The different elements of a business model – revenues, costs, profits, cash flows and investments – should combine to generate a sustainable competitive advantage. As Mullins and Komisar mention (“Getting to Plan B” Hard Business School Press, 2009), a business model must deliver something that is crystal clear and which customers value. A business model must imitate other comparable and well functioning business models but should also be innovative and different where it matters. The starting point is a clear and credible customer promise.
The different business model elements must work seamlessly. Often different parts of the organization focus on different elements revenues, costs, cash flows. As a result, decision making becomes disjointed.
An equally important aspect of managing business model risk is flexibility. When the future is uncertain, planning cannot be perfect. Indeed, too much planning and fine tuning can lead to distraction and loss of focus. Most plans are born out of initial enthusiasm, hope and assumptions rather than hard evidence or data. That is why the initial plan often fails for most entrepreneurs. It is the entrepreneurs who can quickly realize the problems with the current business model and move to Plan B and later on to Plan C that ultimately become successful entrepreneurs.
According to Mullins and Komisar, an effective approach to managing business model risk has four ingredients – Analogs, Antilogs, Leaps of faith and Dashboards. Analogs refer to successful companies which are worth mimicking. Antilogs are companies that serve as reference points for how to be different. Instead of starting from scratch, by studying analogs and antilogs, business risk can be greatly minimized. Unfortunately, all the information needed for a new business/project cannot come from analogs and antilogs. This is where leaps of faith come in. These refer to crucial beliefs and assumptions made while starting the business. These beliefs and assumptions need to be tested by a process called dashboarding. Around the assumptions, hypotheses must be created and tested using metrics. Dashboards help in focusing the company’s attention on critical issues and ensuring that precious resources are focused on removing the critical risks. Dashboards also represent a way of systematically responding to the real life data the company generates.
Wednesday 6 January 2010
Managing Investment Model Risk
The investment model refers to the money needed to enter the business and sustain the operations of the company till it achieves breakeven cash flow. Risk can be reduced by minimizing the upfront investment required. According to Mullins & Komisar, (“Getting to Plan B” Harvard Business Press, 2009) a few key questions must be addressed while managing investment model risk:
§ What are the hard assets – facilities, equipments, needed?
§ What are the development activities that must be completed before launching the product/service in the market place?
§ What are the investments that can be delayed or eliminated?
§ How much revenue and gross margin will the business generate to contribute to the ongoing costs?
Raising money is usually difficult. So the less the money the business needs, the better. Venture capital comes at a price. Venture capitalists are quite likely to demand their pound of flesh. For a small contribution they may demand a high equity stake in the start up. So the investment model must be built carefully to avoid an overdose of the capital. At the same time, the capital base should not be so small that the company runs out of cash before the operations stabilize.
§ What are the hard assets – facilities, equipments, needed?
§ What are the development activities that must be completed before launching the product/service in the market place?
§ What are the investments that can be delayed or eliminated?
§ How much revenue and gross margin will the business generate to contribute to the ongoing costs?
Raising money is usually difficult. So the less the money the business needs, the better. Venture capital comes at a price. Venture capitalists are quite likely to demand their pound of flesh. For a small contribution they may demand a high equity stake in the start up. So the investment model must be built carefully to avoid an overdose of the capital. At the same time, the capital base should not be so small that the company runs out of cash before the operations stabilize.
Managing Working Capital Model Risk
Working capital is the cash a company needs to keep its business running. This includes paying for raw materials, making salary payments, etc. To assess working capital model risk, , a company must examine carefully both its current assets and current liabilities.
Current assets include cash, cash equivalents, accounts receivable and inventory. Current assets represent money that is available to the company.
Current liabilities include accounts payable and short term debt. Current liabilities represent the organizational commitments that the company will have to meet in the near future, typically within one year.
The difference between current assets and current liabilities is nothing but the working capital. Capital has a price. So the better the company manages its working capital, the less external capital it will have to raise. If a business can manage with little working capital, it is a great situation to be in. A few key questions must drive working capital model risk, according to Mullins and Komisar (“Getting to Plan B”, Harvard Business Press, 2009).
§ How can customers be encouraged to pay quickly?
§ How much inventory must be maintained to run the business effectively?
By keeping working capital needs low or negative, a company can put itself in an enviable situation. On the other hand, heavy working capital needs add to the business risk.
Current assets include cash, cash equivalents, accounts receivable and inventory. Current assets represent money that is available to the company.
Current liabilities include accounts payable and short term debt. Current liabilities represent the organizational commitments that the company will have to meet in the near future, typically within one year.
The difference between current assets and current liabilities is nothing but the working capital. Capital has a price. So the better the company manages its working capital, the less external capital it will have to raise. If a business can manage with little working capital, it is a great situation to be in. A few key questions must drive working capital model risk, according to Mullins and Komisar (“Getting to Plan B”, Harvard Business Press, 2009).
§ How can customers be encouraged to pay quickly?
§ How much inventory must be maintained to run the business effectively?
By keeping working capital needs low or negative, a company can put itself in an enviable situation. On the other hand, heavy working capital needs add to the business risk.
Managing Operating Model Risk
A key ingredient of business risk is operating costs. These are all the costs that must be incurred in addition to COGS. If these costs are not kept in check, the company can go bankrupt. There are some key questions which must be addressed while managing operating model risk according to Mullins & Komisar (“Getting to Plan B” Harvard Business School Press, 2009).
§ What level of cost as a percentage of sales must be incurred in the different cost categories?
§ What costs can be reduced or eliminated completely?
§ What costs may have to be increased to make the business strategy more effective?
In many industries, there are various costs that can be eliminated simply by doing things differently. On the other hand, in a few industries, where the customers want the very best, costs may have to be increased to maximize customer delight. The use of technology to automate processes, minimize human error and reduce labour costs is a popular theme in operating model risk management.
§ What level of cost as a percentage of sales must be incurred in the different cost categories?
§ What costs can be reduced or eliminated completely?
§ What costs may have to be increased to make the business strategy more effective?
In many industries, there are various costs that can be eliminated simply by doing things differently. On the other hand, in a few industries, where the customers want the very best, costs may have to be increased to maximize customer delight. The use of technology to automate processes, minimize human error and reduce labour costs is a popular theme in operating model risk management.
Managing the Gross Margin Model Risk
Gross margin is nothing but the difference between revenue and cost of goods sold (COGs). COGs include all the expenses directly related to producing or delivering whatever it is that a company sells. Other costs are excluded from COGs. To assess the gross margin model risk, the following questions must be addressed:
§ How large is the spread between the price and COGs?
§ How should the margin be managed across the product line?
§ How sustainable is the gross margin?
Ref : John Mullins and Randy Komisar , “Getting to Plan B”, Harvard Business Press, 2009
§ How large is the spread between the price and COGs?
§ How should the margin be managed across the product line?
§ How sustainable is the gross margin?
Ref : John Mullins and Randy Komisar , “Getting to Plan B”, Harvard Business Press, 2009
Managing Revenue Model Risk
No business can sustain itself without generating adequate revenues. According to Mullins & Komisar( “Getting to Plan B” Harvard Business Press, 2009) a few key questions need to be addressed while assessing revenue model risk:
§ Who will buy?
§ What will they buy?
§ What pain is the business resolving for the customers?
§ In what way is the business delighting the customers?
§ How soon, how often and how much (many) will customers buy?
§ What is the price the customers are prepared to pay?
If a business is not solving a customer problem or adding to customer delight, revenues will be difficult to sustain. Revenue projections must be made carefully. The business forecast must be compared with that of comparable companies. Assumptions must be validated by building hypotheses and testing them using all available data.
§ Who will buy?
§ What will they buy?
§ What pain is the business resolving for the customers?
§ In what way is the business delighting the customers?
§ How soon, how often and how much (many) will customers buy?
§ What is the price the customers are prepared to pay?
If a business is not solving a customer problem or adding to customer delight, revenues will be difficult to sustain. Revenue projections must be made carefully. The business forecast must be compared with that of comparable companies. Assumptions must be validated by building hypotheses and testing them using all available data.
Understanding Business Risk
Business risk refers to the probability of a business not being able to sell its products and services at a price which is sufficiently remunerative. The world of business risk is less amenable to quantification, compared to financial risk. Business risk often lies in the domain of the strategists where as financial risk lies in the purview of the treasurer/chief risk officer/chief financial officer. While business risk is less quantifiable, efforts should not be spared to understand it properly. A framework provided by John Mullins and Randy Komisar (Read their book “Getting to Plan B” Harvard Business Press, 2009 for more details) is very useful in this regard. According to Mullins and Komisar, five ingredients make up a business model:
§ Revenue model – Which customers will buy the company’s product and at what price?
§ Gross margin model – What proportion of the revenue will be captured by the company after deducting the cost of goods and services (COGs).
§ Operating model – Besides COGs, what are the other costs incurred by the company?
§ Working capital model – How much working capital is needed to run the business?
§ Investment – What are the upfront commitments which must be made to build and run the business?
§ Revenue model – Which customers will buy the company’s product and at what price?
§ Gross margin model – What proportion of the revenue will be captured by the company after deducting the cost of goods and services (COGs).
§ Operating model – Besides COGs, what are the other costs incurred by the company?
§ Working capital model – How much working capital is needed to run the business?
§ Investment – What are the upfront commitments which must be made to build and run the business?
Monday 4 January 2010
Behavioral Issues in Risk Management
Behavioral issues play an important role in risk management. Studies have shown that many New York taxi drivers, set themselves a daily income target. Once they reach their target, they close shop for the day. This tendency to work less on a busy day when easy money is there to be made, defies rational logic. Indeed, such anomalies drive the point home, that while taking decisions with financial implications, logic often takes the backseat.
The behaviours of people are strongly guided by perceptions. Two components of risk influence people’s perceptions – the fear factor and the control factor. When we are very much afraid of the outcome or feel less in control, we perceive the risk to be more. On the other hand, when we are not afraid of the outcome or feel more in control, we perceive the risk to be less.
Scholars, Daniel Kahneman (the 2002 Nobel Prize Winner) and the late Amos Tversky, pioneers of behavioral finance make an important point about how people perceive gains and losses. When looking at a potential gain, people tend to be risk averse and when they look at a potential loss, they are more risk loving. They gain less utility from winning $1000 than what they would forgo if they lose $1000. This asymmetry is especially relevant in the case of a financial loss or gain but can also apply to other situations.
How people perceive gains and losses also depends on the frame of reference. For example, managers who have incurred a major loss may be quite happy if the loss is less than what they had expected. Similarly, the choice of a strategy may depend on the way the possible outcomes are presented.
Cognitive bias in decision making is also an important point to be considered. People tend to give greater weight to information which is more easily available or recalled. The tendency to focus more attention on a particular fact or event, just because it is more visible or fresh in our minds is called availability heuristic. According to Werner De Bondt and Richard Thaler, a significant proportion of market volatility is explained by overreaction to recent news.
People often hold beliefs which are plainly at odds with the evidence, usually because they have been held and cherished for a long time. This is referred to as cognitive dissonance or in more common parlance, denial. Many people also tend to be influenced by outsiders’ suggestions. This may happen even when it is clearly known that the person making the suggestion is not necessarily well informed. Evidence indicates that people also tend to take bigger gambles to maintain the status quo.
People often have an exaggerated notion of their ability to control events. Consequently, they do not pay adequate attention to extreme possibilities. When people think they are in control of circumstances, when they are actually not, they underestimate the risks involved. The tendency on the part of people to think they have a greater influence on events than is actually the case is called magical thinking. Conditions that encourage illusion of control include stress, too much focus on results (without a periodic reflection of what is going on) and a series of positive outcomes.
Barberis, Huang and Santos point out another behavioral factor, the house money effect. When gamblers are ahead, they are more willing to take risks. Similarly, investors who have recently earned high returns will be less risk averse. Over confidence leads to reckless risk taking. This certainly seems to have happened in the case of Barings and Long Term Capital Management.
Another behavioural issue which has an adverse impact on risk management is misinterpretation of past events. Once something happens, people tend to think that they could easily have predicted it. This is called hindsight bias. When something happens and people condition themselves into believing they predicted it, when they actually did not, it is called memory bias.
The tendency to believe that past patterns will repeat themselves in the future is another pitfall in risk management. People are adept at finding patterns even when they do not exist. This phenomenon of treating events as representative of some class or pattern is called representativeness heuristic.
Thaler points out the role of mental accounting which refers to the way individuals and households keep track of financial transactions. People tend to evaluate risks separately than in an integrated fashion. If these risks were evaluated with a broader perspective, investors would be less risk averse. Bernatzl and Thaler have used this concept to explain why equity shares command such a high premium over bonds in the capital markets. Investors tend to focus more on the short-term volatility of shares than their long-term returns. Consequently, they demand a premium as compensation. Instead, if they concentrated on the long term returns offered by shares, they would not perceive them to be much riskier than comparable bonds. In the case of Metallgesellshaft, the German oil refiner, though the long term position was hedged, the top management became pretty much concerned about short term losses. Which is why, they decided to unwind their futures positions even though they were working fine on a long term basis.
Cichdti and Dubin (1994) studied customers who were prepared to pay 45 cents per month as insurance against having to incur a telephone wiring repair cost of $55 with only a .005 profitability. The expected loss in the event of a repair was only (.005) (55) or approximately 28 cents per month. Millions of customers in the US have been known to buy similar protection. If utility-maximising customers had rational expectations about the probability of needing repair, it is unlikely that they would buy the protection.
There are various other behavioral anomalies, a brief mention of some of which is in order here. Contamination effects allow irrelevant but proximate information to influence a decision. The affect heuristic allows preconceived value judgments to interfere with our assessment of costs and benefits. Over confidence in calibration leads us to underestimate the confidence intervals within which our estimates will be robust. Bystander apathy makes us abdicate individual responsibility when in a crowd. The problem of induction makes us generalize on the basis of insufficient information.
Risk management must take into account all these behavioral issues. Ultimately, risks are identified, measured and controlled by people. So human psychology cannot be separated from risk management. It is important to note that “normal” rather than “rational” behaviours are at work while taking risk.
One way to resolve the problem of individual biases is to ask employees to operate in teams. The advantage of a collective approach to beliefs about risk and the frame of reference is that individual biases can be minimised and team members can exercise a restraining influence on each other. Goldman Sachs developed the tradition of partners coming together to evaluate major risks and approve important decisions. This has no doubt contributed to the bank’s strong risk culture.
The behaviours of people are strongly guided by perceptions. Two components of risk influence people’s perceptions – the fear factor and the control factor. When we are very much afraid of the outcome or feel less in control, we perceive the risk to be more. On the other hand, when we are not afraid of the outcome or feel more in control, we perceive the risk to be less.
Scholars, Daniel Kahneman (the 2002 Nobel Prize Winner) and the late Amos Tversky, pioneers of behavioral finance make an important point about how people perceive gains and losses. When looking at a potential gain, people tend to be risk averse and when they look at a potential loss, they are more risk loving. They gain less utility from winning $1000 than what they would forgo if they lose $1000. This asymmetry is especially relevant in the case of a financial loss or gain but can also apply to other situations.
How people perceive gains and losses also depends on the frame of reference. For example, managers who have incurred a major loss may be quite happy if the loss is less than what they had expected. Similarly, the choice of a strategy may depend on the way the possible outcomes are presented.
Cognitive bias in decision making is also an important point to be considered. People tend to give greater weight to information which is more easily available or recalled. The tendency to focus more attention on a particular fact or event, just because it is more visible or fresh in our minds is called availability heuristic. According to Werner De Bondt and Richard Thaler, a significant proportion of market volatility is explained by overreaction to recent news.
People often hold beliefs which are plainly at odds with the evidence, usually because they have been held and cherished for a long time. This is referred to as cognitive dissonance or in more common parlance, denial. Many people also tend to be influenced by outsiders’ suggestions. This may happen even when it is clearly known that the person making the suggestion is not necessarily well informed. Evidence indicates that people also tend to take bigger gambles to maintain the status quo.
People often have an exaggerated notion of their ability to control events. Consequently, they do not pay adequate attention to extreme possibilities. When people think they are in control of circumstances, when they are actually not, they underestimate the risks involved. The tendency on the part of people to think they have a greater influence on events than is actually the case is called magical thinking. Conditions that encourage illusion of control include stress, too much focus on results (without a periodic reflection of what is going on) and a series of positive outcomes.
Barberis, Huang and Santos point out another behavioral factor, the house money effect. When gamblers are ahead, they are more willing to take risks. Similarly, investors who have recently earned high returns will be less risk averse. Over confidence leads to reckless risk taking. This certainly seems to have happened in the case of Barings and Long Term Capital Management.
Another behavioural issue which has an adverse impact on risk management is misinterpretation of past events. Once something happens, people tend to think that they could easily have predicted it. This is called hindsight bias. When something happens and people condition themselves into believing they predicted it, when they actually did not, it is called memory bias.
The tendency to believe that past patterns will repeat themselves in the future is another pitfall in risk management. People are adept at finding patterns even when they do not exist. This phenomenon of treating events as representative of some class or pattern is called representativeness heuristic.
