Credit turmoil leads to better understanding
News 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.
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“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.
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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.
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