Paul Murphy
Comment
(1 comment)
Blindingly obvious, really - Wall Street’s having a sale of returned/shop-soiled stock.
Or, more precisely, investment banks are following the lead of some private equity funds in launching fresh funds to buy leveraged loans that are trading at depressed prices in the secondary market.
Who’s afraid of the big bad banks? Everyone.
Aug 30 16:26
by Sam Jones
Comment
The much whispered-about Lehman Brothers have some harsh words for their detractors: the investment bank today downgraded the outlook for four of their Wall Street stablemates.
Lehman downgraded third and fourth quarter earnings as well as the 2008 outlook for Morgan Stanley,
Like chocolate soldiers - structured credit bankers can’t take the heat
Aug 30 15:23
by Helen Thomas
Comment
We worry that just as we’re getting slowly to grips with the acronym-rich world of structured credit, the people in charge of creating the stuff are all leaving their respective organisations.
The hunt is still on for the last bankers to take their P45s and exit the structured product scene.
Structured finance profits
Thursday, August 30th, 2007
Structured finance profits
FINANCIAL TIMES
http://www.ft.com/cms/s/1/ce5af26e-56d2-11dc
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77cc4-c820-11db-b0dc-000b5df10621.html
Published: August 30 2007 09:27 | Last updated: August 30 2007 12:49
Trying to work out how much exposure investment banks have on their books to the subprime market can be a frustrating business – even for the banks concerned. An easier game is guessing which investment bank will be next to cut staff in structured finance in the wake of the subprime crisis. Royal Bank of Scotland has already set the ball rolling, and there are reports that Lehman Brothers, Goldman Sachs and Bear Stearns are poised to follow suit.
This rapid shedding of staff reflects the urgent need to cut costs as revenues decline in this highly lucrative and (until recently) growth business. Lehman and RBS, for example, topped the underwriting league tables for asset-backed securities last year, according to Dealogic. Cutting back quickly is par for the course for investment banks, with their high staff costs. It will help, but won’t replace lost revenues. For the top 10 global investment banks, fixed income revenues (where most asset-backed business is booked) reached more than $27bn in the first quarter – more than double the total five years before, according to Credit Suisse. And structured finance has been particularly profitable, so margins are likely to decline too.
Is it just a blip? Writedowns may be out of the way quickly, but the loss of confidence in some high-yielding structured products is likely to be more durable. The history of structured finance, though, is that a blow-up in one area is swiftly followed by a surge of demand for ingenious new products elsewhere. And there is no reason why companies should stop hedging currency risk, or locking in energy prices. In fact, increasingly risk-averse investors may even be more inclined to buy structured products with guaranteed returns, for example.
Working out which banks will prove most vulnerable is still tricky, since they do not break down the contribution of different areas of structured finance. That explains the lack of differentiation in the market. The S&P investment banking and brokerage sector is trading at 8.3 times next year’s earnings – and Deutsche Bank, Barclays, RBS, Lehman and Goldman, for example, are all trading at between 7.5 and 8.5 times. This does not mean that they will all cope equally well.
Copyright The Financial Times Limited 2007
Moodys Pres: We make everything as transparent as we possibly can
Thursday, August 30th, 2007
Moody’s President Sees Unprecedented Illiquidity
Topics:Credit | Housing | Mortgages | Subprime Lending
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The credit market is experiencing an unprecedented loss of confidence due to the lack of transparency over where exposures lie rather than underlying credit quality problems, Moody’s Investors Service President Brian Clarkson said on Thursday.
“I’ve been in the marketplace for 20 years … what we’re experiencing is an extreme lack of confidence and lack of liquidity. I have never seen this before,” Clarkson told Reuters in an interview. “A lot of it has to do with transparency: it’s not clear who owns what.”
There are also questions over valuations of illiquid securities, he said, although not necessarily from a credit standpoint. Some structured vehicles — such as the Cheyne Finance fund run by British hedge fund Cheyne Capital Management — have been forced to sell assets due to losses even though the securities they hold have not been downgraded.
“It’s not that a lot of the things people are holding aren’t money good, they are. If you hold them to maturity they will pay interest and principal on a timely basis.”