Thaler points out the role of mental accounting which refers to the way individuals and households keep track of financial transactions. People tend to evaluate risks separately than in an integrated fashion. If these risks were evaluated with a broader perspective, investors would be less risk averse. Bernatzl and Thaler have used this concept to explain why equity shares command such a high premium over bonds in the capital markets. Investors tend to focus more on the short-term volatility of shares than their long-term returns. Consequently, they demand a premium as compensation. Instead, if they concentrated on the long term returns offered by shares, they would not perceive them to be much riskier than comparable bonds. In the case of Metallgesellshaft, the German oil refiner, though the long term position was hedged, the top management became pretty much concerned about short term losses. Which is why, they decided to unwind their futures positions even though they were working fine on a long term basis.
Cichdti and Dubin (1994) studied customers who were prepared to pay 45 cents per month as insurance against having to incur a telephone wiring repair cost of $55 with only a .005 profitability. The expected loss in the event of a repair was only (.005) (55) or approximately 28 cents per month. Millions of customers in the US have been known to buy similar protection. If utility-maximising customers had rational expectations about the probability of needing repair, it is unlikely that they would buy the protection.
There are various other behavioral anomalies, a brief mention of some of which is in order here. Contamination effects allow irrelevant but proximate information to influence a decision. The affect heuristic allows preconceived value judgments to interfere with our assessment of costs and benefits. Over confidence in calibration leads us to underestimate the confidence intervals within which our estimates will be robust. Bystander apathy makes us abdicate individual responsibility when in a crowd. The problem of induction makes us generalize on the basis of insufficient information.
Risk management must take into account all these behavioral issues. Ultimately, risks are identified, measured and controlled by people. So human psychology cannot be separated from risk management. It is important to note that “normal” rather than “rational” behaviours are at work while taking risk.
One way to resolve the problem of individual biases is to ask employees to operate in teams. The advantage of a collective approach to beliefs about risk and the frame of reference is that individual biases can be minimised and team members can exercise a restraining influence on each other. Goldman Sachs developed the tradition of partners coming together to evaluate major risks and approve important decisions. This has no doubt contributed to the bank’s strong risk culture.
Risk fundamentals
There are some fundamentals about risk that need to be carefully understood.
Risk can neither be avoided nor eliminated completely. Indeed, without taking risk, no business can grow. If there were no risks to take, managers would be without jobs!
The Pharaoh in the earlier example was obviously taking a risk in the sense that his investment would have been unproductive had there been no famine. Microsoft has laid huge bets on its next operating system, Windows 7. But without this investment, Microsoft realises it may lose its market share as the threat from Google intensifies. Similarly, Tata Motors has made a huge investment in buying out Daewoo's truck division in South Korea. The Tatas have also purchased the luxury marque, Jaguar, realising that without this kind of investment they may become a marginal player in the global automobile market.
In short, risk management is as much about managing the upside as the downside. But as John Fraser and Betty Simkins [“Ten common misconceptions about Enterprise Risk Management,” Journal of Applied Corporate Finance, fall 2007] mention, the upside should not become a distraction and dilute the focus of tactical risk management. The upside should be dealt with during periodic strategic planning exercises or when circumstances change in a big way. But once the strategy is in place, ERM should focus on the downside: “By keeping shifts in strategy and discussions of the upside apart from normal operations, companies avoid having their management and staff distracted by every whim or misunderstood opportunity.”
Risk management should not be viewed in absolute terms. It is often about making choices and tradeoffs between various kinds of risk. These choices and tradeoffs are closely related to a company's assumptions about its external environment. In the Indian pharma industry, players like Dr Reddy's Laboratories are challenging the patents of global players as the generics market in the US opens up with many blockbuster drugs going off patent. But another leading player, Nicholas Piramal (Nicholas), believes in a different approach - partnering with global majors. Nicholas does not want to challenge patents but wants to join hands with large players in various areas such as contract manufacturing. CEO Ajay Piramal believes that Nicholas' capabilities in managing strategic alliances with the big guns in the pharma industry will stand the company in good stead in the coming years.
All risks are not equally important. Without a clear understanding of the impact and frequency of different risks, some relatively unimportant risks may receive more attention than they warrant. As a result, there may be sub optimal utilization of corporate resources. Risks must be classified according to their frequency and potential impact, to facilitate prioritization.
Not all risks are external. Very often, the risks organizations assume have more to do with their own strategies, internal processes, systems and culture than any external developments. For example, the collapse of the Hyderabad based Global Trust Bank (GTB) in 2004 had more to do with poor management control systems than any other kind of risk. GTB took heavy risks while lending money to low credit worthy customers and investing money in the capital markets. The board failed to ask the right questions and impose the necessary checks and balances.
The crisis at UTI in 2001 was again due more to internal than external factors. UTI made a number of questionable investments in the late 1990s. There is considerable evidence that systems and processes were routinely violated when UTI's fund managers purchased risky stocks.
Every company needs to grow its revenues and generate adequate profits to survive in the long run. Unprofitable or stagnating companies are doomed to failure. So, investments, which are needed to stay ahead of competitors, cannot be avoided. And any investment does carry some amount of risk. Risk management ensures that these risks are identified, understood, measured and controlled. By understanding and controlling risk, a firm can take better decisions about pursuing new opportunities and withdrawing from risky areas.
Risk management cannot be completely outsourced. Companies must be clear about what risks to retain inhouse and what risks to transfer. In general, retaining risks makes sense when the cost of transferring the risk is out of proportion to the probability and impact of any damage. The first step for managers is to understand what risks they are comfortable with and what they are not. Often, companies are not comfortable with risks caused by external factors. This is probably why financial risk management, which deals with volatility in interest and exchange rates, has become popular among non banking organisations in the past few decades. Companies also tend to transfer those risks which are difficult to measure or analyze. A good example is earthquakes, where an insurance cover often makes sense. On the other hand, companies often prefer to retain risks closely connected to their core competencies. Thus, a software company like Microsoft would in normal circumstances, not transfer technology risk, but would in all likelihood hedge currency risk. These are only general guidelines. Ultimately whether to retain the risk or to transfer it should be decided on a case-to-case basis.
Risk can neither be avoided nor eliminated completely. Indeed, without taking risk, no business can grow. If there were no risks to take, managers would be without jobs!
The Pharaoh in the earlier example was obviously taking a risk in the sense that his investment would have been unproductive had there been no famine. Microsoft has laid huge bets on its next operating system, Windows 7. But without this investment, Microsoft realises it may lose its market share as the threat from Google intensifies. Similarly, Tata Motors has made a huge investment in buying out Daewoo's truck division in South Korea. The Tatas have also purchased the luxury marque, Jaguar, realising that without this kind of investment they may become a marginal player in the global automobile market.
In short, risk management is as much about managing the upside as the downside. But as John Fraser and Betty Simkins [“Ten common misconceptions about Enterprise Risk Management,” Journal of Applied Corporate Finance, fall 2007] mention, the upside should not become a distraction and dilute the focus of tactical risk management. The upside should be dealt with during periodic strategic planning exercises or when circumstances change in a big way. But once the strategy is in place, ERM should focus on the downside: “By keeping shifts in strategy and discussions of the upside apart from normal operations, companies avoid having their management and staff distracted by every whim or misunderstood opportunity.”
Risk management should not be viewed in absolute terms. It is often about making choices and tradeoffs between various kinds of risk. These choices and tradeoffs are closely related to a company's assumptions about its external environment. In the Indian pharma industry, players like Dr Reddy's Laboratories are challenging the patents of global players as the generics market in the US opens up with many blockbuster drugs going off patent. But another leading player, Nicholas Piramal (Nicholas), believes in a different approach - partnering with global majors. Nicholas does not want to challenge patents but wants to join hands with large players in various areas such as contract manufacturing. CEO Ajay Piramal believes that Nicholas' capabilities in managing strategic alliances with the big guns in the pharma industry will stand the company in good stead in the coming years.
All risks are not equally important. Without a clear understanding of the impact and frequency of different risks, some relatively unimportant risks may receive more attention than they warrant. As a result, there may be sub optimal utilization of corporate resources. Risks must be classified according to their frequency and potential impact, to facilitate prioritization.
Not all risks are external. Very often, the risks organizations assume have more to do with their own strategies, internal processes, systems and culture than any external developments. For example, the collapse of the Hyderabad based Global Trust Bank (GTB) in 2004 had more to do with poor management control systems than any other kind of risk. GTB took heavy risks while lending money to low credit worthy customers and investing money in the capital markets. The board failed to ask the right questions and impose the necessary checks and balances.
The crisis at UTI in 2001 was again due more to internal than external factors. UTI made a number of questionable investments in the late 1990s. There is considerable evidence that systems and processes were routinely violated when UTI's fund managers purchased risky stocks.
Every company needs to grow its revenues and generate adequate profits to survive in the long run. Unprofitable or stagnating companies are doomed to failure. So, investments, which are needed to stay ahead of competitors, cannot be avoided. And any investment does carry some amount of risk. Risk management ensures that these risks are identified, understood, measured and controlled. By understanding and controlling risk, a firm can take better decisions about pursuing new opportunities and withdrawing from risky areas.
Risk management cannot be completely outsourced. Companies must be clear about what risks to retain inhouse and what risks to transfer. In general, retaining risks makes sense when the cost of transferring the risk is out of proportion to the probability and impact of any damage. The first step for managers is to understand what risks they are comfortable with and what they are not. Often, companies are not comfortable with risks caused by external factors. This is probably why financial risk management, which deals with volatility in interest and exchange rates, has become popular among non banking organisations in the past few decades. Companies also tend to transfer those risks which are difficult to measure or analyze. A good example is earthquakes, where an insurance cover often makes sense. On the other hand, companies often prefer to retain risks closely connected to their core competencies. Thus, a software company like Microsoft would in normal circumstances, not transfer technology risk, but would in all likelihood hedge currency risk. These are only general guidelines. Ultimately whether to retain the risk or to transfer it should be decided on a case-to-case basis.
A very brief history of risk management
Risk management is not exactly a new idea. One of the earliest examples of risk management appears in the Old Testament of the Bible. An Egyptian Pharaoh had a dream. His adviser, Joseph interpreted this dream as seven years of plenty to be followed by seven years of famine. To deal with this risk, the Pharaoh purchased and stored large quantities of corn during the good times. As a result, Egypt prospered during the famine. Similarly, in Matsya Avatar, Lord Vishnu asked Sage King Satyavratha to put one pair of each species safely on board the ship that would help them escape the deluge the Lord was planning to unleash. This ensured the perpetuation of different flora and fauna.
The modern era of risk management probably goes back to the Hindu Arabic numbering system, which reached the West about 800 years back. The Indians developed the system while the Arabs played a key role in spreading the knowledge to the west. Without numbers, it would have been impossible to quantify uncertainty. But mathematics alone was not sufficient. What was needed was a change in mindset. This happened during the Renaissance, when long-held beliefs were challenged and scientific enquiry was encouraged. The Renaissance was a period of discovery, investigation, experimentation and demonstration of knowledge. As theories of probability, sampling and statistical inference evolved, the risk management process became more scientific. Many risk management tools used by traders today originated during the 1654-1760 period. The pioneers of the Renaissance age included Luca Paccioli, Girolamo Cardano, Galileo, Blaise Pascal, Pierre de Fermat, Chevalier de Mere and Christian Huygens.
Strangely enough, gamblers played a major role in the advancement of probability theory. A landmark problem they tried to solve was how to estimate the probability of a win for each team after an unfinished game of cards. These ideas were later supplemented by advances such as the regression to the mean by Francis Galton in 1885 and the concept of portfolio diversification by Harry Markowitz in 1952.
More sophisticated risk management tools have been developed in recent decades. These include models for estimating value-at-risk, volatility, probability of default, exposure at default and loss given default. A landmark event in the history of risk management was the development of the Black Scholes Merton Option Pricing Model in 1973. Thanks to better understanding of various domains, quantitative models and the availability of computing power, it has become possible to quantify risk to a large extent. Yet, as the recent sub prime crisis has demonstrated, these numbers are of little use if mature human judgment is not exercised, by the people involved.
The modern era of risk management probably goes back to the Hindu Arabic numbering system, which reached the West about 800 years back. The Indians developed the system while the Arabs played a key role in spreading the knowledge to the west. Without numbers, it would have been impossible to quantify uncertainty. But mathematics alone was not sufficient. What was needed was a change in mindset. This happened during the Renaissance, when long-held beliefs were challenged and scientific enquiry was encouraged. The Renaissance was a period of discovery, investigation, experimentation and demonstration of knowledge. As theories of probability, sampling and statistical inference evolved, the risk management process became more scientific. Many risk management tools used by traders today originated during the 1654-1760 period. The pioneers of the Renaissance age included Luca Paccioli, Girolamo Cardano, Galileo, Blaise Pascal, Pierre de Fermat, Chevalier de Mere and Christian Huygens.
Strangely enough, gamblers played a major role in the advancement of probability theory. A landmark problem they tried to solve was how to estimate the probability of a win for each team after an unfinished game of cards. These ideas were later supplemented by advances such as the regression to the mean by Francis Galton in 1885 and the concept of portfolio diversification by Harry Markowitz in 1952.
More sophisticated risk management tools have been developed in recent decades. These include models for estimating value-at-risk, volatility, probability of default, exposure at default and loss given default. A landmark event in the history of risk management was the development of the Black Scholes Merton Option Pricing Model in 1973. Thanks to better understanding of various domains, quantitative models and the availability of computing power, it has become possible to quantify risk to a large extent. Yet, as the recent sub prime crisis has demonstrated, these numbers are of little use if mature human judgment is not exercised, by the people involved.
The benefits of risk management
What is the rationale for risk management? Ultimately, risk management must benefit the shareholders. After all many of the risks a company faces, are specific to it. Portfolio theory argues that shareholders are rewarded only for systematic risk. Unsystematic risk, i.e., risk specific to a company can be diversified away by purchasing shares in a reasonably large number of companies. If shareholders can manage risk more efficienty on their own, by buying shares in various corporations, should companies really manage risk? The answer is an emphatic yes.
For starters, shareholders do not have all the information needed to manage the risks a company faces. Moreover, even if they had, individual shareholders would find it inefficient and expensive to manage risks on their own. The transaction costs would be too high if a large number of small hedging transactions are undertaken. Finally, distress situations are eminently avoidable. During such situations, significant value destruction takes place as the assets of the company trade at unrealistically low prices. Recall the collapse of Bear Stearns in March 2008 and Lehman in September 2008.
Prudent risk management ensures that the firm’s cash flows are healthy so that the immediate obligations and future investment needs of the firm are both adequately taken care of. Firms typically run into cash flow problems because they fail to anticipate or handle risks efficiently. These risks include market risks such as vulnerability to interest rate, stock index and exchange rate movements. Then there are credit risks which arise because of excessive investments in the same asset class or lending to the same customer segment. They also include liquidity risks such as liquidity black holes, which result when the entire market shifts to one side, with sellers finding it difficult to find buyers. Firms may also fail to anticipate business risks when the demand suddenly falls or a rival starts taking away market share aggressively with a new business model or technological innovation. Then there are various examples of companies failing to manage operational risk effectively because of poor systems and processes.
Risk management helps in sustaining the staying power of an organization. In 1993, Metallgesellschaft which tried to cover the risk associated with its long term contracts through oil futures ended up losing a huge amount. The star studded team at hedge fund, Long Term Capital Management could do little as unexpected interest rate and currency movements brought the fund to the edge of bankruptcy in 1998. In both the cases, the positions taken were fundamentally sound. But there were serious doubts about their ability to tide through the crisis. Indeed, much of the sub prime crisis has been about liquidity. Under the circumstances, liquidity has become the most potent weapon in many sectors. Liquidity gives the comfort to sustain day-to-day operations and more importantly make those vital investments that are needed to sustain the company’s competitiveness in the long run. Sound risk management goes a long way in ensuring that the organization has the required liquidity to function effectively even in bad times.
For starters, shareholders do not have all the information needed to manage the risks a company faces. Moreover, even if they had, individual shareholders would find it inefficient and expensive to manage risks on their own. The transaction costs would be too high if a large number of small hedging transactions are undertaken. Finally, distress situations are eminently avoidable. During such situations, significant value destruction takes place as the assets of the company trade at unrealistically low prices. Recall the collapse of Bear Stearns in March 2008 and Lehman in September 2008.
Prudent risk management ensures that the firm’s cash flows are healthy so that the immediate obligations and future investment needs of the firm are both adequately taken care of. Firms typically run into cash flow problems because they fail to anticipate or handle risks efficiently. These risks include market risks such as vulnerability to interest rate, stock index and exchange rate movements. Then there are credit risks which arise because of excessive investments in the same asset class or lending to the same customer segment. They also include liquidity risks such as liquidity black holes, which result when the entire market shifts to one side, with sellers finding it difficult to find buyers. Firms may also fail to anticipate business risks when the demand suddenly falls or a rival starts taking away market share aggressively with a new business model or technological innovation. Then there are various examples of companies failing to manage operational risk effectively because of poor systems and processes.
Risk management helps in sustaining the staying power of an organization. In 1993, Metallgesellschaft which tried to cover the risk associated with its long term contracts through oil futures ended up losing a huge amount. The star studded team at hedge fund, Long Term Capital Management could do little as unexpected interest rate and currency movements brought the fund to the edge of bankruptcy in 1998. In both the cases, the positions taken were fundamentally sound. But there were serious doubts about their ability to tide through the crisis. Indeed, much of the sub prime crisis has been about liquidity. Under the circumstances, liquidity has become the most potent weapon in many sectors. Liquidity gives the comfort to sustain day-to-day operations and more importantly make those vital investments that are needed to sustain the company’s competitiveness in the long run. Sound risk management goes a long way in ensuring that the organization has the required liquidity to function effectively even in bad times.
