A dangerous game

With its enthusiastic trade in credit default swaps, the financial industry is playing a deadly version of pass the parcel, says Sunil Poshakwale.

“The CDS market has grown very fast and is worth more than $60 trillion, which is approximately twice the size of the US stock market”
-Sunil Poshakwale, Cranfield School of Management

The current financial crisis gripping the investment industry in the US and other parts of the world reminds me of ‘the pass the parcel game’ that children play at birthday parties. You probably know the game – a parcel is passed around and whoever ends up with the parcel in their hands when the music stops, wins a prize. However, in the case of the investment industry, the parcel called Credit Default Swaps (CDS), which were being passed by one bank to another, contained a ticking time bomb in the shape of contaminated assets that no bank bothered to look at since there was plenty of money to be made from this game.

Credit default swaps provide insurance against the potential losses on the investments in certain assets such as municipal bonds, corporate bonds, mortgage securities, etc. CDS are similar to taking home insurance to protect against losses from fire and other causes. The credit default swaps market is not regulated and as a consequence, CDS contracts can be traded or swapped by one investment bank to another without anyone overseeing the trades. Thus there is no oversight to ensure that the holder of CDS has the required financial capital to meet losses in case the underlying security defaults. In the last few years, CDS became very popular with investment banks as an easy way to make money because in the booming economic period that we experienced in the last decade or so, the general perception was that big corporations and/or banks whose credits were insured via CDS markets were unlikely to fail. No wonder then that the CDS market has grown very fast and according to the International Swaps and Derivative Association (ISDA), it is worth more than $60 trillion which is approximately twice the size of the U.S. stock market and also dwarfs the $12 trillion US mortgage market and $6 trillion U.S. treasuries market. It is worth mentioning that the American Insurance Group (AIG) was recently rescued by the US Federal Reserve through a capital injection of $85bn had written off $450bn worth of CDS.

Besides the CDS, the market for securitised assets such as the Collateralised Debt Obligations (CDO) has also been growing over the years. CDOs are attractive investments for investment banks and hedge funds because of the high potential to make large profits and like CDS, markets for CDOs are unregulated. CDOs comprise a portfolio of fixed-income assets which are divided into different tranches based on the credit ratings of the underlying mortgages. For example, AAA rated CDO is considered safer compared to a BB rated CDO because the exposure to losses are greater in the BB rated CDO compared to the AAA rated CDO. Over the years, CDOs have become an important vehicle for funding of fixed-income assets. Around April 2006, the rating agencies began to re-rate the BB rated bonds as they sensed that given the higher risk, returns on these bonds were not high enough. As a consequence, the spreads on mortgages began to widen and the investors began to leave the BB rated bond market. Around the same period, the sub-prime residential mortgage market in the US started to experience high defaults which caused lenders to become more risk averse. The investors perceived higher risk in holding CDO backed bonds. Consequently, availability of credit became scares and bond yields (return required by investors from investing in bonds) started to rise. One of the reasons for the downfall of Lehman Brothers was that they had a high exposure to the CDO market. It is estimated that Lehman’s exposure to all outstanding corporate CDOs is nearly 60 percent.

Many commentators and financial experts have been blaming the derivative markets for the current financial crisis. However, in my view derivative products such as options, futures, swaps, and their complex combinations were primarily invented to hedge risk. However, since most derivative instruments principally rely on leverage, the investment industry started to use derivatives to make money and quite rightly so. Soon the profit making potential began to dominate the hedging motive and greed overtook rational behavior. The results are for everyone to see. Besides this, in the quest for more profits, investment managers and traders started to develop clever trading strategies in a bid to outsmart each other. This led to development of proprietary investment strategies that became too complicated to price for rest of the market.

The vast profit potential led to excessive greed to make maximum money in the shortest possible time. This short-termist behavior was encouraged by the compensation packages that were available to the investment bankers and trading community since more profits directly translated into higher bonuses. Years of good economic conditions with low inflation and low interest rates further fuelled the growth of financial markets and encouraged excessive risk taking by investment banks. Investment success lavishly compensated by Wall Street and in London plagued rational decision-making.