Ratings agencies have come under fire for not being quick enough to react to the problems in the U.S. subprime mortgage market that have roiled equity and credit markets in July and August.
In recent months they have downgraded hundreds of securities as mortgage defaults have proved higher than expected. That has led to widespread falls in prices for asset-backed securities whether linked to subprime or not as investors have shunned risky structures.
The European Commission said in August it will review the voluntary code used by the agencies, and French President Nicolas Sarkozy said questions should be asked about the role of ratings agencies in the latest crisis.
Too Quick and Too Slow
Clarkson, who before being appointed as president early in August was responsible for overseeing global structured finance among other areas, said Moody’s had also been criticised by some investors for acting too quickly.
“If you’re a buy and hold investor, we acted way too quick. If you’re holding that thing to maturity, you don’t want a downgrade,” he said. “If you’re a mark-to-market investor, or in particular if you’ve shorted the market or shorted particular securities, we acted way too slow.”
He said it was wrong to treat all subprime mortgage deals alike, with some issuers performing in line with expectations.
“You’ll hear that subprime mortgages are a disaster, a meltdown, it’s terrible. There will be significant losses, there’s no doubt about that,” Clarkson said. “(But) the way we view our role in the market post assigning the ratings is to make sure we’re providing the market with as much information as possible on an ongoing basis. And the observation is that it’s not the entire market.”
Clarkson said that Moody’s wanted to work with regulators to avoid being put in a position of having to provide a service that it was unable to do.
“A rating is an opinion. It’s not a promise, not a guarantee. It’s also not static,” he said.
Calls to revamp the business model of the rating agencies, for instance, by making investors rather than issuers pay for ratings may not help.
“Regardless of who pays, there’s always a conflict,” he said. For instance, if an investor pays for a rating, and that rating then has to be downgraded, there is potential for conflict there. “Any time there is money involved, there is potential for conflict.”
He said that criticism suggesting that Moody’s was involved in structuring securitisations was not accurate. “We make it a point not to be structuring transactions,” Clarkson said.
“We make everything as transparent as we possibly can. Our ratings process is transparent. The ratings are not assigned by the analyst, they’re assigned by committees. Our ratings record is out there for everyone to take a look at. Historically, the ratings have held up extremely well.”
Copyright 2007 Reuters Limited. All rights reserved. Republication or redistribution of Reuters content is expressly prohibited without the prior written consent of Reuters.
http://www.cnbc.com/id/20514802
Calls Grow for Foreigners to Have a Say on U.S. Market Rules
Thursday, August 30th, 2007 Calls Grow for Foreigners to Have a Say on U.S. Market Rules
Politicians, regulators and financial specialists outside the United States are seeking a role in the oversight of American markets, banks and rating agencies after recent problems related to subprime mortgages.
Their argument is simple: The United States is exporting financial products, but losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks.
“We need an international approach, and the United States needs to be part of it,” said Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.
While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.
“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”
Half a dozen American banking and financial regulators — including the Securities and Exchange Commission and the Federal Reserve Board — had no comment. Several noted that they were not the sole regulators of the subprime market.
In general, Washington’s reaction has been that it wants “no form of oversight,” said Kenneth Rogoff, an economics professor at Harvard and a former chief economist of the International Monetary Fund.
Banks and investment funds from China to France suffered losses after buying mortgage-related securities and complex financial products based on them in the United States.
In many cases, investors were caught by surprise because American rating agencies had given the products top ratings, leading buyers to believe there was little risk. International investors are also asking why American lenders were allowed to give mortgages to home buyers who could not repay them.
“In a globalized economy with hedge funds, leveraged buyouts and all these investment funds, we have to ask the question about more transparency,” said Claude Bébéar, the chairman of the supervisory board of the insurance company AXA.
In Europe, the credit crisis appears to have emboldened those who have long been pushing for stricter international rules.
Washington and London rebuffed the German government earlier when it pushed for an international code of conduct for hedge funds. Now some economic advisers to the German government are going further, suggesting that rating agencies should be nationalized, that large-scale loans be registered publicly and that minimum standards be developed for complex debt securities.
The head of the Council of Economic Analysis in France, which advises the prime minister, said hedge funds should be subject to stricter disclosure rules about their risk exposure.
