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Date:8th January 2009 |
Compiled by Mr. M. Sathya Kumar |
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Derivatives are
financial weapons of mass destruction —
Warren Buffet. Is this statement valid ? In his annual Chairman’s letter to
shareholders of Berkshire Hathaway Inc for year 2001, Warren Buffet set out his
perspective on financial derivatives — particularly credit
derivatives1, and concluded that "We try to be alert to any sort of
megacatastrophe risk, and that posture may make us unduly apprehensive about
the burgeoning quantities of long-term derivatives contracts and the massive
amount of uncollateralised receivables that are growing alongside. In our
view, derivatives are financial weapons of mass destruction, carrying dangers
that, while now latent, are potentially lethal". The 2008 US Financial Crisis : An overview : Indeed, Warren Buffet’s words of
wisdom in his 2001 letter to shareholders seem almost prophetic in the wake of the
catastrophic financial meltdown that is redefining the landscape of global
finance at the speed that perhaps makes Hurricane Ike look like a
minor high tide. The historic US government takeover2 of twin mortgage buyers
— Fannie Mae3 and Freddie Mac4 on 7 September, 2008,
bankruptcy of the 158 years’ old Lehman Brothers5,
acquisition of the 94 years’ old Merrill Lynch by Bank of America on 15 September,
2008, US Fed and US government $ 85 billion loan bailout of American
International Group7 (AIG) on 16 September, 2008, and scrambling for capital
or other survival kits by the remaining two independent investment banks and
financial brokerages in the US market, namely, Goldman Sachs and Morgan
Stanley, all in a matter of two weeks, is unprecedented in the US — the sacred land of capitalism, where nationalising private
investors’ losses through taxpayers’
bailouts has been sacrilege, ever since the establishment of the US Fed system
after the Great Depression in the 1930s. And yet even this did little to stave off the financial storm
whose end is nowhere in sight. Much like the stages of a scenario of systemic
financial meltdown associated with this severe economic recession that
Professor Nouriel Roubini of the Stern School of Business at New York
University outlined in February 20088 : "A vicious circle
of losses, capital reduction, credit contraction, forced liquidation and fire
sales of assets at below fundamental prices could ensue leading to a
cascading and mounting cycle of losses and further credit contraction. In
illiquid market actual market prices are lower than the lower fundamental
value that they then have given the credit problems in the economy. Market
prices include a large illiquidity discount on top of the discount due to the
credit and fundamental problems of the underlying assets that back the
distressed financial assets. Capital losses then lead to margin calls and
further reduction of risk taking by a variety of financial institutions that
are then forced to mark to market their positions. Such a forced fire sale of
assets in illiquid markets leads to further losses that further contract
credit and trigger further margin calls and disintermediation of credit. The
triggering event for the next round of this cascade is the downgrade of the
monolines and the ensuing sharp drop in equity markets; both will trigger
margin calls and further credit disintermedia-tion ..... A near-global economic
recession could ensue as the financial and credit losses and the credit
crunch spread around the world. Panic, fire sales, cascading fall in asset
prices will exacerbate the financial and real economic distress as a number
of large and systemically important financial institutions go bankrupt." US Treasury Secretary Henry Paulson watched aghast on 17
September 2008 as his dramatic actions of rescuing Fannie Mae, Freddie Mac,
and AIG were met by worldwide stock market panic while inter-bank lending remained
stubbornly frozen. Running out of alternatives, on 21 September 2008 the Bush
administration led by Henry Paulson sent a draft of proposed legislation to
the US Congress asking for $ 700 billion in taxpayer money to get bad
mortgage assets off the books of troubled US financial institutions in a bid
to end the U.S. economy’s worst financial nightmare since the
Great Depression. As a measure of its relative size, this mother of all financial
bailouts in modern history, at $ 700 billion is approx 7.2% of the current
outstanding US national debt of $ 9.67 trillion9, about 24% of the 2008 US
government budget outlay of $ 2.93 trillion10, a tad over 5% of US GDP at
$ 13.67 trillion (2007 est)11, nearly 64% of India’s GDP at $ 1.09 trillion (2007 est)12, and 1.29% of World GDP at $
54.31 trillion (2007 est). Ironically, Henry Paulson, who previously ran the world’s most powerful investment bank Goldman Sachs as its free-marketeering
former chairman now finds himself leading a nationalisation programme that would
make both Fidel Castro and Hugo Chavez blush ! Can the government really
take on the notorious financial instruments tied to sub-prime mortgages,
whose unfathomable loss of value has made the US credit crisis
self-perpetuating, and bury them in a vault funded by the taxpayer ?