Sunday 3 January 2010
The collapse of Lehman Brothers
German immigrants to the US set up Lehman Brothers in 1850. Capitalizing on cotton's high market value, the brothers who owned the firm, accepted raw cotton from customers as payment for merchandise. They then started trading in cotton. Within a few years, this business grew to become the most significant part of the operation. Lehman gradually evolved into a repected investment bank. Managment problems and internal tensions led to the firm being sold to Shearson, an American Express-backed electronic transaction company, in 1984, for $360 million. In 1993, under newly appointed CEO, Harvey Golub, American Express began to divest itself of its banking and brokerage operations. In 1994, it spun off Lehman Brothers Kuhn Loeb as Lehman Brothers Holdings, Inc. through an IPO.
Lehman performed quite well under CEO Richard S. Fuld, Jr.. In 2001, the firm acquired the private-client services, or (PCS), business of Cowen & Co. In 2003, Lehman aggressively re-entered the asset-management business, which it had exited in 1989. Beginning with $2 billion in assets under management, the firm acquired the Crossroads Group, the fixed-income division of Lincoln Capital Management and Neuberger Berman These businesses, together with the PCS business and Lehman's private-equity business, comprised the Investment Management Division. This division generated approximately $3.1 billion in net revenue and almost $800 million in pre-tax income in 2007. Prior to going bankrupt, Lehman had in excess of $275 billion in assets under management. Altogether, since going public in 1994, the firm had increased net revenues from $2.73 billion to $19.2 billion and had increased employee headcount from 8,500 to almost 28,600.
In August 2007, Lehman closed its subprime lender, BNC Mortgage, and took an after-tax charge of $25 million and a $27 million reduction in goodwill. The problems only aggravated in 2008 Lehman faced an unprecedented loss, since it had held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages. In the second quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008, Lehman stock lost 73% of its value as the credit market continued to tighten.
On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the state-controlled Korea Development Bank (KDB) was considering buying the bank. But the gains quickly disappeared on reports KDB was facing difficulties in getting the approval of regulators and in attracting partners for the deal. It culminated on September 9, when Lehman's shares plunged 45% to $7.79, after it was reported that KDB had put talks on hold.
Investor confidence continued to erode as Lehman's stock lost roughly half its value and pushed the S&P 500 down 3.4% on September 9. The Dow Jones lost 300 points the same day on investors' concerns about the security of the bank. The next day, Lehman announced a loss of $3.9 billion and indicated it would to sell off a majority stake in the investment-management business, which included Neuberger Berman. The stock slid seven percent that day. Market rumours were strong that Lehman was reportedly searching for a buyer as its stock price dropped another 40 percent on September 11, 2008.
On Saturday September 13, 2008, Tim Geithner, the president of the Federal Reserve Bank of New York called a meeting to discuss the future of Lehman. Lehman reported that it had been in talks with Bank of America and Barclays for the company's possible sale. However, both Barclays and Bank of America ultimately declined to purchase the entire company.
The International Swaps and Derivatives Association (ISDA) arranged an exceptional trading session on Sunday, September 14, 2008, to allow market participants to offset positions in various derivatives.
In New York, shortly before 1 a.m. the next morning, Lehman announced it would file for Chapter 11 bankruptcy protection citing bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. It further announced that its subsidiaries would continue to operate as normal. A group of Wall Street firms agreed to provide capital and financial assistance for the bank's orderly liquidation. The Federal Reserve, in turn, agreed to a swap of lower-quality assets in exchange for loans and other assistance from the government.
On September 16, 2008, Barclays announced it would acquire a "stripped clean" portion of Lehman for $1.75 billion, including most of Lehman's North America operations. On September 20, the transaction was approved. On September 17, 2008, the New York Stock Exchange delisted Lehman Brothers.
Nomura, Japan's top brokerage firm, agreed to buy the Asian division of Lehman for $225 million and parts of the European division for a nominal fee of $2. It would not take on any trading assets or liabilities in the European units. Nomura decided to acquire only Lehman's employees in the regions, and not its stocks, bonds or other assets.
Did the US government make a big blunder, by not bailing out Lehman? After all, following the bankruptcy there were major upheavals in the financial markets. By October, it was evident that the credit markets had seized up. Companies found it difficult to raise working capital. Trade finance was becoming scarce. Investment decisions were postponed, industrial production shrank and world trade collapsed. By the end of 2008, the world economy was shrinking for the first time since World War II. G7 economies contracted at an annualised rate of 8.4% in the first quarter of 2009.
Former US Treasury secretary, Hank Paulson and Tim Giethner, the incumbent one recently justified their actions stating that the regulators did not have sufficient authority to do a quick bailout. The Fed had tried to broker a deal, but no buyer could be found for Lehman. Barclays which showed interest did not get approval from UK regulators. Bank of America, a potential bidder had already paired up with Merrill.
The collapse of Lehman had some unintended consequences. As Niall Ferguson mentioned[1], Paulson might have taken the right decision without being fully aware: “By showing Americans and particularly their legislators in Congress, just what could happen if even the fourth largest investment bank failed, he created what had hitherto been lacking: the political will for a wholesale bailout of the financial system” If Lehman had been bailed out, there would have been a hue and cry in congress. The TARP bailout would never have been possible. In that case, Citigroup, a bank three times bigger than Lehman would have collapsed.
An editorial in the Financial Times was more emphatic[2], that the US authorities had been right to allow Lehman Brothers to fail. “They could not know how awful it would prove to be and when it comes to saving failing companies, governments should err on the side of inaction. Capitalism relies on the discipline provided by the lure of wealth and the fear of bankruptcy.”
[1] Financial Times, September 15, 2009.
[2] Financial Times, September 14, 2009.
Lehman performed quite well under CEO Richard S. Fuld, Jr.. In 2001, the firm acquired the private-client services, or (PCS), business of Cowen & Co. In 2003, Lehman aggressively re-entered the asset-management business, which it had exited in 1989. Beginning with $2 billion in assets under management, the firm acquired the Crossroads Group, the fixed-income division of Lincoln Capital Management and Neuberger Berman These businesses, together with the PCS business and Lehman's private-equity business, comprised the Investment Management Division. This division generated approximately $3.1 billion in net revenue and almost $800 million in pre-tax income in 2007. Prior to going bankrupt, Lehman had in excess of $275 billion in assets under management. Altogether, since going public in 1994, the firm had increased net revenues from $2.73 billion to $19.2 billion and had increased employee headcount from 8,500 to almost 28,600.
In August 2007, Lehman closed its subprime lender, BNC Mortgage, and took an after-tax charge of $25 million and a $27 million reduction in goodwill. The problems only aggravated in 2008 Lehman faced an unprecedented loss, since it had held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages. In the second quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008, Lehman stock lost 73% of its value as the credit market continued to tighten.
On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the state-controlled Korea Development Bank (KDB) was considering buying the bank. But the gains quickly disappeared on reports KDB was facing difficulties in getting the approval of regulators and in attracting partners for the deal. It culminated on September 9, when Lehman's shares plunged 45% to $7.79, after it was reported that KDB had put talks on hold.
Investor confidence continued to erode as Lehman's stock lost roughly half its value and pushed the S&P 500 down 3.4% on September 9. The Dow Jones lost 300 points the same day on investors' concerns about the security of the bank. The next day, Lehman announced a loss of $3.9 billion and indicated it would to sell off a majority stake in the investment-management business, which included Neuberger Berman. The stock slid seven percent that day. Market rumours were strong that Lehman was reportedly searching for a buyer as its stock price dropped another 40 percent on September 11, 2008.
On Saturday September 13, 2008, Tim Geithner, the president of the Federal Reserve Bank of New York called a meeting to discuss the future of Lehman. Lehman reported that it had been in talks with Bank of America and Barclays for the company's possible sale. However, both Barclays and Bank of America ultimately declined to purchase the entire company.
The International Swaps and Derivatives Association (ISDA) arranged an exceptional trading session on Sunday, September 14, 2008, to allow market participants to offset positions in various derivatives.
In New York, shortly before 1 a.m. the next morning, Lehman announced it would file for Chapter 11 bankruptcy protection citing bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. It further announced that its subsidiaries would continue to operate as normal. A group of Wall Street firms agreed to provide capital and financial assistance for the bank's orderly liquidation. The Federal Reserve, in turn, agreed to a swap of lower-quality assets in exchange for loans and other assistance from the government.
On September 16, 2008, Barclays announced it would acquire a "stripped clean" portion of Lehman for $1.75 billion, including most of Lehman's North America operations. On September 20, the transaction was approved. On September 17, 2008, the New York Stock Exchange delisted Lehman Brothers.
Nomura, Japan's top brokerage firm, agreed to buy the Asian division of Lehman for $225 million and parts of the European division for a nominal fee of $2. It would not take on any trading assets or liabilities in the European units. Nomura decided to acquire only Lehman's employees in the regions, and not its stocks, bonds or other assets.
Did the US government make a big blunder, by not bailing out Lehman? After all, following the bankruptcy there were major upheavals in the financial markets. By October, it was evident that the credit markets had seized up. Companies found it difficult to raise working capital. Trade finance was becoming scarce. Investment decisions were postponed, industrial production shrank and world trade collapsed. By the end of 2008, the world economy was shrinking for the first time since World War II. G7 economies contracted at an annualised rate of 8.4% in the first quarter of 2009.
Former US Treasury secretary, Hank Paulson and Tim Giethner, the incumbent one recently justified their actions stating that the regulators did not have sufficient authority to do a quick bailout. The Fed had tried to broker a deal, but no buyer could be found for Lehman. Barclays which showed interest did not get approval from UK regulators. Bank of America, a potential bidder had already paired up with Merrill.
The collapse of Lehman had some unintended consequences. As Niall Ferguson mentioned[1], Paulson might have taken the right decision without being fully aware: “By showing Americans and particularly their legislators in Congress, just what could happen if even the fourth largest investment bank failed, he created what had hitherto been lacking: the political will for a wholesale bailout of the financial system” If Lehman had been bailed out, there would have been a hue and cry in congress. The TARP bailout would never have been possible. In that case, Citigroup, a bank three times bigger than Lehman would have collapsed.
An editorial in the Financial Times was more emphatic[2], that the US authorities had been right to allow Lehman Brothers to fail. “They could not know how awful it would prove to be and when it comes to saving failing companies, governments should err on the side of inaction. Capitalism relies on the discipline provided by the lure of wealth and the fear of bankruptcy.”
[1] Financial Times, September 15, 2009.
[2] Financial Times, September 14, 2009.
Black September 2008
Many thought that the collapse of Bear Stearns in March 2008 signalled an end to the banking crisis. But it only proved to be a lull in the storm. It was in August that the action again started to pick up. Fannie and Freddie announced their fourth consecutive quarterly loss. On September 7, the US Treasury was forced to bail out the two agencies. Meanwhile, the fortunes of Lehman Brothers, another investment banking icon on Wall Street, had fluctuated wildly in the past few months. Lehman came close to bankruptcy, a couple of times but was saved at the last moment by some desperate measures. On September 15, Lehman threw in the towel and filed for bankruptcy. A big surprise followed the next day when the US Treasury announced a $85 billion bailout of AIG, the respected, global insurance company. AIG had taken huge positions in CDS without realising that credit default insurance was a completely different business compared to its traditional insurance activities. Meanwhile, Merril Lynch, realising it would be difficult to survive as an independent entity, decided to merge with Bank of America. Many of the deeper problems plaguing Merril would become evident only later. At the same time, Goldman Sachs and Morgan Stanley accepted a proposal from the US Treasury to convert themselves from pure play investment banks into bank holding companies. In short, the complexion of Wall Street changed completely in a week.
Saturday 2 January 2010
The collapse of Bear Stearns
Bear Stearns was founded as an equity trading house on May Day 1923 by Joseph Bear, Robert Stearns, and Harold Mayer with $500,000 in capital. By 1933, Bear had opened its first branch office in Chicago. In 1985, Bear Stearns became a publicly traded company. In 2005-2007, Bear was recognized as the "Most Admired" securities by Fortune.
The sub prime crisis changed the fortunes of Bear dramatically. On June 22, 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to "bail out" one of its funds, the High-Grade Structured Credit Fund, while negotiating with other banks to loan money against collateral to another fund, the High-Grade Structured Credit Enhanced Leveraged Fund.
During the week of July 16, 2007, Bear disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages.On August 1, 2007, investors in the two funds took action against Bear and its top board and risk management managers and officers. Two law firms filed arbitration claims with the National Association of Securities Dealers alleging that Bear had misled investors about its exposure to the funds. As a result of the huge hedge fund write downs and its first loss in 83 years, Standard & Poor's downgraded Bear’s credit rating from AA to A.
Co-President Warren Spector was asked to resign on August 5, 2007. Matthew Tannin and Ralph R. Cioffi, both former managers of hedge funds at Bear Stearns Companies, were arrested June 19, 2008, on criminal charges and for misleading investors about the risks involved in the subprime market. Tannin and Cioffi were also named in lawsuits brought forth by Barclays Bank, who claimed they were one of the many investors misled by the executives. They were also named in civil lawsuits brought in 2007 by investors, including Barclays, who claimed they had been misled. Barclays claimed that Bear knew that certain assets in the High-Grade Structured Credit Strategies Enhanced Leverage Master Fund were worth much less than their professed values. The suit claimed that Bear’s managers devised "a plan to make more money for themselves and further to use the Enhanced Fund as a repository for risky, poor-quality investments." Bear had apparently told Barclays that the enhanced fund was up almost 6% through June 2007 — when "in reality, the portfolio's asset values were plummeting."
As of November 30, 2007, Bear had notional contract amounts of approximately $13.40 trillion in derivative financial instruments. In addition, the investment bank was carrying more than $28 billion in 'level 3' assets on its books at the end of fiscal 2007 versus a net equity position of only $11.1 billion. This $11.1 billion supported $395 billion in assets, implying a leverage ratio of 35.5 to 1. This highly leveraged balance sheet, consisting of many illiquid and potentially worthless assets, led to the rapid dilution of investor and lender confidence.
In early 2007, the typical price of a credit default swap, (cost of credit protection) tied to the debt of an investment bank like Bear had been about 25 basis points. By March 14 2008, the cost of buying protection on Bear’s debt had increased to 850 basis points[ “Bloomberg Markets”, July 2008].The widening spread predicted a high probability of default. Doubts about the very existence of Bear mounted.
On March 14, 2008, JP Morgan Chase, backed by the Federal Reserve Bank of New York, agreed to provide a 28-day emergency loan to Bear Stearns. Despite this, belief in Bear's ability to repay its obligations rapidly diminished among counterparties and traders. The Fed sensed that the terms of the emergency loan were not enough to bolster Bear. Worried about the possibility of systemic losses if allowed to open in the markets on the following Monday, the US authorities told CEO Alan Schwartz that he had to sell the firm over the weekend, in time for the opening of the Asian market. Two days later, on March 16, 2008, Bear Stearns finalized its agreement with JP Morgan Chase in the form of a stock swap worth $2 a share. This was a huge climb-down for a stock that had traded at $172 a share as late as January 2007 and $93 a share as late as February 2008. In addition, the Fed agreed to issue a non-recourse loan of $29 billion to JP Morgan Chase, thereby assuming the risk of Bear Stearns's less liquid assets. Bernanke, defended the bailout by stating that Bear’s bankruptcy would have affected the real economy and could have caused a "chaotic unwinding" of investments across the US markets.
The collapse of Bear Stearns was as much due to a lack of confidence as a lack of capital. On March 20, Securities and Exchange Commission Chairman Christopher Cox noted that the bank’s problems escalated when rumors spread about its liquidity crisis which in turn eroded investor confidence in the firm. Bear’s liquidity pool started at $18.1 billion on March 10 and then plummeted to $2 billion on March 13. Ultimately, market rumors about Bear Stearns' difficulties became self-fulfilling.
On March 24, 2008, a new agreement raised JPMorgan Chase's offer to $10 a share, up from the initial $2 offer, that meant an offer of $1.2 billion. The revised deal was meant to quiet upset investors and any subsequent legal action brought against JP Morgan Chase as a result of the deal. The higher price was also meant to prevent employees, whose compensation consisted of Bear Stearns stock, from leaving for other firms.
The sub prime crisis changed the fortunes of Bear dramatically. On June 22, 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to "bail out" one of its funds, the High-Grade Structured Credit Fund, while negotiating with other banks to loan money against collateral to another fund, the High-Grade Structured Credit Enhanced Leveraged Fund.
During the week of July 16, 2007, Bear disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages.On August 1, 2007, investors in the two funds took action against Bear and its top board and risk management managers and officers. Two law firms filed arbitration claims with the National Association of Securities Dealers alleging that Bear had misled investors about its exposure to the funds. As a result of the huge hedge fund write downs and its first loss in 83 years, Standard & Poor's downgraded Bear’s credit rating from AA to A.