Christian de Boissieu, president of the group and a member of the Committee for Credit and Investment Institutions, which helps regulate French banks, is calling for a global register of hedge funds. In addition, he said, complex securities should be scrutinized before being sold to bank portfolios.
President Nicolas Sarkozy of France, who has vowed to “moralize financial capitalism,” has asked his finance minister, Christine Lagarde, to prepare a proposal for stricter disclosure rules on market participants before an October meeting of finance ministers from the Group of 7. On Monday, in a foreign policy speech, Mr. Sarkozy called again for stronger global regulations to avoid financial crises.
The Chinese central bank said yesterday that it was moving to standardize disclosure of all asset-backed securities as it increases its own market for the financial instruments. Information about loans, terms and borrowers will need to be included in any new securities in China, it said.
The United States and Britain are the source of the bulk of the world’s sophisticated financial products, like the ones that broke down recently.
“At the heart of the issue is that the largest financial institutions continue to innovate and create ever more sophisticated products,” said Chris Rexworthy, director of enhanced regulatory services at IMS Consulting in London and a former regulator with the Financial Services Authority in Britain.
Regulators talk about the importance of stress-testing, Mr. Rexworthy said, but recent developments create concerns that “institutions are either not investing enough effort in this, getting it wrong, or just producing things too complex for their risk-assessment models to cope with.”
“Greater cooperation on the international stage between regulators is undoubtedly one of the things we need to see more of.”
United States regulators are aware of the problem. Regulators have found that credit standards were loosened for home loans, and that borrowers in some cases did not understand or qualify for the loans they were given.
Treasury Secretary Henry M. Paulson Jr. said in June that the department was seeking better oversight, increased efficiency and a reduction in overlap in general.
Some American regulators have been pushing for more international cooperation. The Securities and Exchange Commission has been discussing greater oversight of hedge funds, and it signed several cooperation agreements with regulators from China to Germany in the last 18 months.
The S.E.C. understands “the need for closer international cooperation,” said Andrew Larcos, the public affairs officer for the International Organization of Securities Commissions, the global regulatory body.
Still, Mr. Larcos added, because the subprime mortgage loans that started the crisis were primarily from the United States, the situation obviously raises questions about market regulation.
In the United States, much of the focus is on rating agencies, which are paid by banks for rating products, and which sometimes attached investment-grade ratings to securities that turned out to be not up to that standard.
Joseph Mason, a finance professor at Drexel University in Philadelphia, and Josh Rosner, the managing director of the research firm Graham Fisher, have pushed for more oversight of rating agencies.
“It’s not just the U.S. regulators that failed, though they did fail,” Mr. Rosner said. International regulators have “thrown the keys to the rating agencies,” which have been left in charge of the safety and soundness of bank capital, insurance and pension money.
In Australia, where investors have embraced financial products like derivatives and swaps, several hedge funds were hard hit by exposure to subprime loans, and analysts said they expected it would be months before the extent of the problem became clear.
As geographical boundaries are broken down, “a problem in one location is a problem everywhere,” said Dick Bryan, a professor of economics at the University of Sydney.
“There is the need to challenge the sovereignty of national regulators,” he said. “Why should the rules of lending in the U.S. be left to U.S. regulators when the consequences go everywhere?”
Asian nations were pushing for regional cooperation even before the latest credit problems, as cross-border investing and their equity markets have boomed.
Whether the outcry will result in changes remains to be seen. Soon after the 1997 Asian financial crisis, President Bill Clinton and a number of regulators and politicians pushed to remake the global financial system. But the impetus faded as markets stabilized.
Economists now expect an increase in international regulation, particularly because Washington has raised questions about the need to impose standards on large investment funds controlled by countries like Russia and China.
Ms. Lagarde, the French finance minister, predicted that negotiations might indeed succeed. “There are a lot of shifts happening,” she said. “Once the dust has settled we will see where the different powers stand and what will be on the bargaining table.”
http://www.nytimes.com/2007/08/29/business/worldbusiness/29regulate.html?
ei=5087%0A&em=&en=f5581730440849aa&ex=
1188619200&pagewanted=print
Credit turmoil leads to better understanding
Thursday, August 30th, 2007News Analysis: Credit turmoil leads to better understanding of risk
Published: August 30, 2007
The entertainment for roughly 500 financial executives at the Deutsche Bank global derivatives conference last month in Barcelona did not come cheap: the Rolling Stones reportedly received more than $5 million.