Time will tell. The on or off-balance sheet obligations of Fannie Mae and
Freddie Mac, the two independent government-sponsored enterprises (GSEs) is
just over $ 5 trillion. Together, Fannie Mae and Freddie Mac own or guarantee
about half of the $ 12 trillion of mortgages in the U.S.13 The
government accounts for these GSEs as if they are unconnected to its balance
sheet. Notably, their obligations at over $ 5 trillion exceed 50% of
current US national debt14. The net exposure to US taxpayers is difficult to determine at
the time of the takeover and depends on several factors, such as declines in
housing prices and losses on mortgage assets in the future. Over 98% of
Fannie’s loans were paying timely during 200815. Both Fannie and Freddie had
positive net worth as of the date of the takeover, meaning the value of their
assets exceeded their liabilities. As Domnic Rushe17 points out, two things seem to be clear :
First, the economic influence of American presidents is severely limited.
Secondly, US financial markets have become so complex and reliant on highly
technical trading instruments that even some of the country’s best-known economists declared themselves bewildered by the head-spinning turn
of events. "As an economist, I am supposed to have something intelligent
to say about the current financial crisis", said Professor Steven
Levitt, the author of Freakonomics, a best-selling guide on the way markets
work. "To be honest, however, I haven’t the foggiest idea what this all
means". The US financial carnage for sure has its fallouts beyond the US
coasts, albeit in differing intensity, depending on the inter-dependencies
and dispersal of the sub-prime risks across financial firms globally through
investments in the securitised obligations of US sub-prime mortgages or
through counter-party exposures to the affected US firms. Adding to this are
UK sub-prime debt-related financial distresses with causes similar to those
that underpin the current US financial crisis19. And indeed, the worst may be
still ahead of us, and not behind us, notwithstanding the unprecedented
concerted attempt by global central banks and monetary authorities to arrest
if not reverse the palpable fear, gloom and doom that seem to have engulfed
global financial markets in the wake of these unprecedented rapid
developments. The 2008 US Financial Crisis : Triggers &
Causes : To be sure, the insight that credit derivatives are
potentially lethal did not come to Warren Buffet painlessly. It came only
after experiencing their toxicity first-hand in the derivatives business of a
subsidiary20 of Gen Re21 which was acquired by Berkshire Hathaway — which business was potentially distressed, remained unsold despite efforts,
and had to be eventually wound up after picking up its credit derivative
losses. It took four years to unwind its portfolio of credit derivatives — at a loss of $ 400 million till 2007, and another $ 500
million in Q1 200822. After months of analysis, investigation, research, introspection
that would inevitably follow once the current mayhem passes, and a few
congressional committees and enquiry commissions later, the causes and
possible cures for not repeating the ongoing financial havoc would continue
to be intensely debated the world over amongst financial experts, policy
makers, regulators, and politicians for a long time to come. All will keenly
await these emerging insights on causes of this historic and incredibly
expensive lesson in figuring out the vices that afflict modern
finance. Meanwhile, an analytical overview of the crisis would seem to point
to a pivotal role played by the proliferating credit derivatives in the
crisis. Of course, credit derivatives are not alone to be blamed. The
following key triggers (some interlinked) seem to emerge as the immoral
pillars that shoulder responsibility for the crisis : (i) Reckless Sub-prime Lending; (ii) Originate, Securities & Service Model, also called the
Origination & Distribution (O&D) Model; (iii) Proliferation of complex, illiquid, and inherently high-leverage,
over-the-counter Credit Derivatives, bereft of an informed and market-driven
mechanism for managing counter-party risk thro a margining system or
regulatory capital, with preponderant dependence on credit rating of the
counter party that wrote the credit derivative; (iv) Regulatory framework permissive of extreme leverage in the
non-bank shadow financial system encompassing investment banks, broker
dealers, SIVs, hedge funds, money market funds, monoline credit insurers, and
GSEs, leaving little equity capital to weather an asset price downturn; (v) Prolonged correction in real estate (housing) prices,
following the piercing of the asset price bubble in the US housing market
that was caused by an ecosystem awash with liquidity and ease credit availability
at low interest rate during most of this decade; (vi) Secular underestimation of low-probability systemic risk
events when they haven’t happened recently, and treating them as being
impossible; (vii) Inherent tendency of financial markets in times of extreme
crisis and fear, to embrace extreme risk aversion, herd a flight to safety,
amplify (rather than absorb) the shock, quickly precipitate a liquidity
crisis at the systemic level that transforms the scramble for liquidity at a
firm level into a solvency problem at unbelievable speed, irrespective of its
asset liability profile. Whereas the converse is often true in times of
financial markets boom, when a latent solvency problem of a financial firm
that is already understated on account of higher than fundamental values, can
remain hidden under a surfeit of liquidity; (viii) Fair value accounting requirement under FAS 157 and IFRS
7 for financial instruments including derivatives, which : firstly,
brings enormous subjectivity in normal times in marking-to-model illiquid
derivative instruments such as credit derivatives, with potency for errors in
profit accounting, both honest and intentional; secondly, in times of crisis,
exacerbates the valuation problem of an already illiquid instrument due to
malfunctioning of the orderly sales assumption underlying the
accounting framework of fair value; and thirdly, mistaking as realised
losses, the extreme mark-to-market (MTM) or mark-to-model losses determined
in times of crisis, the financial markets rapidly precipitate a solvency
crisis though the asset liability profile of the financial firm may enable it
the weather the extreme event MTM losses (e.g., AIG, perhaps). Reckless US Sub-prime Lending : Most of this decade witnessed reckless lending in the US credit
market through mortgage loans, car loans, credit cards, etc. to borrowers
with impaired or limited credit histories, known as, sub-prime23, which encompassed loans with no
down-payment, no verification of income, jobs and assets (called NINJA or
LIAR loans), interest rate only, negative amortisation, teaser rates, etc.,
which were occurring across the entire spectrum of mortgages; about 60% of
all mortgage origination since 2005 through 2007 had these reckless and toxic
features24. Origination and Distribution (O&D) Model The origination, securitisation and servicing model (also
known as, the Origination and Distribution model) proliferated in the US on
the back of a booming mortgage credit market. The O&D model worked
something like this : Typically, a huge investment bank26 (HIB), would
encourage mortgage banks all over the country to make home loans, often
providing the capital, and then HIB would purchase these loans and package them
into large securities called Residential Mortgage Backed Securities (RMBS).