Co-President Warren Spector was asked to resign on August 5, 2007. Matthew Tannin and Ralph R. Cioffi, both former managers of hedge funds at Bear Stearns Companies, were arrested June 19, 2008, on criminal charges and for misleading investors about the risks involved in the subprime market. Tannin and Cioffi were also named in lawsuits brought forth by Barclays Bank, who claimed they were one of the many investors misled by the executives. They were also named in civil lawsuits brought in 2007 by investors, including Barclays, who claimed they had been misled. Barclays claimed that Bear knew that certain assets in the High-Grade Structured Credit Strategies Enhanced Leverage Master Fund were worth much less than their professed values. The suit claimed that Bear’s managers devised "a plan to make more money for themselves and further to use the Enhanced Fund as a repository for risky, poor-quality investments." Bear had apparently told Barclays that the enhanced fund was up almost 6% through June 2007 — when "in reality, the portfolio's asset values were plummeting."
As of November 30, 2007, Bear had notional contract amounts of approximately $13.40 trillion in derivative financial instruments. In addition, the investment bank was carrying more than $28 billion in 'level 3' assets on its books at the end of fiscal 2007 versus a net equity position of only $11.1 billion. This $11.1 billion supported $395 billion in assets, implying a leverage ratio of 35.5 to 1. This highly leveraged balance sheet, consisting of many illiquid and potentially worthless assets, led to the rapid dilution of investor and lender confidence.
In early 2007, the typical price of a credit default swap, (cost of credit protection) tied to the debt of an investment bank like Bear had been about 25 basis points. By March 14 2008, the cost of buying protection on Bear’s debt had increased to 850 basis points[ “Bloomberg Markets”, July 2008].The widening spread predicted a high probability of default. Doubts about the very existence of Bear mounted.
On March 14, 2008, JP Morgan Chase, backed by the Federal Reserve Bank of New York, agreed to provide a 28-day emergency loan to Bear Stearns. Despite this, belief in Bear's ability to repay its obligations rapidly diminished among counterparties and traders. The Fed sensed that the terms of the emergency loan were not enough to bolster Bear. Worried about the possibility of systemic losses if allowed to open in the markets on the following Monday, the US authorities told CEO Alan Schwartz that he had to sell the firm over the weekend, in time for the opening of the Asian market. Two days later, on March 16, 2008, Bear Stearns finalized its agreement with JP Morgan Chase in the form of a stock swap worth $2 a share. This was a huge climb-down for a stock that had traded at $172 a share as late as January 2007 and $93 a share as late as February 2008. In addition, the Fed agreed to issue a non-recourse loan of $29 billion to JP Morgan Chase, thereby assuming the risk of Bear Stearns's less liquid assets. Bernanke, defended the bailout by stating that Bear’s bankruptcy would have affected the real economy and could have caused a "chaotic unwinding" of investments across the US markets.
The collapse of Bear Stearns was as much due to a lack of confidence as a lack of capital. On March 20, Securities and Exchange Commission Chairman Christopher Cox noted that the bank’s problems escalated when rumors spread about its liquidity crisis which in turn eroded investor confidence in the firm. Bear’s liquidity pool started at $18.1 billion on March 10 and then plummeted to $2 billion on March 13. Ultimately, market rumors about Bear Stearns' difficulties became self-fulfilling.
On March 24, 2008, a new agreement raised JPMorgan Chase's offer to $10 a share, up from the initial $2 offer, that meant an offer of $1.2 billion. The revised deal was meant to quiet upset investors and any subsequent legal action brought against JP Morgan Chase as a result of the deal. The higher price was also meant to prevent employees, whose compensation consisted of Bear Stearns stock, from leaving for other firms.
How the Investment banks were trapped
In mid-2007, SIVs held $1.4 trillion of sub prime MBSs and CDOs. Banks found SIVs attractive for more than one reason. Not only could sizable profits be generated for creating and managing SIVs, but also due to their off balance sheet nature, little capital was needed to back them.
SIVs issued commercial paper to finance much longer term investments. This was fine as long as money market funds were willing takers. But when the performance of the SIVs deteriorated, the money market funds withdrew. So, the SIVs turned to their parent companies for funding. In late 2007, when nearly all the SIVs looked like failing simultaneously, the big banks brought the SIV investments back to their balance sheets.
Conduits were similar to SIVs. They held the loans until they could be pooled into securities. Conduits were also funded with short term paper. Like the SIVs, the conduits also ran into trouble when the money market funds withdrew.
In hindsight, it is clear that one distorting force leading to the popularity of SIVs was regulatory and ratings arbitrage. The Basel norms required that banks hold capital of at least 8 percent of the loans on their balance sheets. This capital requirement was much lower for contractual credit lines. Moreover, there was no capital charge at all for “reputational” credit lines—noncontractual liquidity backstops that sponsoring banks provided to SIVs to maintain their reputation. Thus, moving a pool of loans into off-balance-sheet vehicles, and then granting a credit line to that pool to ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to hold to conform with Basel regulations. While all this happened, the risk for the bank remained essentially unchanged.
Basel II implemented capital charges based on asset ratings, but banks were able to reduce their capital charges by pooling loans in off-balance-sheet vehicles. Because of the reduction of idiosyncratic risk through diversification, assets issued by these vehicles received a better rating than did the individual securities in the pool. In addition, issuing short-term assets improved the overall rating even further, since banks sponsoring these SIVs were not sufficiently downgraded for granting liquidity backstops.
Raghuram Rajan[1] has raised a very interesting point. Why did the originators of these complex securities—the financial institutions that should have understood the deterioration of the underlying quality of mortgages—hold on to so many of the mortgage-backed securities (MBS) in their own portfolios? Clearly, some people in the bank thought these securities were worthwhile investments, despite their risk. Investment in mortgage securities seemed to be part of a culture of excessive risk-taking that had overtaken many banks. A key factor contributing to this culture is that, over short periods of time, it is very hard, especially in the case of new products, to tell whether a financial manager is generating true alpha or whether the current returns are simply compensation for a risk that has not yet shown itself but will eventually materialize. In short, are the returns being measured after adjusting for the full cost, including the risk involved? A simple example illustrates this point. Consider credit insurance. If traders are given bonuses by treating the entire insurance premium as income, without setting apart a significant fraction as a reserve for an eventual payout, they have a strong incentive to get more of such business and earn more bonuses. Thus, the traders in AIG wrote credit default swaps, pocketed the premiums as bonuses, but did not bother to set aside reserves in case the bonds covered by the swaps actually defaulted. And the traders who bought AAA-rated mortgage backed securities (MBS) were essentially getting the additional spread on these instruments relative to corporate AAA securities (the spread being the insurance premium) while ignoring the additional default risk entailed in these untested securities.
Many investment banks fell unwittingly into the CDO trap, by moving heavily into super-senior debt, the tranche with the highest priority for receiving cash flows if the CDO defaulted. Rating agencies gave super-senior CDO debt a triple-A rating, irrespective of what constituted the CDO. Thanks to the triple-A tag, banks were only required to hold minimal capital against super senior debt. This debt typically offered a spread of about 10 basis points over risk-free bonds. Some banks kept tens of billions of dollars of super-senior debt on their balance sheet and looked at the spread as an easy and continuing source of profit.
Looking back, it is clear that the triple A rating given to the super senior tranche was completely illusory.
Joseph R Mason[2], has dealt in detail with the rating discrepancies Corporate bonds rated Baa, the lowest Moody's investment grade rating, had an average 2.2 per cent default rate over five-year periods from 1983 to 2005. From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 per cent. In other words, Baa CDO securities were 10 times as risky as its Baa corporate bonds. Similarly, over time horizons of both five years and seven years, S&P attached a higher default probability to a CDO rated AA than to an ABS rated A. Over a three year time horizon, a CDO rated AA had a higher probability of default than an ABS rated A-.
Such data created some intriguing possibilities. A seven-year ABS rated AA+had an idealized default probability of 0.168%. If the security (all by itself) had been repackaged and called a CDO, it might have got a rating of AAA because the idealized default rate for the AAA rated CDOs was 0.285% over seven years. As Mason put it, “Municipal bond insurance for an Al state general obligation bond therefore merely translates the Al municipal rating to the Aaa corporate (global) rating of the monoline guarantor without any reduction in risk.”
As Anna J Schwartz mentioned[3], “The design of mortgage-backed securities collateralized by a pool of mortgages assumed that the pool would give the securities value. The pool, however, was an assortment of mortgages of varying quality.” The designers left it to the rating agencies to determine the price of the security. But the rating agencies had no formula for this task. They assigned ratings to complex securities as if they were ordinary corporate bonds. And these ratings overstated the value of the securities and were fundamentally arbitrary.
According to Brunnermeier “rating at the edge” might also have contributed to favorable ratings of structured products versus corporate bonds. While a AAA-rated bond represented a band of risk ranging from a near-zero default risk to a risk that just made it into the AAA-rated group, banks worked closely with the rating agencies to ensure that AAA tranches were always sliced in such a way that they just crossed the dividing line to reach the AAA rating.
Fund managers, “searching for yield,” were attracted to buying structured products because they promised high expected returns with a small probability of catastrophic loss. In addition, some fund managers may have favored the relatively illiquid junior tranches precisely because they traded so infrequently and were therefore hard to value. These managers could make their monthly returns appear attractively smooth over time because they had some flexibility with regard to when they could revalue their portfolios.
As information flowed about the poor quality of the underlying assets, the markets became increasingly weary about CDOs and their tranches. The prices of some tranches of debt fell by 30 per cent in a few months. Instead of booking profits, banks were faced with the possibility of write downs. Yet few anticipated the quantum of the write downs. Only as banks like UBS, Citigroup and Morgan Stanley started to announce big losses during the second half of 2007, the magnitude of the crisis became more evident.
[1] Federal Reserve Bank of St. Louis Review September/October, Part 1 2009. Pp. 397-402.
[2] “The (continuing) Information problems in structured Finance” Journal of Applied Finance, The Journal of Structured Finance, Spring 2008.
[3] “Origins of the financial market crisis of 2008” Cato Journal, Winter 2009.
SIVs issued commercial paper to finance much longer term investments. This was fine as long as money market funds were willing takers. But when the performance of the SIVs deteriorated, the money market funds withdrew. So, the SIVs turned to their parent companies for funding. In late 2007, when nearly all the SIVs looked like failing simultaneously, the big banks brought the SIV investments back to their balance sheets.
Conduits were similar to SIVs. They held the loans until they could be pooled into securities. Conduits were also funded with short term paper. Like the SIVs, the conduits also ran into trouble when the money market funds withdrew.
In hindsight, it is clear that one distorting force leading to the popularity of SIVs was regulatory and ratings arbitrage. The Basel norms required that banks hold capital of at least 8 percent of the loans on their balance sheets. This capital requirement was much lower for contractual credit lines. Moreover, there was no capital charge at all for “reputational” credit lines—noncontractual liquidity backstops that sponsoring banks provided to SIVs to maintain their reputation. Thus, moving a pool of loans into off-balance-sheet vehicles, and then granting a credit line to that pool to ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to hold to conform with Basel regulations. While all this happened, the risk for the bank remained essentially unchanged.
Basel II implemented capital charges based on asset ratings, but banks were able to reduce their capital charges by pooling loans in off-balance-sheet vehicles. Because of the reduction of idiosyncratic risk through diversification, assets issued by these vehicles received a better rating than did the individual securities in the pool. In addition, issuing short-term assets improved the overall rating even further, since banks sponsoring these SIVs were not sufficiently downgraded for granting liquidity backstops.
Raghuram Rajan[1] has raised a very interesting point. Why did the originators of these complex securities—the financial institutions that should have understood the deterioration of the underlying quality of mortgages—hold on to so many of the mortgage-backed securities (MBS) in their own portfolios? Clearly, some people in the bank thought these securities were worthwhile investments, despite their risk. Investment in mortgage securities seemed to be part of a culture of excessive risk-taking that had overtaken many banks. A key factor contributing to this culture is that, over short periods of time, it is very hard, especially in the case of new products, to tell whether a financial manager is generating true alpha or whether the current returns are simply compensation for a risk that has not yet shown itself but will eventually materialize. In short, are the returns being measured after adjusting for the full cost, including the risk involved? A simple example illustrates this point. Consider credit insurance. If traders are given bonuses by treating the entire insurance premium as income, without setting apart a significant fraction as a reserve for an eventual payout, they have a strong incentive to get more of such business and earn more bonuses. Thus, the traders in AIG wrote credit default swaps, pocketed the premiums as bonuses, but did not bother to set aside reserves in case the bonds covered by the swaps actually defaulted. And the traders who bought AAA-rated mortgage backed securities (MBS) were essentially getting the additional spread on these instruments relative to corporate AAA securities (the spread being the insurance premium) while ignoring the additional default risk entailed in these untested securities.
Many investment banks fell unwittingly into the CDO trap, by moving heavily into super-senior debt, the tranche with the highest priority for receiving cash flows if the CDO defaulted. Rating agencies gave super-senior CDO debt a triple-A rating, irrespective of what constituted the CDO. Thanks to the triple-A tag, banks were only required to hold minimal capital against super senior debt. This debt typically offered a spread of about 10 basis points over risk-free bonds. Some banks kept tens of billions of dollars of super-senior debt on their balance sheet and looked at the spread as an easy and continuing source of profit.
Looking back, it is clear that the triple A rating given to the super senior tranche was completely illusory.
Joseph R Mason[2], has dealt in detail with the rating discrepancies Corporate bonds rated Baa, the lowest Moody's investment grade rating, had an average 2.2 per cent default rate over five-year periods from 1983 to 2005. From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 per cent. In other words, Baa CDO securities were 10 times as risky as its Baa corporate bonds. Similarly, over time horizons of both five years and seven years, S&P attached a higher default probability to a CDO rated AA than to an ABS rated A. Over a three year time horizon, a CDO rated AA had a higher probability of default than an ABS rated A-.
Such data created some intriguing possibilities. A seven-year ABS rated AA+had an idealized default probability of 0.168%. If the security (all by itself) had been repackaged and called a CDO, it might have got a rating of AAA because the idealized default rate for the AAA rated CDOs was 0.285% over seven years. As Mason put it, “Municipal bond insurance for an Al state general obligation bond therefore merely translates the Al municipal rating to the Aaa corporate (global) rating of the monoline guarantor without any reduction in risk.”
As Anna J Schwartz mentioned[3], “The design of mortgage-backed securities collateralized by a pool of mortgages assumed that the pool would give the securities value. The pool, however, was an assortment of mortgages of varying quality.” The designers left it to the rating agencies to determine the price of the security. But the rating agencies had no formula for this task. They assigned ratings to complex securities as if they were ordinary corporate bonds. And these ratings overstated the value of the securities and were fundamentally arbitrary.
According to Brunnermeier “rating at the edge” might also have contributed to favorable ratings of structured products versus corporate bonds. While a AAA-rated bond represented a band of risk ranging from a near-zero default risk to a risk that just made it into the AAA-rated group, banks worked closely with the rating agencies to ensure that AAA tranches were always sliced in such a way that they just crossed the dividing line to reach the AAA rating.
Fund managers, “searching for yield,” were attracted to buying structured products because they promised high expected returns with a small probability of catastrophic loss. In addition, some fund managers may have favored the relatively illiquid junior tranches precisely because they traded so infrequently and were therefore hard to value. These managers could make their monthly returns appear attractively smooth over time because they had some flexibility with regard to when they could revalue their portfolios.
As information flowed about the poor quality of the underlying assets, the markets became increasingly weary about CDOs and their tranches. The prices of some tranches of debt fell by 30 per cent in a few months. Instead of booking profits, banks were faced with the possibility of write downs. Yet few anticipated the quantum of the write downs. Only as banks like UBS, Citigroup and Morgan Stanley started to announce big losses during the second half of 2007, the magnitude of the crisis became more evident.
[1] Federal Reserve Bank of St. Louis Review September/October, Part 1 2009. Pp. 397-402.
[2] “The (continuing) Information problems in structured Finance” Journal of Applied Finance, The Journal of Structured Finance, Spring 2008.
[3] “Origins of the financial market crisis of 2008” Cato Journal, Winter 2009.
Understanding the Credit crunch
As the sub prime crisis unfolded, linkages among different markets became evident. The uncertainty in the interbank market spilled over to the corporate market, especially for lower rated loans and bonds. Banks had been using junk bonds to finance leveraged buyouts. They had hoped to off-load them to investors quickly. But in the troubled environment, the junk bonds remained on the balance sheet.
Monolines briefly mentioned earlier, had been providing insurance on municipal bonds. This was widely considered a pretty safe business as state and local governments rarely defaulted. But many guarantors expanded beyond this business. They entered the CDS market in a big way. The rating agencies threatened to downgrade the ratings of the bond insurer. And as the bond insurers were downgraded, so too were the bond issuers. Even municipalities with stable finances found interest rates on their bonds going up.
As the mortgage market correction gained momentum, investors began to focus more closely on credit quality and valuation challenges in illiquid markets. The first signs of the impending liquidity squeeze came in the asset-backed commercial paper (ABCP) market, when issuers began to encounter difficulties rolling over outstanding volumes. When nervousness about funding needs and the liabilities of banks intensified, liquidity demand surged, causing a major disruption in the interbank money markets.
Mark Brunnermeier [ “Deciphering the liquidity and credit crunch 2007-2008,” Journal of Economic Perspectives.], has explained how liquidity problems amplified the sub prime crisis in various ways. When asset prices dropped, financial institutions’ capital eroded and, at the same time, lending standards and margins tightened. Both effects caused fire-sales, pushing down prices and tightening funding even further. Banks also became concerned about their future access to capital markets and started hoarding funds.