Central bank and regulatory bodies have been badly exposed in the current crisis. To some extent the criticism of these institutions that have primary responsibility to regulate the banking sector and financial market operations is justified. In my view, regulators can only effectively regulate if they understand what they are regulating. Therefore, it is not a question of more or less regulation but rather how ‘effective’ is the regulation. Regulatory authorities allowed investment banks to race ahead with trading of complex products and deals without making sure that both the regulator and the banks doing such deals understood the risks and that the counterparties involved had the necessary capital base to take those risks. There is an urgent need for governments to ensure that those who are responsible for regulation are either appropriately qualified or trained so that they have a sound understanding of the underlying risks.

One of the central tenets of the free market economy is that the markets are generally efficient. It is believed that markets are able to price risks appropriately and therefore reflect correctly the fair value of assets being traded in the market. However, markets are made up of small investors and some very large and influential investors. Unfortunately, the system has allowed some investment banks to become too powerful. This in itself is a breach of basic investment management principle which suggests that diversification is the key to reducing risks. When some institutions and investment banks become too influential, the systemic risk increases since they dominate trading volumes and are able to manipulate the asset prices.
There would be widespread implications of the financial markets meltdown in the US and the UK. One of the reasons for the recent takeovers (Merrill Lynch by Bank of America in the US and HBOS by Lloyds TSB in the UK) was that both Merrill Lynch and HBOS would have found it difficult to raise further capital on their own. Both have perfectly viable and possibly profitable businesses but because of the credit crunch, they would not have been able to borrow required money from the market because of the lower capital base caused by the write-downs of bad assets in their balance sheet. Some European banks, for example, Fortis in Europe, Bradford and Bingley in the UK, Wachovia in the US (and the list is growing every day) have found themselves in a similar predicament. It is worth noting that collectively, European banks together have €258bn worth of maturing debt in 2008 alone. In the case of HBOS, it needed to rollover debt worth Euro 1.6bn maturing in 2008. Thus one of the major consequences of the credit crunch is that the banks will have to de-leverage their balance sheets. De-leveraging would require infusion of additional capital so that maturing debts could be paid and debt to capital ratio is lowered.

Second, because of the high levels of debts on banks’ balance sheet, the shareholders will demand higher risk premium on the banking sector shares. It is not surprising therefore, that the banking stocks have been the loss leaders on Wall Street and London as well as in other markets.

Third, though bonds are considered much safer compared to investing in equity shares because bondholders have the first claim on a company’s assets, currently high levels of defaults on bonds would make it very difficult for banks and corporations to raise capital by issuing bonds. As a consequence the bond yields will continue to rise and so will the cost of borrowing.

Fourth, the whole finance industry will shrink in size because as the market values of overvalued assets fall, the value of capital required to finance the new levels of investments will also have to fall. There will be consolidation as we are witnessing and fewer big players in banking industry in future.

There are some serious implications of the credit crunch for the real economy. To start with, there will be reduced availability of capital to businesses. This may adversely affect new investments and growth. The slowdown resulting from the scarce availability of capital for businesses may lead to higher future job losses. The scarcity of finance would lead to increase in the cost of capital which will mean that business will have to tighten their operating costs or else they will be reporting lower future profits. Prospects of lower corporate profits will adversely affect the stock values. Thus the stock markets are unlikely to reach the heady levels that we have experienced in the last few years.

Large falls in the equity markets are bad news for the average person on the street even if he/she had nothing to do with the sub-prime mortgages. Losses on equity investments would reduce the value of portfolio investments held by pension funds and this is the next problem the governments around the world will have to deal with. If pension funds suffer losses on their investments then those who are dependent on the pension income are likely to suffer too. Many others who may have bought additional residential properties with an aim to use the sale proceeds in lieu of pension income in the next 5 years or so will find that they may not be able to afford the luxurious holidays they had planned. Worst hit will be those who cashed in by releasing equity from inflated house prices since they would find themselves with an expensive loan that they would have to repay in case the house prices do not regain the same levels which existed before the onset of the sub-prime crisis. Less credit availability will also mean a less luxurious life style since people will find it difficult to borrow money to spend on luxury goods. This may be good news since less demand will lead to fall in prices and those who have the cash will be able to get the best bargains. After all ‘cash is king’ as they say. Alas, banks did not heed to this age-old advice or else we would not have been in this financial mess.

Sunil S Poshakwale BCom DCMA MBA PhD is Professor of International Finance, Cranfield School of Management