“The best part is, it’s coming out of your bonuses,” Mick Jagger, the lead singer, joked to the crowd.
The hosts of the conference could well afford it. After all, the business of creating new finance vehicles like derivatives and structured products had exploded in recent years. And at the time of the conference just seven weeks ago, there remained a mostly rosy view of such investments, for their ability to help businesses and investors spread out risk.
But the global financial turmoil - set off by problems with subprime mortgages - has prompted a backlash in some quarters against such financial engineering.
More broadly, it has led to a better understanding of the downside of spreading risk so well - it can be felt in all corners of the world, roiling hedge funds, banks and stock markets as far as away as Australia and Germany. In effect, reducing risk on a global scale appears to have increased it for some players.
Today in Business
“The market appears to be finding it harder to truly understand the inherent and underlying risks involved,” said Chris Rexworthy, who was a regulator with Britain’s Financial Services Authority for 10 years before moving recently to the private sector.
In the United States, regulators and lawmakers appear to think that the new and often unregulated investment vehicles - which have shrunk the world and speeded up business in much the same way as the Internet did - are not all inherently flawed. Rather, it is up to investors to scrutinize more closely what they are buying.
This opinion is captured in an analogy offered by Peter Douglas, the founder of GFIA, a hedge fund research firm in Singapore. He likens using derivatives to power tools. If you know how to use them, he said, they are exponentially better and faster for building a house, compared to using hammers, screwdrivers and handsaws.
If you don’t, “you could drill a hole in your head,” he said.
Funds and banks around the world have taken hits because they purchased bonds, or securities related to bonds, backed by bad home loans, often bundled into financial instruments called collateralized debt obligations, or CDOs.
The losses have often surprised their investors, and in same cases the funds and banks’ own executives, who were unaware of the extent of their risks.
The crisis extended as far as the $2.2 trillion money market that finances the day-to-day operations of businesses, as investors wondered whether the underlying assets were sound. “It’s amazing how much ignorance and fear are out there,” said Kevin Davis, a professor of finance at the University of Melbourne.
The confusion about these products lies in part because they are so complex.
Structured products are pooled assets that have been sliced and diced into ever more smaller, more specialized pieces.
They offered investors higher returns at a time when traditional fixed-income, or debt-related products, were producing low returns. As low interest rates fueled a lending boom to borrowers with weak credit, banks looked for new ways to package those loans, so they could sell more. A central building block to offset the risk was asset-backed securities, which are bonds backed by pools of mortgages or other income-producing assets, such as student loans, auto loans, and credit card receivables.
Banks and other financial institutions pooled those asset-backed securities into new pools, dividing them up again and issuing securities against them, creating collateralized debt obligations.
The idea took off, with new combinations that were further removed from the original asset. New creations included CDOs of CDOs, called CDO-squared. There is even a CDO-cubed.
According to JPMorgan, there are about $1.5 trillion in collateralized debt obligations, and about $500 billion to $600 billion in structured finance CDOs, referring to those made up of bonds backed by subprime mortgages, slightly safer mortgages and commercial mortgage backed securities.
Many of the products have proven to be highly problematic as the underlying assets - the subprime mortgages - have gone bust, revealing dangerous levels of leverage in the securities and very few people who know how to figure out their value. As a result, they have become like a potent computer virus, leaving many people fearful that they too will be affected.
“A lot of risk in the subprime asset-backed market is embedded in, and amplified by, CDOs,” said Rod Dubitsky, head of asset-backed research at Credit Suisse.
When defaults in subprime loans started to rise, the impact was felt faster and further than if all the complex asset-backed products did not exist.
Weaknesses in the system were laid bare, including ratings that did not accurately reflect risk and faulty assumptions on how diversified pools would act and multiple layers of leverage.
That in turn unsettled investors in other markets as well who started selling anything they thought might be risky at all, from stocks to loans, and in some cases putting their money into cash.