The nature of funding aggravated these problems. Most investors preferred assets with short maturities, such as short-term money market funds. It allowed them to withdraw funds at short notice to accommodate their own funding needs. It might also have served as a commitment device to discipline banks with the threat of possible withdrawals. On the other hand, most mortgages had maturities measured in decades.
In the traditional banking model, commercial banks financed these loans with deposits that could be withdrawn at short notice. In the build up to sub prime, the same maturity mismatch was transferred to a “shadow” banking system consisting of off-balance-sheet investment vehicles and conduits. These structured investment vehicles raised funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year, primarily to money market funds.
The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposed the banks to funding liquidity risk. To ensure funding liquidity for the vehicle, the sponsoring bank had granted a credit line to the vehicle, called a “liquidity backstop.” As a result, the banking system still carried the liquidity risk. When investors suddenly stopped buying asset-backed commercial paper, preventing these vehicles from rolling over their short-term debt, the assets came back to the balance sheets of the banks.
Another important trend was an increase in the maturity mismatch on the balance sheet of investment banks, due to a growth on balance sheet financing with short-term repurchase agreements, or “repos.” Much of the growth in repo financing as a fraction of investment banks’ total assets was due to an increase in overnight repos. The fraction of total investment bank assets financed by overnight repos (as opposed to term repos with a maturity of upto three months) roughly doubled from 2000 to 2007. The excessive dependence on overnight repos caused serious liquidity problems as the crisis aggravated.
Monolines briefly mentioned earlier, had been providing insurance on municipal bonds. This was widely considered a pretty safe business as state and local governments rarely defaulted. But many guarantors expanded beyond this business. They entered the CDS market in a big way. The rating agencies threatened to downgrade the ratings of the bond insurer. And as the bond insurers were downgraded, so too were the bond issuers. Even municipalities with stable finances found interest rates on their bonds going up.
As the mortgage market correction gained momentum, investors began to focus more closely on credit quality and valuation challenges in illiquid markets. The first signs of the impending liquidity squeeze came in the asset-backed commercial paper (ABCP) market, when issuers began to encounter difficulties rolling over outstanding volumes. When nervousness about funding needs and the liabilities of banks intensified, liquidity demand surged, causing a major disruption in the interbank money markets.
Mark Brunnermeier [ “Deciphering the liquidity and credit crunch 2007-2008,” Journal of Economic Perspectives.], has explained how liquidity problems amplified the sub prime crisis in various ways. When asset prices dropped, financial institutions’ capital eroded and, at the same time, lending standards and margins tightened. Both effects caused fire-sales, pushing down prices and tightening funding even further. Banks also became concerned about their future access to capital markets and started hoarding funds.
The nature of funding aggravated these problems. Most investors preferred assets with short maturities, such as short-term money market funds. It allowed them to withdraw funds at short notice to accommodate their own funding needs. It might also have served as a commitment device to discipline banks with the threat of possible withdrawals. On the other hand, most mortgages had maturities measured in decades.
In the traditional banking model, commercial banks financed these loans with deposits that could be withdrawn at short notice. In the build up to sub prime, the same maturity mismatch was transferred to a “shadow” banking system consisting of off-balance-sheet investment vehicles and conduits. These structured investment vehicles raised funds by selling short-term asset-backed commercial paper with an average maturity of 90 days and medium-term notes with an average maturity of just over one year, primarily to money market funds.
The strategy of off-balance-sheet vehicles—investing in long-term assets and borrowing with short-term paper—exposed the banks to funding liquidity risk. To ensure funding liquidity for the vehicle, the sponsoring bank had granted a credit line to the vehicle, called a “liquidity backstop.” As a result, the banking system still carried the liquidity risk. When investors suddenly stopped buying asset-backed commercial paper, preventing these vehicles from rolling over their short-term debt, the assets came back to the balance sheets of the banks.
Another important trend was an increase in the maturity mismatch on the balance sheet of investment banks, due to a growth on balance sheet financing with short-term repurchase agreements, or “repos.” Much of the growth in repo financing as a fraction of investment banks’ total assets was due to an increase in overnight repos. The fraction of total investment bank assets financed by overnight repos (as opposed to term repos with a maturity of upto three months) roughly doubled from 2000 to 2007. The excessive dependence on overnight repos caused serious liquidity problems as the crisis aggravated.
CDOs and the Sub Prime Crisis
One of the fascinating aspects of the sub prime crisis has been the degree of opaqueness created in the financial system by securitisation. The vehicle which has made this possible is the Collateralised Debt Obligation (CDO). CDOs allow asset backed securities to be mixed with subprime mortgage loans and placed into different risk classes, or tranches, each with its own repayment schedule. Upper tranches receive 'AAA' ratings as they are promised the first cash flows that come into the security. Lower tranches have lower priority but carry higher coupon rates to compensate for the increased default risk. Finally at the bottom, lies the "equity" tranche. Its cash flows may be wiped out if the default rate on the entire ABS creeps above 5 to 7%.
A simple illustration will explain how a CDO operates. Say a bank has granted 1000 subprime mortgage loans with an overall principal value of $ 300 million.
Based on the historical delinquency rates of 4% and average losses for defaulted sub prime mortgages of 25%, the expected loss for the pool would be 4% of 25%, i.e., 1%, or USD 3mn. This loss rate would be too high for the instrument to achieve a AAA credit rating.
So the bank redistributes the cash flows of the underlying mortgages to four different tranches. Tranche 1, the "AAA"-rated tranche, has a senior claim on all interest and principal payments of the mortgage pool. No other tranche may receive any cash-flows till all payments on the AAA tranche are met. Its size equals say 80% of the overall volume of the mortgage pool, or 0.8 x 300 million, i.e., $240 million.
Tranche 2, the "A"-rated tranche, is subordinated to the AAA tranche, but remains senior to all remaining tranches. Its size is 12% of the over-all volume, or 0.12 x 300 million i.e., 36 million.
Tranche 3, the "BB"-rated or High Yield tranche represents another 5% of the overall volume, i.e., $15 million and is subordinated to both higher-rated tranches.
The “Equity tranche” equals 3% of the pool volume, ie., $9 million and receives anything that is left over, after all other tranches are fully serviced.
If the losses remain within $3 million, the equity tranche takes all losses while all other tranches receive the full amount of interest and principal payments. Even with a cyclical rise in default rates, the AAA tranche would be well protected from losses.
Let us assume that if delinquency rates rise to 25%, losses on defaulted subprime mortgages will rise to 50%. This may result in a loss rate of 0.25 x 0.5 = 12.5% i.e., (.125) (300) = $37.5 million. This would erase the Equity tranche (3%, 9 million) and the BB tranche (5%, 15 million) entirely. The remaining losses ($13.5 million) would be absorbed by the A tranche which would lose 37.5% of principal (13.5/36). The AAA tranche would not carry losses, but its buffer for further losses would largely disappear. It would be living at the edge, so to say!
Through the process of tranching, the subprime mortgage lenders found a way to sell their risky debt. Nearly 80% of these bundled securities were rated investment grade ('A' rated or higher), by the rating agencies, who earned lucrative fees for their work in rating the ABSs.
Having found a way to originate and distribute risky mortgages, banks moved into subprime lending very aggressively. Basic requirements like proof-of-income and down payment were waived off by some mortgage lenders. By using teaser rates within adjustable-rate mortgages (ARM), borrowers were enticed into an initially affordable mortgage in which payments would skyrocket in a few years. The CDO market ballooned to more than $600 billion in issuance during 2006 alone - more than 10 times the amount issued just a decade earlier.
A simple illustration will explain how a CDO operates. Say a bank has granted 1000 subprime mortgage loans with an overall principal value of $ 300 million.
Based on the historical delinquency rates of 4% and average losses for defaulted sub prime mortgages of 25%, the expected loss for the pool would be 4% of 25%, i.e., 1%, or USD 3mn. This loss rate would be too high for the instrument to achieve a AAA credit rating.
So the bank redistributes the cash flows of the underlying mortgages to four different tranches. Tranche 1, the "AAA"-rated tranche, has a senior claim on all interest and principal payments of the mortgage pool. No other tranche may receive any cash-flows till all payments on the AAA tranche are met. Its size equals say 80% of the overall volume of the mortgage pool, or 0.8 x 300 million, i.e., $240 million.
Tranche 2, the "A"-rated tranche, is subordinated to the AAA tranche, but remains senior to all remaining tranches. Its size is 12% of the over-all volume, or 0.12 x 300 million i.e., 36 million.
Tranche 3, the "BB"-rated or High Yield tranche represents another 5% of the overall volume, i.e., $15 million and is subordinated to both higher-rated tranches.
The “Equity tranche” equals 3% of the pool volume, ie., $9 million and receives anything that is left over, after all other tranches are fully serviced.
If the losses remain within $3 million, the equity tranche takes all losses while all other tranches receive the full amount of interest and principal payments. Even with a cyclical rise in default rates, the AAA tranche would be well protected from losses.
Let us assume that if delinquency rates rise to 25%, losses on defaulted subprime mortgages will rise to 50%. This may result in a loss rate of 0.25 x 0.5 = 12.5% i.e., (.125) (300) = $37.5 million. This would erase the Equity tranche (3%, 9 million) and the BB tranche (5%, 15 million) entirely. The remaining losses ($13.5 million) would be absorbed by the A tranche which would lose 37.5% of principal (13.5/36). The AAA tranche would not carry losses, but its buffer for further losses would largely disappear. It would be living at the edge, so to say!
Through the process of tranching, the subprime mortgage lenders found a way to sell their risky debt. Nearly 80% of these bundled securities were rated investment grade ('A' rated or higher), by the rating agencies, who earned lucrative fees for their work in rating the ABSs.
Having found a way to originate and distribute risky mortgages, banks moved into subprime lending very aggressively. Basic requirements like proof-of-income and down payment were waived off by some mortgage lenders. By using teaser rates within adjustable-rate mortgages (ARM), borrowers were enticed into an initially affordable mortgage in which payments would skyrocket in a few years. The CDO market ballooned to more than $600 billion in issuance during 2006 alone - more than 10 times the amount issued just a decade earlier.
Securitisation and the sub prime crisis
Securitisation as a concept was introduced by Lewis S Ranieri in 1977, but has gained currency only in recent years. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006. Of the $10.7 trillion worth of residential mortgage debt, $6.3 trillion had been securitised by mid-2007. A brief account of how securitisation works, follows.
Securitisation as the name suggests converts loans into tradable securities. Illiquid loans are packaged into a special purpose vehicle and sold in parcels to investors who are happy to receive payments from the underlying mortgages over time. Effectively, securitisation aims at generating cash out of relatively illiquid instruments. Lenders can free up capital for more lending. On the other hand, investors receive returns higher than they would have got in case of equivalent traditional investments. In the early 2000s, as the housing market boomed, securitisation seemed to create a win-win situation for lenders and investors.
As the market boomed, financial engineering and increased trading went hand in hand. Many investment banks bought the mortgages from lenders and securitized these mortgages into bonds, which were sold to investors in various forms. This “plain vanilla” securitisation soon gave way to more sophisticated structured products. Assets of different risk characteristics were combined. The cash flows expected from these assets were tranched and traded in the extremely large and very liquid secondary mortgage market. This is how Collaterised Debt Obligations (CDOs) were born.
The originate-to-distribute model of securitisation ensured that the identity of the original instruments was completely lost. Indeed, the instruments were transformed beyond recognition. Simple instruments became “exotic” ones.
In hte process, a huge shadow banking system was created. Banks did not want to keep mortgages and loans on their balance sheet as they needed more capital backing. Instead, they held mortgage backed securities with low risk weights as per the Basle framework. The funding for the loans increasingly came from non banking institutions. These included investment banks, hedge funds, money market funds, finance companies, asset backed conduits and SIVs.
According to Mark Zandy of Economy.com, the shadow banking system provided credit to the tune of $6 trillion by the second quarter of 2007. The shadow banking system was subject to minimal regulatory oversight and did not have to make significant public disclosures. The use of leverage amplified the problem. At the peak of the frenzy in 2005-06, hedge funds were leveraging their investments as many as 50 times.
Securitisation as the name suggests converts loans into tradable securities. Illiquid loans are packaged into a special purpose vehicle and sold in parcels to investors who are happy to receive payments from the underlying mortgages over time. Effectively, securitisation aims at generating cash out of relatively illiquid instruments. Lenders can free up capital for more lending. On the other hand, investors receive returns higher than they would have got in case of equivalent traditional investments. In the early 2000s, as the housing market boomed, securitisation seemed to create a win-win situation for lenders and investors.
As the market boomed, financial engineering and increased trading went hand in hand. Many investment banks bought the mortgages from lenders and securitized these mortgages into bonds, which were sold to investors in various forms. This “plain vanilla” securitisation soon gave way to more sophisticated structured products. Assets of different risk characteristics were combined. The cash flows expected from these assets were tranched and traded in the extremely large and very liquid secondary mortgage market. This is how Collaterised Debt Obligations (CDOs) were born.
The originate-to-distribute model of securitisation ensured that the identity of the original instruments was completely lost. Indeed, the instruments were transformed beyond recognition. Simple instruments became “exotic” ones.
In hte process, a huge shadow banking system was created. Banks did not want to keep mortgages and loans on their balance sheet as they needed more capital backing. Instead, they held mortgage backed securities with low risk weights as per the Basle framework. The funding for the loans increasingly came from non banking institutions. These included investment banks, hedge funds, money market funds, finance companies, asset backed conduits and SIVs.
According to Mark Zandy of Economy.com, the shadow banking system provided credit to the tune of $6 trillion by the second quarter of 2007. The shadow banking system was subject to minimal regulatory oversight and did not have to make significant public disclosures. The use of leverage amplified the problem. At the peak of the frenzy in 2005-06, hedge funds were leveraging their investments as many as 50 times.
The genesis of the sub prime crisis
The sub prime crisis assumed monstrous proportions thanks to a combination of factors. These included:
v low interest rates,
v political intervention,
v a laissez-faire attitude on the part of government officials and regulators,
v lax and predatory lending practices,
v a false belief that the housing boom would go on forever,
v a originate-to-distribute securitization process that separated origination from ultimate credit risk,
v imbalances in the global financial system,
v new derivatives like credit default swaps that fuelled speculation in segments of the mortgage market.
Let us explore these themes in a little more detail in the following paragraphs.
Many economists and market analysts believe the roots of the current financial melt down go back at least eight years in time. The US economy had been facing the risk of a deep recession after the dotcom bubble burst in early 2000. This situation was worsened by the 9/11 terrorist attacks, which created a great deal of panic and uncertainty among Americans. In response, the US Central bank, the Federal Reserve (Fed) under the leadership of Alan Greenspan tried to stimulate the economy by reducing interest rates aggressively. In particular, Greenspan hoped housing would get the momentum back into the US economy. Between New Year’s Day 2001 and mid-2003, the Fed cut the Federal Funds rate from 6.5% to 1%. The rate remained at 1% for 12 months from July 2003 to July 2004. Naturally people got an opportunity to borrow much more money than they otherwise would have been able to afford.
owning a house is part of the American dream. And the housing market, which is huge as mentioned earlier, has a big impact on the business cycle in the US. Not surprisingly, American politicians have strongly supported the cause of home ownership. Over the years, various pieces of legislation have been introduced in the US to make mortgages affordable to more people.
· The Federal Housing Administration (FHA) was set up in 1934 to insure mortgage loans provided given by private firms. Initially, a borrower had to make a 20% down payment to qualify for the loan. Later, this requirement was reduced. By 2004, the required down payment for FHA’s most popular program was 3%.
· The Home Mortgage Disclosure Act, 1975 asked lending institutions to report their loan data so that the underserved segments could be targeted for special attention.
· The Community Reinvestment Act (CRA), 1977 required institutions to provide loans to people in low and moderate income neighbourhoods. Congress amended CRA in 1989 to make banks’ CRA ratings public information. In 1995, the regulators got the power to deny approval for a merger to a bank with low CRA rating.
· The Depository Institutions Deregulatory and Monetary Control Act (DIDMCA), 1980 eliminated restrictions on home loan interest rates. Financial institutions could charge borrowers a premium interest rate.
· The Alternative Mortgage Transaction Parity Act (AMTPA) allowed lenders to charge variable interest rates and use balloon payments.
In 1992, Congress directed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. In 1996, Fannie and Freddie were told to allocate 42% of this financing to such borrowers. The target increased to 50% in 2000 and 52% in 2005. Fannie and Freddie were also directed to support “special affordable” loans to borrowers with low income. Fannie and Freddie could sustain this aggressive lending as the markets believed there was an implicit guarantee from the government. So the cost of funds was only slightly more than that of Treasury securities. In September 2003, during House Financial Services Committee proceedings, suggestions were made to rein in Fannie and Freddie. But people like Barney Frank who is leading the efforts to restore the health of the American banking system today, fought hard to maintain the status quo.
President Bush personally championed the cause of housing when he articulated his vision of an “ownership society.” In 2003, he signed the American Dream Down payment Act, a program offering money to lower income households to help with down payments. The Bush administration also put pressure on Fannie Mae and Freddie Mac to provide more mortgage loans to low income groups. By the time of the sub prime crisis, these two pillars of the American housing system had become heavy investors in the triple A rated, senior tranches of CDOs, which lay at the heart of the crisis.