They would take loans from different mortgage banks and different regions. They generally grouped the loans together as to their initial
quality as in prime mortgages, ALT-A and the now infamous sub-prime
mortgages. They also grouped together second lien loans, which were the loans
generally made to get 100% financing or cash-out financing as home owners
borrowed against the equity in their homes. Typically, a RMBS would be sliced
into anywhere from 5 to 15 different pieces called tranches. They would go to
the ratings agencies, who would give them a series of ratings on the various
tranches, and who actually had a hand in saying what the size of each tranche
could be. The top or senior-level tranche had the rights to get paid back
first in the event there was a problem with some of the underlying loans.
That tranche was typically rated AAA. Then the next tranche would be rated AA
and so on down to junk level. The lowest level was called the equity level,
and this lowest level would take the first losses. For that risk, they also
got any residual funds if everyone paid. The lower levels paid very high
yields for the risk they took. Then, since it was hard to sell some of the lower levels of
these securities, HIB would take a lot of the lower-level tranches and put
them into another security called a Collateralised Debt Obligation or CDO.
And yes, they sliced them up into tranches and went to the rating agencies
and got them rated. The highest tranche was typically again AAA. Through the
alchemy of finance, HIB took sub-prime mortgages and turned 96% (give or take
a few points depending on the CDO) of them into AAA bonds. Almost like taking
nuclear waste and turning it into gold. Clever trick when you can do it, and
everyone, from mortgage broker to investment bankers was paid handsomely to
dance at the party. There is no method for reporting on CDO issuance or on
sub-prime loans outstanding (there are classification issues for sub-primes,
and that is compounded by the fact that many of the originators were mortgage
brokers who had no reporting obligations). Estimates of the size of the
sub-prime market range from $1 to $1.3 trillion. By contrast, more credible
estimates of CDOs outstanding are closer to $3.9 trillion with the Financial
Times reporting that global CDO issuance in 2006 alone was $2.6 trillion28. Proliferating Credit Derivatives : To be sure, the credit boom was accompanied and supported by
proliferation of complex, illiquid, and inherently high-leverage,
over-the-counter Credit Derivatives, bereft of a market-driven mechanism for
managing counter-party risk thro a margining system or regulatory capital or
a clearing corporation that acted as a central counter party. And, the
preponderant dependence was on credit rating of the counter party that wrote
the credit derivative or the collaterals it was asked to keep. Credit
Derivatives include unfunded credit derivative products, such as Credit
Default Swap (CDS), Total return swap, Portfolio Credit Default Swap, Credit
Default Swap on Asset-Backed Securities, Credit default swaption, Credit
Spread Option, CDS Index Products, or Constant Maturity Credit Default Swap
(CMCDS); as well as funded credit derivative products, such as Credit-Linked
Note (CLN), Synthetic Collateralised Debt Obligation (CDO), Constant
Proportion Debt Obligation (CPDO), Synthetic Constant Proportion Portfolio
Insurance (Synthetic CPPI). There are numerous types of CDSs, some far more
complex than others. More than half of all CDSs cover indexes of companies
and debt securities, such as asset-backed securities, the Basel committee says.