The advent of radically more complex structured products coincided with another trend in finance: the explosion of credit derivatives, financial tools that enabled institutions like banks and hedge funds to try and hedge exposure to the vast credit market, like loans to corporations, or ownership of corporate bonds.
“Credit derivatives are the fastest growing part of any bank,” said Derek Smith, head of flow credit trading at Deutsche Bank. He cited growth in 2007 of 80 percent for his company and average annual growth of about 40 percent for the industry.
Today in Business
Blythe Masters, a veteran of the credit derivatives revolution and the head of global derivatives at JPMorgan Chase, added, “There has been a wall of money coming at the credit markets in the past five years.”
Credit default swaps (what are widely known as a credit derivatives) allow two parties to exchange the credit risk of an issuer, like a company. For example, if an investor buys a credit default swap on General Motors, called buying protection, he or she makes money when the credit weakens and makes a lot of money if GM goes bankrupt.
In the meantime, the seller of protection makes a fee from the buyer and profits if the company’s credit improves.
Credit derivatives radically shifted the financial landscape for two reasons: they allowed banks to hedge some of their exposure to the huge loans they gave corporations, and they have allowed investors to bet against, or short credit, as a hedge and to speculate.
For banks, shedding exposure to the credit risk of companies, or governments or individuals means not having to reserve as much capital for potential losses. That frees up capital to make even more loans - to homeowners, institutional investors, corporations or hedge funds.
“In the early 1990s, the bank made loans to a company,” recalled Masters of JPMorgan. “But how much was too much? When you reached the limit of capacity, you were shut down with doing business. Now you could buy credit protection and free up capacity for more business.”
The banks found a perfect partner in hedge funds, lightly regulated pools of capital with high fees that were looking for better returns. Insurance companies and pension funds also sought the higher returns, called yield, as interest rates hit historically low rates.
Conceptually, the advent of credit derivatives meant spreading out risk and minimizing the potential D-Day effect of a big bank blow-up. “Fundamentally, having 100 or 1,000 people with a slice of the risk is better than a bank holding 100 percent of the risk,” said Robert Pickel, chief executive of the International Swaps and Derivatives Association.
As the market for CDOs backed by structured products choked in recent weeks, the credit derivatives market has performed well, say participants.
“Credit derivatives have done a good job at doing exactly what they should do: They have accurately and immediately reflected the markets’ pricing of risk throughout this crisis,” Masters said. “That’s a good thing. They have also offered liquidity.”
But there has been a lot of pain as well. Investors purchasing derivatives are making a bet that the underlying stock or bond or loan is going to rise or fall, but they don’t own it. Because buying a derivative requires much less capital than buying the loan or bond it is derived from, banks and traders can buy more of them than they could loans or bonds. That can translate into huge gains - or, in times of stress, outsized losses.
Some institutions are not parsing what products are riskier than others, but rather they are rushing for the door. First State Investments, based in Singapore, has cut its holdings in all Asian financial firms in recent weeks.
At this point “it doesn’t really matter what their exposure is” to subprime products through derivatives, said Alistair Thompson, the deputy head of Asia-Pacific equities at First State. “What concerns us is the sentiment” in the market, he said.
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Predicting where the next subprime related blowup could come from, or even the size of the problem in Asia, has proven difficult for analysts and rating agents.
Goldman Sachs, for example, in an Aug. 16 report, downgraded its outlook on Asian financial stocks from “attractive” to “neutral,” estimating that there was as much as $172 billion in worldwide losses from mortgage loans that have gone bad, nearly double the estimate from the Federal Reserve.
Moody’s, on the other hand, said earlier in August that Asian banks exposure to the problem would be “limited” and “manageable” without being more specific.
The surprises are certainly not over: there were whispers among investors in Australia this week that some local funds are still turning up unexpected subprime exposure because of credit derivatives, weeks after the problems first surfaced.
Goldman Sachs analysts estimate that it will be another three to six months before all of Asian banks exposure to subprime losses turns up.
While that happens, markets are sure to remain skittish. “Liquidity can just be turned off, and essentially it is a confidence game,” said Thompson.
Jenny Anderson reported from New York and Heather Timmons from New Delhi.
http://www.iht.com/articles/2007/08/30/business/derivatives.php?page=3