At some points of time, Congress did raise some concerns about predatory lending, i.e., aggressive lending in which borrowers are not fully aware of the long term implications of the loan. In 1994, Congress passed the Home Ownership and Equity Protection Act (HOEPA) which authorised the Fed to prohibit predatory lending practices by any lender, irrespective of who regulated the lender. The Fed however used these powers only sparingly.
By mid-2004, fears about deflation had diminished while those about inflation had increased. When the Fed got into a tightening act, the benchmark interest rate went up to 5.25%. People who had borrowed when rates were 1% did not have time to adjust to the pressures of larger interest payments. With traditional profit making opportunities drying up, lenders became willing to take greater risks and entered the subprime segment in a big way. They did this by introducing adjustable rate mortgages, which came with several options:
v Low introductory interest rate that adjusted after a few years.
v Payment of only interest on the loan for a specified period of time.
v Payment of less interest than was due, the balance being added to the mortgage.
v Balloon payments in which the borrower could pay off the loan at the end of a specified period of time.
Adjustable Rate Mortgages (ARMs) had been around for the past 25 years. But in the past, they were offered to creditworthy borrowers with stable incomes and who could make bigger down payments. In 2006, 90% of the sub prime loans involved ARMs.
Traditionally, as a risk mitigation measure, lenders insisted that borrowers making small down payments must buy mortgage insurance. But insurance was costly. To allow home buyers to avoid buying mortgage insurance, generally required for large loans with low down payments, lenders counselled borrowers to take out two mortgages. This way, they circumvented the system and made it easier than ever for people to get a mortgage loan. In short, borrowers and lenders collaborated to beat the system!
As homes became more and more unaffordable, lenders became even more aggressive. Loans were offered without the need for borrowers to prove their income. “Stated income” loans went mainstream. They came to be known as liars’ loans. By 2006, well over half of the subprime loans were stated income loans. Some builders even set up their own mortgage lending affiliates to ensure that credit kept flowing even if traditional lenders refused to lend.
Home equity played a big role in fuelling the boom. As real estate prices continued to rise, sub prime borrowers were able to roll over their mortgages after a specified number of years. They paid the outstanding loan with funds from a new larger loan based on the higher valuation of the property. Thus, borrowers could immediately spend the gain they booked on the property. From 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. In the 2000s, home equity withdrawals were financing 3% of all personal consumption in the US.
Even with soaring house prices, the market could not have expanded so much without securitization. Previously, mortgages appeared directly on a bank's balance sheet and had to be backed by equity capital. Securitization allowed banks to bundle many loans into tradable securities and thereby free up capital. Banks were also able to issue more mortgage loans for a given amount of underlying capital.
For securitisation to take off, clever marketing was required. Few investors would have looked seriously at sub prime mortgage securities considered alone. To make subprime mortgages more palatable to investors, they were mixed with higher rated instruments. In the products so created, different groups of investors were entitled to different streams of cash flows based on the risk return disposition of the investors. These products came to be known as Collateralised Debt Obligations (CDOs). We shall cover CDOs in more detail a little later in the chapter.
As mentioned in Chapter 2, the imbalances in the global financial system also played a crucial role in helping securitisation take off. Many countries in the Asia Pacific and the Middle East had registered huge trade surpluses with the US and accumulated huge amounts of foreign exchange reserves. Traditionally, these countries had invested their excess dollars in US treasury bills and bonds. To generate more returns, they began to look at other US instruments including those related to mortgage, more seriously.
Complex, opaque instruments and heavy speculation transformed the market conditions dramatically. The basic principles of risk pricing were conveniently ignored. Indeed, the risk pricing mechanism broke down. A study by the Fed indicated that the average difference in mortgage interest rates between subprime and prime mortgages declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. This happened even as subprime borrower and loan characteristics deteriorated overall during the 2001–2006 period. The more investors started to buy mortgage backed securities, the more the yields fell. Eventually a high rated security fetched barely more than a sub prime mortgage loan. But investors, having succumbed to the temptation, failed to back off. Rather than trying to reduce their positions, they tried to generate greater returns, using leverage.
As mentioned earlier, the payment burden for subprime mortgage borrowers increased sharply after an initial period. Borrowers were betting on rising home prices to refinance their mortgages at lower rates of interest and use the capital gains for other spending. Unfortunately, this bet did not pay off. Real estate prices started to drop in 2006 while interest rates rose. So the easy gains from refinancing mortgages evaporated. Many of the sub prime mortgages had an adjustable interest rate. The interest rate was low for an initial period of two to five years. Then it was reset. These reset rates were significantly higher than the initial fixed "teaser rate" and proved to be beyond what most subprime borrowers could pay. This double whammy, fall in home value and higher reset rates, proved to be too much for many borrowers.
To get an idea of the magnitude of the problem, the value of U.S. subprime mortgages had risen to about $1.3 trillion as of March 2007. Of this amount, the estimated value of subprime adjustable-rate mortgages (ARM) resetting at higher interest rates was $400 billion for 2007 and $500 billion for 2008. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, about three times the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%. Subprime ARMs only represented 6.8% of the home loans outstanding in the US. But they accounted for 43.0% of the foreclosures started during the third quarter of 2007.
The number of home loan of defaults arose from an annualised 775,000 at the end of 2005 to nearly 1 million by the end of 2006. A second wave of defaults and foreclosures began in the spring of 2007. A third wave of loan defaults and disclosures happened when home equity turned negative for many borrowers. As many as 446,726 U.S. household properties were subject to some sort of foreclosure action from July to September 2007. The number increased to 527,740 during the fourth quarter of 2007. For all of 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively compared to 2006. These developments forced a crash in the housing market. At the start of 2007, new and existing home sales were running close to 7.5 million units per year. By the end of the year, the number had fallen below 5.5 million.
Total home equity was valued (in the US) at its peak at $13 trillion in 2006. This dropped to $8.8 trillion by mid-2008. Total retirement assets fell from $10.3 trillion to $8 trillion during the same period. At the same time, savings and investment assets lost $1.2 trillion and pension assets $1.3 trillion during the same period.
v low interest rates,
v political intervention,
v a laissez-faire attitude on the part of government officials and regulators,
v lax and predatory lending practices,
v a false belief that the housing boom would go on forever,
v a originate-to-distribute securitization process that separated origination from ultimate credit risk,
v imbalances in the global financial system,
v new derivatives like credit default swaps that fuelled speculation in segments of the mortgage market.
Let us explore these themes in a little more detail in the following paragraphs.
Many economists and market analysts believe the roots of the current financial melt down go back at least eight years in time. The US economy had been facing the risk of a deep recession after the dotcom bubble burst in early 2000. This situation was worsened by the 9/11 terrorist attacks, which created a great deal of panic and uncertainty among Americans. In response, the US Central bank, the Federal Reserve (Fed) under the leadership of Alan Greenspan tried to stimulate the economy by reducing interest rates aggressively. In particular, Greenspan hoped housing would get the momentum back into the US economy. Between New Year’s Day 2001 and mid-2003, the Fed cut the Federal Funds rate from 6.5% to 1%. The rate remained at 1% for 12 months from July 2003 to July 2004. Naturally people got an opportunity to borrow much more money than they otherwise would have been able to afford.
owning a house is part of the American dream. And the housing market, which is huge as mentioned earlier, has a big impact on the business cycle in the US. Not surprisingly, American politicians have strongly supported the cause of home ownership. Over the years, various pieces of legislation have been introduced in the US to make mortgages affordable to more people.
· The Federal Housing Administration (FHA) was set up in 1934 to insure mortgage loans provided given by private firms. Initially, a borrower had to make a 20% down payment to qualify for the loan. Later, this requirement was reduced. By 2004, the required down payment for FHA’s most popular program was 3%.
· The Home Mortgage Disclosure Act, 1975 asked lending institutions to report their loan data so that the underserved segments could be targeted for special attention.
· The Community Reinvestment Act (CRA), 1977 required institutions to provide loans to people in low and moderate income neighbourhoods. Congress amended CRA in 1989 to make banks’ CRA ratings public information. In 1995, the regulators got the power to deny approval for a merger to a bank with low CRA rating.
· The Depository Institutions Deregulatory and Monetary Control Act (DIDMCA), 1980 eliminated restrictions on home loan interest rates. Financial institutions could charge borrowers a premium interest rate.
· The Alternative Mortgage Transaction Parity Act (AMTPA) allowed lenders to charge variable interest rates and use balloon payments.
In 1992, Congress directed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. In 1996, Fannie and Freddie were told to allocate 42% of this financing to such borrowers. The target increased to 50% in 2000 and 52% in 2005. Fannie and Freddie were also directed to support “special affordable” loans to borrowers with low income. Fannie and Freddie could sustain this aggressive lending as the markets believed there was an implicit guarantee from the government. So the cost of funds was only slightly more than that of Treasury securities. In September 2003, during House Financial Services Committee proceedings, suggestions were made to rein in Fannie and Freddie. But people like Barney Frank who is leading the efforts to restore the health of the American banking system today, fought hard to maintain the status quo.
President Bush personally championed the cause of housing when he articulated his vision of an “ownership society.” In 2003, he signed the American Dream Down payment Act, a program offering money to lower income households to help with down payments. The Bush administration also put pressure on Fannie Mae and Freddie Mac to provide more mortgage loans to low income groups. By the time of the sub prime crisis, these two pillars of the American housing system had become heavy investors in the triple A rated, senior tranches of CDOs, which lay at the heart of the crisis.
At some points of time, Congress did raise some concerns about predatory lending, i.e., aggressive lending in which borrowers are not fully aware of the long term implications of the loan. In 1994, Congress passed the Home Ownership and Equity Protection Act (HOEPA) which authorised the Fed to prohibit predatory lending practices by any lender, irrespective of who regulated the lender. The Fed however used these powers only sparingly.
By mid-2004, fears about deflation had diminished while those about inflation had increased. When the Fed got into a tightening act, the benchmark interest rate went up to 5.25%. People who had borrowed when rates were 1% did not have time to adjust to the pressures of larger interest payments. With traditional profit making opportunities drying up, lenders became willing to take greater risks and entered the subprime segment in a big way. They did this by introducing adjustable rate mortgages, which came with several options:
v Low introductory interest rate that adjusted after a few years.
v Payment of only interest on the loan for a specified period of time.
v Payment of less interest than was due, the balance being added to the mortgage.
v Balloon payments in which the borrower could pay off the loan at the end of a specified period of time.
Adjustable Rate Mortgages (ARMs) had been around for the past 25 years. But in the past, they were offered to creditworthy borrowers with stable incomes and who could make bigger down payments. In 2006, 90% of the sub prime loans involved ARMs.
Traditionally, as a risk mitigation measure, lenders insisted that borrowers making small down payments must buy mortgage insurance. But insurance was costly. To allow home buyers to avoid buying mortgage insurance, generally required for large loans with low down payments, lenders counselled borrowers to take out two mortgages. This way, they circumvented the system and made it easier than ever for people to get a mortgage loan. In short, borrowers and lenders collaborated to beat the system!
As homes became more and more unaffordable, lenders became even more aggressive. Loans were offered without the need for borrowers to prove their income. “Stated income” loans went mainstream. They came to be known as liars’ loans. By 2006, well over half of the subprime loans were stated income loans. Some builders even set up their own mortgage lending affiliates to ensure that credit kept flowing even if traditional lenders refused to lend.
Home equity played a big role in fuelling the boom. As real estate prices continued to rise, sub prime borrowers were able to roll over their mortgages after a specified number of years. They paid the outstanding loan with funds from a new larger loan based on the higher valuation of the property. Thus, borrowers could immediately spend the gain they booked on the property. From 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. In the 2000s, home equity withdrawals were financing 3% of all personal consumption in the US.
Even with soaring house prices, the market could not have expanded so much without securitization. Previously, mortgages appeared directly on a bank's balance sheet and had to be backed by equity capital. Securitization allowed banks to bundle many loans into tradable securities and thereby free up capital. Banks were also able to issue more mortgage loans for a given amount of underlying capital.
For securitisation to take off, clever marketing was required. Few investors would have looked seriously at sub prime mortgage securities considered alone. To make subprime mortgages more palatable to investors, they were mixed with higher rated instruments. In the products so created, different groups of investors were entitled to different streams of cash flows based on the risk return disposition of the investors. These products came to be known as Collateralised Debt Obligations (CDOs). We shall cover CDOs in more detail a little later in the chapter.
As mentioned in Chapter 2, the imbalances in the global financial system also played a crucial role in helping securitisation take off. Many countries in the Asia Pacific and the Middle East had registered huge trade surpluses with the US and accumulated huge amounts of foreign exchange reserves. Traditionally, these countries had invested their excess dollars in US treasury bills and bonds. To generate more returns, they began to look at other US instruments including those related to mortgage, more seriously.
Complex, opaque instruments and heavy speculation transformed the market conditions dramatically. The basic principles of risk pricing were conveniently ignored. Indeed, the risk pricing mechanism broke down. A study by the Fed indicated that the average difference in mortgage interest rates between subprime and prime mortgages declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. This happened even as subprime borrower and loan characteristics deteriorated overall during the 2001–2006 period. The more investors started to buy mortgage backed securities, the more the yields fell. Eventually a high rated security fetched barely more than a sub prime mortgage loan. But investors, having succumbed to the temptation, failed to back off. Rather than trying to reduce their positions, they tried to generate greater returns, using leverage.
As mentioned earlier, the payment burden for subprime mortgage borrowers increased sharply after an initial period. Borrowers were betting on rising home prices to refinance their mortgages at lower rates of interest and use the capital gains for other spending. Unfortunately, this bet did not pay off. Real estate prices started to drop in 2006 while interest rates rose. So the easy gains from refinancing mortgages evaporated. Many of the sub prime mortgages had an adjustable interest rate. The interest rate was low for an initial period of two to five years. Then it was reset. These reset rates were significantly higher than the initial fixed "teaser rate" and proved to be beyond what most subprime borrowers could pay. This double whammy, fall in home value and higher reset rates, proved to be too much for many borrowers.
To get an idea of the magnitude of the problem, the value of U.S. subprime mortgages had risen to about $1.3 trillion as of March 2007. Of this amount, the estimated value of subprime adjustable-rate mortgages (ARM) resetting at higher interest rates was $400 billion for 2007 and $500 billion for 2008. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, about three times the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%. Subprime ARMs only represented 6.8% of the home loans outstanding in the US. But they accounted for 43.0% of the foreclosures started during the third quarter of 2007.
The number of home loan of defaults arose from an annualised 775,000 at the end of 2005 to nearly 1 million by the end of 2006. A second wave of defaults and foreclosures began in the spring of 2007. A third wave of loan defaults and disclosures happened when home equity turned negative for many borrowers. As many as 446,726 U.S. household properties were subject to some sort of foreclosure action from July to September 2007. The number increased to 527,740 during the fourth quarter of 2007. For all of 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively compared to 2006. These developments forced a crash in the housing market. At the start of 2007, new and existing home sales were running close to 7.5 million units per year. By the end of the year, the number had fallen below 5.5 million.
Total home equity was valued (in the US) at its peak at $13 trillion in 2006. This dropped to $8.8 trillion by mid-2008. Total retirement assets fell from $10.3 trillion to $8 trillion during the same period. At the same time, savings and investment assets lost $1.2 trillion and pension assets $1.3 trillion during the same period.
Lessons from Iceland's financial crisis
The 2008–2009 Icelandic financial crisis illustrates how an interconnected global financial system can threaten the very existence of a small economy with an outsized financial sector. The crisis was triggered off by the collapse of all three of the country's major banks following their difficulties in refinancing their short-term debt. In late September 2008, the government stepped in and partly nationalised Glitnir, the third-largest bank. Having tried to bail out one bank, the government soon had to take care of the two others, Landsbanki and Kaupthing. Relative to the size of its economy, Iceland’s banking collapse was the largest suffered by any country in economic history.
The financial crisis had serious consequences for the Icelandic economy. The national currency fell sharply in value. Foreign currency transactions were suspended for weeks. The market capitalisation of the Icelandic stock exchange dropped by more than 90%. The nation's gross domestic product decreased by 5.5% in real terms in the first six months of 2009. The standard of living in the country came down dramatically.Looking back, the collapse of Iceland’s banks, was not a sudden development. After a set back in 2006, when the main banks struggled to finance themselves, the banks had been trying to shift to safer policies. The banks had attempted to attract foreign deposits to back their assets abroad. On the other hand, the central bank had been raising interest rates to try to cool the economy. In the end, however, thanks to the frozen credit markets, the banks were unable to roll over their debts.
Various factors contributed to Iceland’s fall. One of them was the monetary policy pursued by the country’s central bank. High interest rates encouraged domestic firms and households to borrow in foreign currency, and also attracted currency speculators. This brought large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth. The speculators and borrowers profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation. All this fuelled both economic growth and inflation, prompting the central bank to raise interest rates further. The end result was a bubble caused by the interaction between domestic interest rates and foreign currency inflows.
Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP. This was a clear sign that the financial sector had assumed monumental proportions. Yet in normal circumstances, this was not a cause for worry. Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts. But in this crisis, the strength of a bank's balance sheet was of little consequence. What mattered was the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. The size of the state relative to the size of the banks became the crucial factor. Going by this criterion, the government was in no position to guarantee the banks.