The rest include coverage of a single company’s
debt or
collateralised debt obligations. In its simplest form, a CDS is akin to credit insurance or a
credit default guarantee. It is an agreement between two counterparties, in
which one makes periodic payments to the other and gets promise of a payoff
if a third party defaults. The first party gets credit protection, a kind of
insurance, and is called the ‘buyer’. The second party gives
credit protection and is called the ‘seller’. The
third party, the one that might go bankrupt or default, is known as the ‘reference entity’. The ‘protection buyer’ gets a large payoff if the reference entity defaults
within a certain period of time, while the ‘protection seller’ collects periodic payments for assuming the risk of default29. CDS resemble an insurance
policy, as they can be used by debt owners to hedge, or insure against a
default on a debt. However, because there is no requirement to actually hold
any asset or suffer a loss, credit default swaps can also be used for
speculative purposes. The rate of growth of CDS has been breathtaking. According to
the International Swap Dealers Association (ISDA), the notional amount
outstanding of CDS grew to a staggering $62.2 trillion at 2007 year end31, up
from a modest $0.92 trillion at 2001 year end32, depicting a CAGR of an
astounding 102%, and making CDS the fastest-growing financial instrument of
all times33. Indeed, this rapid growth of Credit Derivatives formed the
backbone of the origination, securitisation and servicing model which
proliferated in tandem during the period. Most financial instruments of CDS scale, like Treasury
futures, are traded on exchanges. Once brokers match a Treasury future trade,
the clearing corporation (CC) of the exchange steps in as the central counter
party for both the buyer and the seller. The exchange insists on daily
collateral-postings. If you make a loss because you sold a future that’s rising in price, you have to post additional collateral; if the future
price drops the next day, you get that portion of your collateral back. In short, iron-clad procedures ensure that the CC always has
enough cash to settle up with the parties when contracts close out. CDS,
however, trade ‘over the counter’, without an
exchange. While most counterparties insist on some initial collateral, the
arrangements are inconsistent, and updating of positions is haphazard.
Perhaps a third of the ‘long’ players, or protection
sellers, moreover, are hedge funds, typically very highly leveraged. While
they love selling protection for the cash income, if they are faced with a
spate of default payouts, they could easily default themselves. Counter-party risk can become complicated in a hurry. In a
typical CDS deal, a hedge fund will sell protection to a bank, which will
then resell the same protection to another bank, and such dealing will continue,
sometimes in a circle that has created a huge concentration of risk. As one
leading derivatives trader expressed the process, "The risk keeps
spinning around and around in this daisy chain like a vortex. There are only
six to ten dealers who sit in the middle of all this. I don’t think the regulators have the information that they need to
work that
out.’’ Like many exotic financial products which are extremely
complex and profitable in times of easy credit, when markets reverse, in
addition to spreading risk, credit derivatives, in this case, also amplify
risk considerably. Traders, and even the banks that serve as dealers, don’t always know exactly what is covered by a
credit-default-swap contract.36 The universal feature common to all types of
credit derivatives though, is the astounding leverage they incorporate in the
books of the sellers of credit derivatives. As Warren Buffet points out "Unless
derivatives contracts are collateralised or guaranteed, their ultimate value
also depends on the creditworthiness of the counter parties to them. In the
meantime, though, before a contract is settled, the counter parties record
profits and losses — often huge in amount — in their current earnings statements without so much as a
penny changing hands". Unlike exchange-traded products which tend to be standardised,
relatively short term (usually not more than a year), liquid, mark-to-market
and margin on a daily basis, a typical CDS is customised, opaque, five years
term, illiquid and often with embedded complexities. The market for CDS is entirely unregulated and seems to have
been allowed to grow to a staggering $ 62.2 trillion without any
supervision. And, as F. William Engdahl points out, there are no public
records showing whether sellers have the assets to pay out if a reference
obligation defaults. Remarkably, sellers of protection aren’t required by law to set aside reserves in the CDS market.
While banks ask protection sellers to put up some money when making the
trade, there are no industry standards. It would be the equivalent of a
licensed insurance company selling insurance protection against hurricane
damage with no reserves against potential claims. The U.S. Fed only has supervision to regulate bank CDS
exposures39, but not that of investment banks or hedge funds, both of which
are significant CDS issuers. Hedge funds, for instance, are estimated to have
written 31% in CDS protection.40 Predictably, the other big sellers and
buyers of CDS are the big five investment banks41, and the monoline bond insurers42.
Yet, J.P. Morgan Chase remains by far the largest seller and buyer of CDS. It appears that US Fed could not let Bear Stearns enter
bankruptcy because — and only because — the
trillions of dollars of credit default swaps on its books would be wiped out. All the
banks and institutions that had insurance written by Bear would not be able
to say that they were insured or hedged anymore and they would have to
write-down billions and billions of dollars in losses that they’ve been carrying at higher values, because they could say
that they were insured for those losses.43 A similar problem seems to have
brought down AIG. A small AIG corporate subsidiary apparently wrote $441
billion worth of credit default swaps on corporate bonds, and worse, mortgage-backed
securities. As the value of these insured-referenced entities fell, AIG had
massive write-downs and additionally had to post more collateral. And when
its ratings were downgraded on 15 September, 2008, the company had to post even
more collateral, which it didn’t have. In
short, what happened in one small AIG corporate subsidiary appears to have blown
apart the largest insurance company in the world44. The financial system would surely have been better off had it
introspected upon Warren Buffet’s following words of
wisdom45 : "Many people argue that derivatives reduce systemic problems,
in that participants who can’t bear
certain risks are able to transfer them to stronger hands. These
people believe that derivatives act to stabilise the economy, facilitate
trade, and eliminate bumps for individual participants. And, on a micro
level, what they say is often true. Indeed, at Berkshire, I sometimes engage
in large-scale derivatives transactions in order to facilitate certain
investment strategies. Charlie46 and I believe, however, that the
macro picture is dangerous and getting more so. Large amounts of risk,
particularly credit risk, have become concentrated in the hands of relatively
few derivatives dealers, who in addition trade extensively with one other.