The Icelandic authorities failed to show leadership. They did not communicate appropriately with their international counterparts, leading to an atmosphere of mistrust. At the same time, Iceland failed to receive support from Britain when the Scandinavian nation badly needed the support. The UK authorities seemed to have overreacted, using antiterrorist laws to take over Icelandic assets, and causing the bankruptcy of the remaining Icelandic bank.
To conclude, the original cause of the Icelandic crisis was a combination of inappropriate monetary policy and an outsized banking system. Throughout 2008, the Icelandic currency had been falling due to the currency speculators running for shelter. But the extreme global financial uncertainty, the mishandling of the crisis by the Icelandic authorities and the overreaction of the UK authorities served as the tipping points. In conclusion, we must appreciate that Iceland was done in as much by its policy failures as by the interconnectedness of the global financial system.
========
The financial crisis had serious consequences for the Icelandic economy. The national currency fell sharply in value. Foreign currency transactions were suspended for weeks. The market capitalisation of the Icelandic stock exchange dropped by more than 90%. The nation's gross domestic product decreased by 5.5% in real terms in the first six months of 2009. The standard of living in the country came down dramatically.Looking back, the collapse of Iceland’s banks, was not a sudden development. After a set back in 2006, when the main banks struggled to finance themselves, the banks had been trying to shift to safer policies. The banks had attempted to attract foreign deposits to back their assets abroad. On the other hand, the central bank had been raising interest rates to try to cool the economy. In the end, however, thanks to the frozen credit markets, the banks were unable to roll over their debts.
Various factors contributed to Iceland’s fall. One of them was the monetary policy pursued by the country’s central bank. High interest rates encouraged domestic firms and households to borrow in foreign currency, and also attracted currency speculators. This brought large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth. The speculators and borrowers profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation. All this fuelled both economic growth and inflation, prompting the central bank to raise interest rates further. The end result was a bubble caused by the interaction between domestic interest rates and foreign currency inflows.
Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP. This was a clear sign that the financial sector had assumed monumental proportions. Yet in normal circumstances, this was not a cause for worry. Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts. But in this crisis, the strength of a bank's balance sheet was of little consequence. What mattered was the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. The size of the state relative to the size of the banks became the crucial factor. Going by this criterion, the government was in no position to guarantee the banks.
The Icelandic authorities failed to show leadership. They did not communicate appropriately with their international counterparts, leading to an atmosphere of mistrust. At the same time, Iceland failed to receive support from Britain when the Scandinavian nation badly needed the support. The UK authorities seemed to have overreacted, using antiterrorist laws to take over Icelandic assets, and causing the bankruptcy of the remaining Icelandic bank.
To conclude, the original cause of the Icelandic crisis was a combination of inappropriate monetary policy and an outsized banking system. Throughout 2008, the Icelandic currency had been falling due to the currency speculators running for shelter. But the extreme global financial uncertainty, the mishandling of the crisis by the Icelandic authorities and the overreaction of the UK authorities served as the tipping points. In conclusion, we must appreciate that Iceland was done in as much by its policy failures as by the interconnectedness of the global financial system.
========
Decoupling and recoupling
Britain was the colonial superpower of the world till the start of the 20th century. Following World War II, the US took over the global economic leadership. Japan and Germany became economically powerful as they became export powerhouses. Till about 30 years back, the G-7 countries (USA, Canada, Britain, France, Germany, Italy, Japan) dominated the global economic agenda. The developed countries did not really take the developing ones like India and China very seriously. These Asian giants were considered too poor and too insignificant and struggling to get their economies going. But since the late 1990s, China and India, thanks to economic liberalisation, have emerged as two of the most dynamic economies of the world. Many economists have argued that these emerging markets have grown to a point where they would more than compensate for any slowdown in western economies. This phenomenon has come to be called decoupling.
In the early months of the sub prime crisis, the champions of decoupling seemed to be winning the argument. China and India continued to grow smartly even as the economies of the Western nations went from bad to worse. In the initial stages, the capital flows to the emerging economies actually increased. In the case of India, for example, the net FII flows during the five-month period from September 2007 to January 2008 was US$ 22.5 billion as against an inflow of US$ 11.8 billion during April-July 2007, the four months prior to the onset of the crisis.
But as the crisis deepened in 2008, it became clear that emerging economies could not be completely insulated from the current financial crisis. There was a reversal of portfolio flows due to unwinding of stock positions by FIIs to replenish cash balances abroad. Withdrawal of FII investment led to a stock market crash in many emerging economies and many currencies plunged against the US dollar. In the case of India, the extent of reversal of capital flows was $ 15.8 billion during the five month period February-June, 2008.
The situation worsened, following the collapse of Lehman Brothers in mid-September 2008. The Lehman bankruptcy combined with the fall of Fannie Mae, Freddie Mac and AIG created a crisis of confidence that led to the seizure of the interbank market. This had a trickle-down effect on trade financing in the emerging economies. Together with slackening global demand and declining commodity prices, it led to a fall in exports. Many South-East Asian countries that depended upon exports were severely affected. China’s GDP growth slowed down appreciably.
As the events unfolded, it became clear that India was far too integrated into the global economy. Export growth which had been robust till August 2008, became low in September and negative from October 2008 to March 2009. The sharp decline in growth to 5.8 per cent in the second half of 2008-09 from 7.8 per cent in the first half of 2008-09, seemed to support the recoupling perspective.
Meanwhile, the Indian financial markets were affected indirectly through the linkages with the global economy. The drying up of liquidity, caused by repatriation of portfolio investments by FIIs, affected credit markets in the second half of 2008-09. This was compounded by the “risk aversion” of banks to extend credit in the face of a general downturn. There was a contraction in reserve money by more than 15 per cent between August 2008 and November 2008. A series of unconventional measures by the Reserve Bank helped to push up the rate of growth of bank credit from 25.4 per cent in August 2008 to 26.9 per cent in November 2008. However, this only partly offset the impact on Indian companies due to the freezing of financial markets in the US and EU. The Indian IT industry went into a tailspin and employees became resigned to salary cuts and job losses, a dramatic change from the “red hot” labour markets of 2006 and 2007.
Other emerging markets also started facing a slow down. Dubai, the hub of the middle east, saw a major crash in the real estate markets and severe job cuts. This jewel of the middle east had to be “bailed out,” by the government of Abu Dhabi. Singapore, one of the major hubs of East Asia went through a severe recession.
As mentioned earlier, emerging economies also suffered in terms of foreign investment inflows due to a retreat to safety away from the emerging economies. In 2008, investors pulled out $67.2 billion for emerging market equity and bond funds, the worst since 1995. This represented more than 50% of the inflows of $130.5 billion into emerging markets between March 2003 and end of 2007.
Now as we approach the fall of 2009, many Asian economies seem to be rebounding smartly, through their growth alone may not be able to pull the global economy back on track. The rebound of the Asian economies has been aided by a turnaround in manufacturing, return of normalcy to trade finance and a huge fiscal stimulus. Many Asian economies entered the downturn with healthy government finances. Hence they have been able to inject a fiscal stimulus easily. Despite this impressive growth, The Economist[August 15, 2009.]sounded a word of caution: “But it would be a big mistake if Asia’s recovery led its politicians to conclude that there was no need to change their exchange rate policies or adopt structured reforms to boost consumption.” China for example, despite its impressive growth does not yet have a deep, well functioning financial system. The difficulties faced by Chinese leaders in stimulating domestic demand, have been partly due to the inadequacies of the country’s financial sector.
In the early months of the sub prime crisis, the champions of decoupling seemed to be winning the argument. China and India continued to grow smartly even as the economies of the Western nations went from bad to worse. In the initial stages, the capital flows to the emerging economies actually increased. In the case of India, for example, the net FII flows during the five-month period from September 2007 to January 2008 was US$ 22.5 billion as against an inflow of US$ 11.8 billion during April-July 2007, the four months prior to the onset of the crisis.
But as the crisis deepened in 2008, it became clear that emerging economies could not be completely insulated from the current financial crisis. There was a reversal of portfolio flows due to unwinding of stock positions by FIIs to replenish cash balances abroad. Withdrawal of FII investment led to a stock market crash in many emerging economies and many currencies plunged against the US dollar. In the case of India, the extent of reversal of capital flows was $ 15.8 billion during the five month period February-June, 2008.
The situation worsened, following the collapse of Lehman Brothers in mid-September 2008. The Lehman bankruptcy combined with the fall of Fannie Mae, Freddie Mac and AIG created a crisis of confidence that led to the seizure of the interbank market. This had a trickle-down effect on trade financing in the emerging economies. Together with slackening global demand and declining commodity prices, it led to a fall in exports. Many South-East Asian countries that depended upon exports were severely affected. China’s GDP growth slowed down appreciably.
As the events unfolded, it became clear that India was far too integrated into the global economy. Export growth which had been robust till August 2008, became low in September and negative from October 2008 to March 2009. The sharp decline in growth to 5.8 per cent in the second half of 2008-09 from 7.8 per cent in the first half of 2008-09, seemed to support the recoupling perspective.
Meanwhile, the Indian financial markets were affected indirectly through the linkages with the global economy. The drying up of liquidity, caused by repatriation of portfolio investments by FIIs, affected credit markets in the second half of 2008-09. This was compounded by the “risk aversion” of banks to extend credit in the face of a general downturn. There was a contraction in reserve money by more than 15 per cent between August 2008 and November 2008. A series of unconventional measures by the Reserve Bank helped to push up the rate of growth of bank credit from 25.4 per cent in August 2008 to 26.9 per cent in November 2008. However, this only partly offset the impact on Indian companies due to the freezing of financial markets in the US and EU. The Indian IT industry went into a tailspin and employees became resigned to salary cuts and job losses, a dramatic change from the “red hot” labour markets of 2006 and 2007.
Other emerging markets also started facing a slow down. Dubai, the hub of the middle east, saw a major crash in the real estate markets and severe job cuts. This jewel of the middle east had to be “bailed out,” by the government of Abu Dhabi. Singapore, one of the major hubs of East Asia went through a severe recession.
As mentioned earlier, emerging economies also suffered in terms of foreign investment inflows due to a retreat to safety away from the emerging economies. In 2008, investors pulled out $67.2 billion for emerging market equity and bond funds, the worst since 1995. This represented more than 50% of the inflows of $130.5 billion into emerging markets between March 2003 and end of 2007.
Now as we approach the fall of 2009, many Asian economies seem to be rebounding smartly, through their growth alone may not be able to pull the global economy back on track. The rebound of the Asian economies has been aided by a turnaround in manufacturing, return of normalcy to trade finance and a huge fiscal stimulus. Many Asian economies entered the downturn with healthy government finances. Hence they have been able to inject a fiscal stimulus easily. Despite this impressive growth, The Economist[August 15, 2009.]sounded a word of caution: “But it would be a big mistake if Asia’s recovery led its politicians to conclude that there was no need to change their exchange rate policies or adopt structured reforms to boost consumption.” China for example, despite its impressive growth does not yet have a deep, well functioning financial system. The difficulties faced by Chinese leaders in stimulating domestic demand, have been partly due to the inadequacies of the country’s financial sector.
The global economic imbalances and the sub prime crisis
At the heart of the sub prime crisis lies the huge global economic imbalances that have developed in recent years. In the past decade, emerging markets have grown impressively by exporting to the western countries especially the US in a big way. As Raghuram Rajan[Federal Reserve Bank Of St. Louis Review September/October, Part 1 2009. pp. 397-402.]mentions, this was a response to a wave of crises that swept through the emerging markets in the late 1990s. East Asia, Russia, Argentina, Brazil, and Turkey all went through turmoil during the 1997-98 currency crisis. As a result, these countries became far more circumspect about borrowing from abroad to finance domestic demand. They cut back on investment and reduced consumption. Formerly net absorbers of financial capital from the rest of the world, many of these countries started to record trade surpluses and became net exporters of financial capital.
Many of these emerging markets were also characterised by high savings rates. In mid-2008, emerging-economy central banks held over $5 trillion in reserves, a five fold increase from 2000. The large savings surplus in these economies caused a flood of capital to America. These surplus funds had to go somewhere. Bulk of these funds were parked in safe government securities in the US. This flood of capital helped in pushing long-term interest rates down.
In a speech in Beijing on December 9, 2008, Lorenzo Bini Smaghi of the European Central Bank explained how a marked asymmetry in the global financial system aggravated the economic imbalances. In the developed countries, rapid financial innovation and sophisticated financial products encouraged easy financing and consequently indebtedness. On the other hand, relatively rudimentary financial systems in the emerging markets encouraged the recycling of current account surpluses and savings into developed countries, especially the US to fund their growing deficits. At the same time, economies like India and China “managed” their currency even as many western countries had floated their currencies. To manage their currencies, the emerging markets were compelled to buy dollars and dollar denominated assets. If they did not do so, their currencies would have appreciated, making exports more difficult. These countries also made significant purchases of paper issued by government sponsored enterprises like Fannie Mae and Freddie Mac.
At the same time, the rise of China and India not only made many products cheaper but also added vast pools of cheap and skilled labour to the global economy. So inflationary pressures remained low, enabling the Fed to manage the economy with low interest rates. The Fed’s simple argument was: Why raise interest rates and thereby threaten the growth prospects of an impressively performing economy when inflation is under control?
Low interest rates, while good for economic growth, also created a bubble in the real estate market. They spurred off an unprecedented demand for homes and home loans. Raghuram Rajan has explained how the surplus capital might have landed in the real estate sector. Corporations in the US and industrialized countries initially absorbed the savings of emerging markets by expanding investment, in areas such as information technology. But this proved unsustainable. The investment was cut back sharply after the collapse of the information technology bubble. And as monetary policy continued to be accommodative, these funds moved into interest sensitive sectors such as automobiles and housing. This triggered off a housing boom.
But the housing boom had to collapse at same point of time. And only when it collapsed, did policy makers begin to appreciate the true significance of the global economic imbalances. Indeed, the sub prime crisis can be viewed as the consequence of the disorderly, unwinding of the economic imbalances that had accumulated in the global financial system over time. The disorderly adjustments have thrown the system out of balance. There has been a sudden escalation in risk aversion even as there have been corrections in prices of real estate, oil, various financial assets. There have also been sharp reversals in the direction of capital flows and exchange rates movements. The net consequence is that the global GDP growth has come down sharply.
Tackling the global imbalances will require a complete change in the mindset of the countries involved. And by no stretch of imagination, will it be an easy task. In mid August, 2009, a leading US Economic policy spokesman, Larry Summers called for a shift in the US economy from a consumption based one to an export oriented one. At the same time, American politicians have been putting pressure on China to revalue its currency, thereby reducing exports and increasing domestic consumption. Many commentators have argued that China’s high savings – high investment economy (at the cost of consumption) is destabilizing for the world economy. Some progress has already been made since the onset of the financial crisis. The US trade deficit has already come down from 6% of GDP at the peak to about 3% currently. At the same time China’s current account surplus has shrunk from 11% of GDP to about 9.8%. But there is no guarantee that this trend will continue unless the US can tackle its huge budget deficit. At the G-20 meeting at Pittsburgh in September 2009, a lot of time was devoted to the issue of achieving balanced, higher global GDP growth.
Many of these emerging markets were also characterised by high savings rates. In mid-2008, emerging-economy central banks held over $5 trillion in reserves, a five fold increase from 2000. The large savings surplus in these economies caused a flood of capital to America. These surplus funds had to go somewhere. Bulk of these funds were parked in safe government securities in the US. This flood of capital helped in pushing long-term interest rates down.
In a speech in Beijing on December 9, 2008, Lorenzo Bini Smaghi of the European Central Bank explained how a marked asymmetry in the global financial system aggravated the economic imbalances. In the developed countries, rapid financial innovation and sophisticated financial products encouraged easy financing and consequently indebtedness. On the other hand, relatively rudimentary financial systems in the emerging markets encouraged the recycling of current account surpluses and savings into developed countries, especially the US to fund their growing deficits. At the same time, economies like India and China “managed” their currency even as many western countries had floated their currencies. To manage their currencies, the emerging markets were compelled to buy dollars and dollar denominated assets. If they did not do so, their currencies would have appreciated, making exports more difficult. These countries also made significant purchases of paper issued by government sponsored enterprises like Fannie Mae and Freddie Mac.
At the same time, the rise of China and India not only made many products cheaper but also added vast pools of cheap and skilled labour to the global economy. So inflationary pressures remained low, enabling the Fed to manage the economy with low interest rates. The Fed’s simple argument was: Why raise interest rates and thereby threaten the growth prospects of an impressively performing economy when inflation is under control?
Low interest rates, while good for economic growth, also created a bubble in the real estate market. They spurred off an unprecedented demand for homes and home loans. Raghuram Rajan has explained how the surplus capital might have landed in the real estate sector. Corporations in the US and industrialized countries initially absorbed the savings of emerging markets by expanding investment, in areas such as information technology. But this proved unsustainable. The investment was cut back sharply after the collapse of the information technology bubble. And as monetary policy continued to be accommodative, these funds moved into interest sensitive sectors such as automobiles and housing. This triggered off a housing boom.
But the housing boom had to collapse at same point of time. And only when it collapsed, did policy makers begin to appreciate the true significance of the global economic imbalances. Indeed, the sub prime crisis can be viewed as the consequence of the disorderly, unwinding of the economic imbalances that had accumulated in the global financial system over time. The disorderly adjustments have thrown the system out of balance. There has been a sudden escalation in risk aversion even as there have been corrections in prices of real estate, oil, various financial assets. There have also been sharp reversals in the direction of capital flows and exchange rates movements. The net consequence is that the global GDP growth has come down sharply.
Tackling the global imbalances will require a complete change in the mindset of the countries involved. And by no stretch of imagination, will it be an easy task. In mid August, 2009, a leading US Economic policy spokesman, Larry Summers called for a shift in the US economy from a consumption based one to an export oriented one. At the same time, American politicians have been putting pressure on China to revalue its currency, thereby reducing exports and increasing domestic consumption. Many commentators have argued that China’s high savings – high investment economy (at the cost of consumption) is destabilizing for the world economy. Some progress has already been made since the onset of the financial crisis. The US trade deficit has already come down from 6% of GDP at the peak to about 3% currently. At the same time China’s current account surplus has shrunk from 11% of GDP to about 9.8%. But there is no guarantee that this trend will continue unless the US can tackle its huge budget deficit. At the G-20 meeting at Pittsburgh in September 2009, a lot of time was devoted to the issue of achieving balanced, higher global GDP growth.
Deregulation and innovation and the sub prime crisis
Rapid deregulation and financial innovation combined to set the stage for the sub prime crisis. This blog provides a brief hsitorical perspective.
After the economic turmoil of the 1970s, the market economy found passionate champions in Ronald Reagan and Margaret Thatcher. Believing that freer markets would bring economic gains, they took the plunge and abolished various controls. Both Reagan and Thatcher had a lot of fan following. And they commanded respect in many countries. Liberalisation of the financial system soon became a major theme in many developed countries.
In London, the Big Bang of 1986 abolished the distinction between brokers and jobbers and allowed foreign firms, with more capital, into the market. These firms could handle larger transactions, more cheaply. The Big Bang undoubtedly played a big role in the emergence of London as a preeminent global financial centre. Meanwhile, the No.1 financial centre in the world, New York had already introduced a similar reform in 1975, following pressure from institutional investors.
These reforms had major implications for the business models of market participants. The fall in commissions contributed to the long-term decline of broking as a source of revenue. The effect was disguised for a while by a higher volume of transactions. But the broker-dealers (the then popular name for investment bankers) increasingly had to commit their own capital to deals. In turn, this made trading on their own account, or proprietary trading, a potentially attractive source of revenue. No bank made more impressive strides in this area, than Goldman Sachs.
Meanwhile, commercial banks faced intense competition in corporate lending. At the same time, retail banking required expensive branch networks. Naturally, commercial banks wanted to diversify into more lucrative “fee based” businesses. With their strong balance-sheets, they started to compete with investment banks for the underwriting of securities. Investment banks responded by getting bigger. As banks became more diversified, they also became more complex.
As the same time, there were major advances in risk management thanks to innovative financial instruments and sophisticated quantitative techniques. Option contracts have been known since ancient times but the 1970s saw an explosion in their use. The development of the Black Scholes Merton Option Pricing Model, for which Myron Scholes and Robert Merton later won the Nobel Prize, no doubt played an important role. While Black Scholes enabled options trading to take off, other derivatives also became rapidly popular. Currency swaps and interest-rate swaps enabled hedging and speculation in currency and interest rate risk respectively. More recently, credit derivatives have made possible the slicing and dicing of credit risk in ways which would have been unimaginable about 40 years back.
The concept of securitisation rapidly became popular. Securitisation was projected as a mechanism for spreading risk and creating new growth opportunities for banks by freeing up capital. Commercial banks did not have to depend on the slow and costly business of attracting retail deposits to fund their transactions. Of course, securitisation was also misused by some market participants. That is how the sub prime crisis was fuelled.
As deregulation gathered momentum, the global financial system faced crises from time to time. These included the failures of Drexel Burnham Lambert, which dominated the junk-bond market and the collapse of Barings. But these crises were regarded as individual instances of mismanagement or fraud, rather than evidence of any systemic problem. The American savings-and-loan crisis, (mentioned earlier) which was a systemic failure was resolved with the help of a bail-out plan and easy monetary policy, and dismissed as an aberration. Even the Long Term Capital Management crisis of 1998 did not create any serious problems. A Fed sponsored bailout ensured that the markets continued to function normally.
But the recent financial meltdown has resulted in a lot of soul searching about the merits of aggressive deregulation. The melt down has been unprecedented in terms of magnitude and impact. The long drawn out crisis is a reflection of how complex and inter connected the world of finance has become. An array of financial instruments has emerged that make it possible to bundle, unbundle and rebundle risk in various ways. Deregulation, technology and globalization have transformed the world of finance beyond recognition. At the end of 2007, the notional value of all derivative contracts globally was estimated at $600 trillion or 11 times the world GDP. Ten years back, it had been $75 trillion or 2.5 times the world GDP.
Clearly, finance has grown much more rapidly than the underlying, “real” economy. That probably explains why regulation has become so difficult.
After the economic turmoil of the 1970s, the market economy found passionate champions in Ronald Reagan and Margaret Thatcher. Believing that freer markets would bring economic gains, they took the plunge and abolished various controls. Both Reagan and Thatcher had a lot of fan following. And they commanded respect in many countries. Liberalisation of the financial system soon became a major theme in many developed countries.
In London, the Big Bang of 1986 abolished the distinction between brokers and jobbers and allowed foreign firms, with more capital, into the market. These firms could handle larger transactions, more cheaply. The Big Bang undoubtedly played a big role in the emergence of London as a preeminent global financial centre. Meanwhile, the No.1 financial centre in the world, New York had already introduced a similar reform in 1975, following pressure from institutional investors.
These reforms had major implications for the business models of market participants. The fall in commissions contributed to the long-term decline of broking as a source of revenue. The effect was disguised for a while by a higher volume of transactions. But the broker-dealers (the then popular name for investment bankers) increasingly had to commit their own capital to deals. In turn, this made trading on their own account, or proprietary trading, a potentially attractive source of revenue. No bank made more impressive strides in this area, than Goldman Sachs.
Meanwhile, commercial banks faced intense competition in corporate lending. At the same time, retail banking required expensive branch networks. Naturally, commercial banks wanted to diversify into more lucrative “fee based” businesses. With their strong balance-sheets, they started to compete with investment banks for the underwriting of securities. Investment banks responded by getting bigger. As banks became more diversified, they also became more complex.
As the same time, there were major advances in risk management thanks to innovative financial instruments and sophisticated quantitative techniques. Option contracts have been known since ancient times but the 1970s saw an explosion in their use. The development of the Black Scholes Merton Option Pricing Model, for which Myron Scholes and Robert Merton later won the Nobel Prize, no doubt played an important role. While Black Scholes enabled options trading to take off, other derivatives also became rapidly popular. Currency swaps and interest-rate swaps enabled hedging and speculation in currency and interest rate risk respectively. More recently, credit derivatives have made possible the slicing and dicing of credit risk in ways which would have been unimaginable about 40 years back.
The concept of securitisation rapidly became popular. Securitisation was projected as a mechanism for spreading risk and creating new growth opportunities for banks by freeing up capital. Commercial banks did not have to depend on the slow and costly business of attracting retail deposits to fund their transactions. Of course, securitisation was also misused by some market participants. That is how the sub prime crisis was fuelled.
As deregulation gathered momentum, the global financial system faced crises from time to time. These included the failures of Drexel Burnham Lambert, which dominated the junk-bond market and the collapse of Barings. But these crises were regarded as individual instances of mismanagement or fraud, rather than evidence of any systemic problem. The American savings-and-loan crisis, (mentioned earlier) which was a systemic failure was resolved with the help of a bail-out plan and easy monetary policy, and dismissed as an aberration. Even the Long Term Capital Management crisis of 1998 did not create any serious problems. A Fed sponsored bailout ensured that the markets continued to function normally.
But the recent financial meltdown has resulted in a lot of soul searching about the merits of aggressive deregulation. The melt down has been unprecedented in terms of magnitude and impact. The long drawn out crisis is a reflection of how complex and inter connected the world of finance has become. An array of financial instruments has emerged that make it possible to bundle, unbundle and rebundle risk in various ways. Deregulation, technology and globalization have transformed the world of finance beyond recognition. At the end of 2007, the notional value of all derivative contracts globally was estimated at $600 trillion or 11 times the world GDP. Ten years back, it had been $75 trillion or 2.5 times the world GDP.
Clearly, finance has grown much more rapidly than the underlying, “real” economy. That probably explains why regulation has become so difficult.
Towards integrated risk management: the three ways of managing risk
In a world of risk, it is important not only for banks but also for non banking corporations to manage risks strategically and holistically. Integrated risk management is all about the identification and assessment of the risks faced by a company as a whole, followed by the formulation and implementation of a companywide strategy to manage them. According to Lisa Melbroek[[“Integrated Risk Management for the firm: A senior Manager’s Guide,” Working Paper, Harvard Business School, 2002] companies must learn to use the best combination of three complementary approaches to risk management.
v The first is to modify the company's operations suitably.
v The second is to reduce debt in the capital structure.
v The third is to use insurance or financial instruments like derivatives to transfer the risk.
Take the case of the environmental risk that a heavy chemicals manufacturer faces. Modifying the company's operations could mean installation of sophisticated pollution control equipment. The company could also reduce debt and keep plenty of capital to deal with any contingencies arising out of environmental mishaps. The company can also achieve risk transfer by buying an insurance policy that would protect it in case an accident occurs.
An oil company needs a steady supply of petroleum crude to feed its refinery. Oil prices can fluctuate, owing to various social, economic and political factors. Indeed, they have done so in recent months. The company can set up, or at least tie up, with a large number of oilfields all over the world to insulate itself from volatility. This would limit the damage due to Opec actions, terrorist strikes or instability in Islamic countries. In case of a long recession, the best bet for a company would be to keep minimum debt and maintain huge cash reserves. The company may also resort to buying oil futures contracts that guarantee the supply of crude at predetermined prices.
A company like Walt Disney, which operates theme parks, is exposed to weather risks. If the weather is not sunny, people will not turn up. So, Disney took a decision to set up its second theme park in Florida. Today, the company can buy weather derivatives or an insurance policy to hedge the risks arising from inclement weather.
A similar argument may well apply to the Board of Control for Cricket in India (BCCI). These days, with big money involved, especially in the form of television rights, cricket matches are scheduled all through the year. So the threat of rain is real. If a match is washed off, the losses will be heavy. BCCI has two options. It can stick to the cities where there is little rain. In the long run, it can even explore the possibility of indoor stadia. This is the operational solution. Alternatively, BCCI can take insurance cover. This is the risk transfer approach.
The software giant, Microsoft, operates in an industry where technology risks are high. The company manages risk by maintaining low overheads and zero debt. But Microsoft also has organisational mechanisms to deal with risk. The capacity of a software company is effectively the number of software engineers on its payroll. Excess capacity can create serious problems during a downturn. Right from the beginning, Microsoft’s founder, Bill Gates was particular about not employing more persons than required. So, Microsoft has always maintained lean staffing, depending on temporary workers to deal with surges in workload from time to time. This not only reduces the risk associated with economic slowdowns but also results in greater job security for its most talented workers. In contrast, many Indian software services companies have traditionally maintained a huge “bench.” This has become a major liability during the current downturn.
India’s well known software services company, Infosys maintains plenty of cash. Infosys believes cash gives a lot of comfort in a volatile industry, characterised by swift changes in technology, and shifts in client spending patterns. To sustain operations under adverse conditions, and make investments in marketing and R&D, Infosys depends heavily on equity and keeps little debt on its balance sheet.
Airlines can manage their exposure to fluctuating oil prices by taking operational measures to cut fuel consumption. This might involve better maintenance of the air craft or purchase of more fuel-efficient engines. Another option is to buy financial instruments such as futures to hedge this risk. This is the risk transfer approach.
Various factors determine the choice of the approach to handling risk. Often a combination of these approaches makes sense. The choice between a financial and organisational solution varies from risk to risk. As we briefly mentioned earlier, strategic risks, which are core to the business and are critical to the generation of shareholder value have to be retained. So they invariably need organisational solutions. Where suitable financial instruments do not exist for risk transfer, organizational solutions may be unavoidable. In the case of some risks, organisational solutions may be too complicated, too expensive or may conflict with the company's strategic goals. In such situations, risk transfer solutions such as derivatives or insurance may be more efficient than organisational solutions.
The ultimate strategy for the rainy day is to keep overheads and debt low and hold plenty of cash to tide over uncertainties about which managers have little idea today. Indeed, equity is an all-purpose risk cushion. The larger the amount of risk that cannot be accurately measured or quantified, the more the equity component should be. It is no surprise that technology companies like Microsoft and Infosys keep little or no debt on the balance-sheet. Of course, equity is a more expensive source of funds. Equity holders expect a much higher rate of return, compared to debt providers. But that might well be a small price to pay in a volatile business environment. During a severe downturn, a comfortable capital position can give a company a major competitive advantage by allowing it to pursue an acquisition or a major investment that might well have had to be postponed otherwise.
v The first is to modify the company's operations suitably.
v The second is to reduce debt in the capital structure.
v The third is to use insurance or financial instruments like derivatives to transfer the risk.
Take the case of the environmental risk that a heavy chemicals manufacturer faces. Modifying the company's operations could mean installation of sophisticated pollution control equipment. The company could also reduce debt and keep plenty of capital to deal with any contingencies arising out of environmental mishaps. The company can also achieve risk transfer by buying an insurance policy that would protect it in case an accident occurs.
An oil company needs a steady supply of petroleum crude to feed its refinery. Oil prices can fluctuate, owing to various social, economic and political factors. Indeed, they have done so in recent months. The company can set up, or at least tie up, with a large number of oilfields all over the world to insulate itself from volatility. This would limit the damage due to Opec actions, terrorist strikes or instability in Islamic countries. In case of a long recession, the best bet for a company would be to keep minimum debt and maintain huge cash reserves. The company may also resort to buying oil futures contracts that guarantee the supply of crude at predetermined prices.
A company like Walt Disney, which operates theme parks, is exposed to weather risks. If the weather is not sunny, people will not turn up. So, Disney took a decision to set up its second theme park in Florida. Today, the company can buy weather derivatives or an insurance policy to hedge the risks arising from inclement weather.
A similar argument may well apply to the Board of Control for Cricket in India (BCCI). These days, with big money involved, especially in the form of television rights, cricket matches are scheduled all through the year. So the threat of rain is real. If a match is washed off, the losses will be heavy. BCCI has two options. It can stick to the cities where there is little rain. In the long run, it can even explore the possibility of indoor stadia. This is the operational solution. Alternatively, BCCI can take insurance cover. This is the risk transfer approach.
The software giant, Microsoft, operates in an industry where technology risks are high. The company manages risk by maintaining low overheads and zero debt. But Microsoft also has organisational mechanisms to deal with risk. The capacity of a software company is effectively the number of software engineers on its payroll. Excess capacity can create serious problems during a downturn. Right from the beginning, Microsoft’s founder, Bill Gates was particular about not employing more persons than required. So, Microsoft has always maintained lean staffing, depending on temporary workers to deal with surges in workload from time to time. This not only reduces the risk associated with economic slowdowns but also results in greater job security for its most talented workers. In contrast, many Indian software services companies have traditionally maintained a huge “bench.” This has become a major liability during the current downturn.
India’s well known software services company, Infosys maintains plenty of cash. Infosys believes cash gives a lot of comfort in a volatile industry, characterised by swift changes in technology, and shifts in client spending patterns. To sustain operations under adverse conditions, and make investments in marketing and R&D, Infosys depends heavily on equity and keeps little debt on its balance sheet.
Airlines can manage their exposure to fluctuating oil prices by taking operational measures to cut fuel consumption. This might involve better maintenance of the air craft or purchase of more fuel-efficient engines. Another option is to buy financial instruments such as futures to hedge this risk. This is the risk transfer approach.
Various factors determine the choice of the approach to handling risk. Often a combination of these approaches makes sense. The choice between a financial and organisational solution varies from risk to risk. As we briefly mentioned earlier, strategic risks, which are core to the business and are critical to the generation of shareholder value have to be retained. So they invariably need organisational solutions. Where suitable financial instruments do not exist for risk transfer, organizational solutions may be unavoidable. In the case of some risks, organisational solutions may be too complicated, too expensive or may conflict with the company's strategic goals. In such situations, risk transfer solutions such as derivatives or insurance may be more efficient than organisational solutions.
The ultimate strategy for the rainy day is to keep overheads and debt low and hold plenty of cash to tide over uncertainties about which managers have little idea today. Indeed, equity is an all-purpose risk cushion. The larger the amount of risk that cannot be accurately measured or quantified, the more the equity component should be. It is no surprise that technology companies like Microsoft and Infosys keep little or no debt on the balance-sheet. Of course, equity is a more expensive source of funds. Equity holders expect a much higher rate of return, compared to debt providers. But that might well be a small price to pay in a volatile business environment. During a severe downturn, a comfortable capital position can give a company a major competitive advantage by allowing it to pursue an acquisition or a major investment that might well have had to be postponed otherwise.
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