The troubles of one could quickly infect the others. On top of that, these
dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties,
as I’ve mentioned, are linked in ways
that could cause them to contemporaneously run into a problem because of a
single event (such as the implosion of the telecom industry or the
precipitous decline in the value of merchant power projects). Linkage, when
it suddenly surfaces, can trigger serious systemic
problems . . . History teaches us that a crisis often
causes problems to correlate in a manner undreamed of in more tranquil
times". Excessive Leverage-Permissive Regulatory Framework : Leverage is a double-edged sword. It is the life blood of
business and economic growth when used wisely and moderately. Indeed, most
business and economic activity — large or
small, would come to a grinding halt if no credit or leverage were available from
the banking system or the shadow non-bank financial system. Concomitantly, if
the banking and financial system could not or did not lend, household savers
would have no safe avenue of earning a fixed return, except by investing in
treasury securities. Role of leverage and credit is therefore central to
economic progress. Yet, excessive leverage leaves little margin of error if
things go wrong, and can be perilous. At what level leverage is moderate or
excessive may differ across economies, businesses and business cycles.
Nonetheless, in any economy, financial firms tend to use more leverage
than the real economy firms. It is this inherent leveraged
nature of banks and financial firms that forms the basis of regulatory
capital requirements and other regulations to which these firms need to be
subjected in the larger public interest. Within the financial system, banks
tend to be most rigorously regulated firms due to their public-facing,
deposit-taking, and cheque-writing features. And, banking regulations usually
limit the leverage ratio of banks through a minimum capital to risk — weighted assets ratio (CRAR) on an ongoing basis.
The Basel II framework evolved by The Bank for International Settlements47
(BIS) in 2006 sets a CRAR of 9% for adoption by banking regulators globally. At 2007 year end, Fannie Mae and Freddie Mac had an effective
leverage of an astounding 65x48 and 79x49, respectively. And, the leverage
ratio for the big five investment banks at 2007 year end was 27.8x50 for
Merrill Lynch, 30.7x51 for Lehman Bros, 32.8x52 for Bear Stearns, 32.6x53 for
Morgan Stanley, and 26.2x54 for Goldman Sachs. Way back in 1975, SEC established a net capital rule that
required broker dealers (such as these investment banks) who traded
securities for customers as well as on their own account, to limit their
leverage to 12x. Reportedly, according to a former SEC official55, SEC
granted exemption to these five investment banks from the net capital rule
which limited their leverage to 12x. [Though, their annual reports suggest
that leverage was higher than 12x even in 2003, at 15.7x for Merrill Lynch,
23.7x for Lehman Bros, 26.4x for Bear Stearns, 23x for Morgan Stanley and
18.7x for Goldman Sachs]. Add to this, their derivatives-heavy activities
including in the toxic CDO and CDS obligations56 which in a generous measure
were correlated to the US housing market and sub-prime credits. Not surprisingly, as the downturn in the US housing market
proceeded, these investment banks were caught in a vicious circle of credit
derivative losses, asset illiquidity, mark-to-market losses, consequential
margin calls, leverage contraction, and fire sale of assets at below
fundamental prices causing another cascading and mounting cycle of losses and
further credit contraction and rating57 downgrades. Indeed, asset prices are
determined by the available liquidity, that is, by the cash in the market.
It is necessary for people to hold liquidity and stand ready to buy assets
when they are sold. With extreme leverage providing little margin for error, what
initially started as a liquidity problem quickly precipitated into a solvency
problem, making them scurry for capital that was not readily available. Bear
Stearns was sold to the commercial bank J. P. Morgan Chase on 31 May, 2008 in
a deal mostly brokered by US Treasury Secretary Henry Paulson; Lehman Bros
filed for bankruptcy on 7 September, 2008; Merrill Lynch was sold to another
commercial bank, Bank of America; and finally, Morgan Stanley and Goldman
Sachs signed a letter or intent with US Federal Reserve on 22 September, 2008
to convert themselves to a bank holding company. Annuls of modern finance
will take note of year 2008, inter alia, as the year in which an era
of powerful, iconic, high-octane, non-bank Wall Street investment banks came
to an end. A comment Warren Buffet made in answering a question at
Berkshire’s 2004 annual shareholders’ meeting seems to say it all : "almost anything can
happen in financial markets . . . [but] the only way really smart people can
get clobbered is through the use of leverage . . . [because leverage] can
keep you from playing out your hand . . . we [at Berkshire]
just don’t believe in lots of [financial]
leverage." Beside the leverage in these investment banks, is the colossal
leverage sitting in the balance sheets of the other lightly supervised firms
in the shadow financial system, comprising, hedge funds, SIVs, conduits,
money-market funds, monoline insurers and other non-bank financial
institutions, that needs to be reckoned with. All these firms are subject to
market risk, credit risk and especially liquidity/roll-over risk as they
borrow short term in liquid form and hold assets that are more long term and
illiquid.59 And, there
are no reliable estimates of either the magnitude or the inter-linkages of
these leverage exposures. While species such as SIVs, conduits in the US
shadow financial system has already experienced a generalised run on them,
the daisy-chain reaction of the unfolding US financial crisis on the entire
spectrum of this US shadow financial system is far from over. US Housing Market Downturn : The years that preceded the recent turbulence saw an exceptionally
strong performance of the world economy — another
phase of
what has come to be known as the ‘Great
Moderation’. Following the global slowdown of 2001, the world economy had
recovered rather rapidly, posting record growth rates in 2004, 2005 and 2006.
This strength went hand in hand with unusually strong performance in
financial markets and the financial system more generally, underpinned by the
strength of asset prices. Pretty much globally, residential property prices
had been rising rapidly, acting as a critical support for household spending.
Their prolonged strength had been especially in evidence in several
English-speaking countries, including the United States, in some European
economies, including Spain, and in parts of Asia, not the least China. Across
a wide spectrum of asset classes, volatilities and risk premia looked
exceptionally low, including to varying degrees in fixed income, credit,
equity and foreign exchange markets. The record profitability and capital
position of financial intermediaries was high by historical standards. Against the backdrop of historically low interest rates and
booming asset prices, credit aggregates, alongside monetary aggregates, had
been expanding rapidly. Despite the rapid increase in credit, however, the
balance sheets and repayment capacity of corporations and, to a lesser
extent, households did not appear to be under any strain. The high level of
asset prices kept leverage ratios in check while the combination of strong
income flows and low interest rates did the same with debt service ratios. In
fact, in the aggregate, the corporate sector enjoyed unusually strong
profitability and a comfortable liquidity position, even though in some
sectors leverage was elevated as a result of very strong leveraged buyout
(LBO) and so-called ‘recapitalisation’ activity. But
debt-to-income ratios in the household sectors exhibited a marked upward
trend, on the back of a major rise in mortgage debt.61 After a prolonged rise in housing prices from 2000 to 2005 on
the back of an ecosystem of easy availability of credit at low interest
rates, the US ushered into a housing price correction in 2006, perhaps the
worst in US history with no sign of it bottoming out any time soon. As
Professor Nouriel Roubini of the Stern School of Business at New York
University outlined in February 200862 : "At this
point it is clear that US home prices will fall between 20% and 30% from
their bubbly peak; that would wipe out between $ 4 trillion and $ 6
trillion of household wealth. While the sub-prime meltdown is likely to cause
about 2.2 million foreclosures, a 30% fall in home values would imply that
over 10 million households would have negative equity in their homes and
would have a big incentive to use ‘jingle mail’
(i.e., default, put the home keys in an envelope and send it to their mortgage
bank). Moreover, soon enough a few very large home builders will go bankrupt
and join the dozens of other small ones that have already gone bankrupt, thus
leading to another freefall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of
a worsening housing recession". Henry Paulson in the preamble to his unprecedented historic
$ 700 billion financial bailout proposal of 21 September, 2008,
attributed the central cause of the credit crunch to the "illiquid
mortgage assets that have lost value as the housing correction has proceeded".63
Fair Value Accounting of Complex Derivative Products :
Valuation Challenges : The accounting framework for disclosing valuations of structured
finance products differs according to an institution’s location. U.S. firms adopt that country’s generally accepted accounting principles (U.S. GAAP), while
European firms with listed securities use international financial reporting
standards (IFRS). Non-listed European firms may use IFRS or their respective
national guidelines, each of which may allow different valuation approaches.
In the rest of the world, firms may use either national standards or IFRS.64
(refer Annexure 1). In both cases, the U.S. GAAP and IFRS treatments are
substantially the same, but there are some subtle differences. The Standards
FAS 157 and IFRS 7, which elaborate the disclosures for financial
instruments, are new to their respective frameworks and at the end of 2007
disclosures under these standards were only made by early adopters that
included most major financial entities. FAS 157 defines fair value as ". . . the
price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the
measurement date. FAS 157 recognises fair value as an exit value from a sale,
while currently IFRS is less prescriptive. In determining fair value, both IFRS and U.S. GAAP prescribe a
hierarchy of fair value methodologies starting with observable prices in
active markets and moving to a mark-to-model in which some of the material
inputs are unobservable. However, only FAS 157 requires disclosure of a
formal three-level classification of all financial instruments in the
financial statements. ‘Level-one’ valuation requires
observable prices for the same instrument in liquid markets. When observable
prices are unavailable for the valuation date, ‘Level-two’ valuation allows
the use of prices on nearby dates, or the use of arbitrage-type valuation
models that use the observable prices of other financial instruments. For
example, such a model might value a CDO tranche on the basis of credit
spreads or implied correlations of similar CDO tranches. For instruments for
which level-one and level-two valuations inputs are not available, ‘Level three’ allows the use of theoretical valuation models
that use as inputs various relevant fundamental parameters. This makes
valuation of level-three assets highly dependent on, and sensitive to, the
model’s assumptions. Indeed, fair value accounting of complex illiquid structured
derivative products is fraught with the following dangers : firstly,
brings enormous subjectivity in normal times in marking-to-model illiquid
derivative instruments such as credit derivatives, with potency for errors in
profit accounting, both honest and intentional; secondly, in times of
crisis, exacerbates the valuation problem of an already illiquid instrument
due to malfunctioning of the orderly sales assumption
underlying the accounting framework of fair value; and thirdly,
mistaking as realised losses, the extreme mark-to-market (MTM) or
mark-to-model losses determined in times of crisis, the financial markets
rapidly precipitate a solvency crisis though the asset liability profile of
the financial firm may enable it the weather the extreme event MTM losses
(e.g., AIG, perhaps). Warren Buffet in his 2002 letter to Berkshire shareholders had
some scathing criticism of the fair value accounting and valuation problems
in complex derivative products : "Errors will usually be honest, reflecting only the human
tendency to take an optimistic view of one’s
commitments. But the parties to derivatives also have enormous incentives to cheat
in accounting for them. Those who trade derivatives are usually paid (in whole or
part) on ‘earnings’ calculated by mark-to-market accounting.
But often
there is no real market (think about our contract involving twins) and ‘mark-to-model’ is utilised. This
substitution can bring on large-scale mischief. As a general rule, contracts
involving multiple reference items and distant settlement dates increase the
opportunities for counter parties to use fanciful assumptions. In the twins
scenario, for example, the two parties to the contract might well use
differing models allowing both to show substantial profits for many years. In
extreme cases, mark-to-model degenerates into what I would call mark-to-myth. Of course, both internal and outside auditors review the
numbers, but that’s no easy job. For example,
General Re Securities at year end (after ten months of winding down its
operation) had 14,384 contracts outstanding, involving 672 counter parties
around the world. Each contract had a plus or minus value derived from one or
more reference items, including some of mind-boggling complexity. Valuing a
portfolio like that, expert auditors could easily and honestly have widely
varying opinions. The valuation problem is far from academic : In recent
years, some huge-scale frauds and near-frauds have been facilitated by
derivatives trades. In the energy and electric utility sectors, for example,
companies used derivatives and trading activities to report great ‘earnings’ — until the roof fell in when they
actually tried to convert the derivatives-related receivables on their
balance sheets into cash. ‘Mark-to-market’ then
turned out to be truly ‘mark-to-myth.’ I can assure you that the
marking errors in the derivatives business have not been symmetrical. Almost
invariably, they have favoured either the trader who was eyeing a
multi-million dollar bonus or the CEO who wanted to report impressive ‘earnings’ (or both). The bonuses were paid, and the CEO profited from his
options. Only much later did shareholders learn that the reported earnings
were a sham." Low-Probability Extreme Events — Underestimation versus Panic : Surprise is endemic above all in the world of finance66. As Peter Bernstein pointed out
in his celebrated book67 way back in 1996, discontinuities, irregularities,
and volatilities seem to be proliferating rather than diminishing. In the
world of finance, new instruments turn up at a bewildering pace, new markets
are growing faster than old markets, and global interdependence makes risk
management increasingly complex. Indeed, our faith in risk management
encourages us to take risks we would not otherwise take. On most counts, that
is beneficial, but we must be wary of adding to the amount of risk in the
system. The science of risk management sometimes creates new risks even as it
brings old risks under control. We cannot enter data about the future into
the computer because such data are inaccessible to us. So we pour in data
from the past to fuel the decision-making mechanisms created by our models,
be they linear or non-linear. But therein lies the logician’s
trap; past data from real life constitute a sequence of events rather than a set of
independent observations, which is what the laws of probability demand.
History provides us with only one sample of the economy and the capital
markets, not with thousands of separate and randomly distributed numbers.
Even though many economic and financial variables fall into distributions
that approximate a bell curve, the picture is never perfect. Once again,
resemblance to truth is not the same as truth. It is in those outliers and
imperfections that the wildness lurks.68 In tranquil times, low probability events are treated by most
as being impossible. The inherent tendency of financial markets in times of
extreme crisis and panic is to embrace extreme risk aversion herding a flight
to safety, thus amplifying (rather than absorb) the shock and quickly
precipitating a liquidity crisis at the systemic level that transforms the
scramble for liquidity at a firm level into a solvency problem at
unbelievable speed, irrespective of its asset-liability profile. Whereas, the
converse is often true in times of financial markets boom, when a latent solvency
problem of a financial firm that is already understated on account of higher
than fundamental values, can remain hidden under a surfeit of liquidity. As
Warren Buffet put it succinctly in answering a question at Berkshire’s 2004 annual shareholders’ meeting, "People
tend to underestimate low-probability events when they haven’t happened recently, and they tend to overestimate low-probability
events when they have happened recently." Once again, another comment of Warren Buffet at the same
annual meeting seems almost prophetic : "A ‘transformative’ catastrophe is less likely to come from
natural causes (earthquakes, etc.) than from man-made causes, especially in
financial markets". Indeed, as a preamble to his unprecedented historic
$700 billion financial bailout proposal that is intended to avoid a financial
catastrophe, Henry Paulson admitted that his solution "will cost
hundreds of billions" but said that he was "convinced that this
bold approach will cost American families far less than the alternative — a continuing series of financial institution failures and
frozen credit markets unable to fund economic expansion."69 Epilogue As Robert J. Samuelson70 once pointed out : "The
basic lesson from the Great Depression is that governments cannot permit
massive collapses of banks or spending. The deeper lesson is that there are
times when the world changes so much and events move so rapidly that even the
well-informed do not know how to respond. This is the story of the
depression. Now it seems preventable. Then, it was baffling." As Peter L. Bernstein observes in his celebrated book71 :
"The past seldom obliges by revealing to us when wildness will break
out in the future. Wars, depressions, stock-market booms and crashes, and
ethnic massacres come and go, but they always seem to arrive as surprises.
After the fact, however, when we study the history of what happened, the
source of the wildness appears to be so obvious to us that we have a hard
time understanding how people on the scene were oblivious to what lay in wait
for them." Annexure 172
1 As Warren Buffet clarified later in an interview to Spiegel
http://www.spiegel.de/international/business 2 Euphemistically called, conservatorship of Federal
Housing Finance Agency (FHFA) 3 Assets $ 882 billion, Leverage 20x, Underwritten
Mortgage Guarantees Outstanding $ 2.88 trillion — Fannie Mae 2007 Annual Report 4 Assets $ 794 billion, Leverage 30x, Underwritten
Mortgage Guarantees Outstanding $ 2.10 trillion — Freddie Mac 2007 Annual Report 5 Assets $ 691 billion, Leverage 30x — Lehman Brothers 2007 Annual Report 6 Assets $ 1.02 trillion, Leverage 32x — Merrill Lynch 2007 Annual Report 7 Assets $1.06 trillion, Leverage 11x — AIG Annual Report 8 http://www.marketoracle.co.uk/Article3677.html 9 http://www.brillig.com/debt_clock. Of course, this also does
not include the US government unfunded obligations towards Medicaid, Social
Security, Medicare, etc. promises under current laws, present valued at $40.1
trillion (http://www.gao.gov/financial/fy2007/07frusg.pdf). If included, the
figure of $1.09 trillion would rise to a staggering $59.1 trillion. 10 The Budget of the United States Government for 2009, (http://www.america.gov) 11 The Budget of the United States Government for 2009,
(http://www.america.gov) 12
http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal) 13
http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=aMz0dl3IdwjU 14 at $9.67 trillion, http://www.brillig.com/debt_clock 15
http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=aMz0dl3IdwjU 16 http://www.fanniemae.com/ir/pdf/earnings/2008/q22008.pdf 17 Domnic Rushe, The Sunday Times, 21 September, 2008 http://business.timesonline.co.uk/tol/business/economics/article4794879.ece 18 Dominic Rushe, The Sunday Times, 21 September, 2008
http://business.timesonline.co.uk/tol/business/economics/article4794879.ece 19 The bail-out of UK’s fifth
largest mortgage lender Northern Rock by the Bank of England earlier this year, and
the acquisition of Halifax Bank of Scotland (HBOS) by the Lloyds Bank on 18
September, 2008 are examples 20 Called General Re Securities, a derivatives dealer 21 A reinsurance company 22 Credit Default Swaps are a Valuable Invention, But
Largely Unregulated, Charles R. Morris, 10 June, 2008, The Washington
Independent 23 Technically, in US mortgage lending "sub-prime"
refers to loans that do not meet Fannie Mae or Freddie Mac guidelines.
http://en.wikipedia.org/wiki/Subprime_lending 24 Professor Nouriel Roubini of the Stern School of Business
at New York University outlined in February 2008.
http://www.marketoracle.co.uk/Article3677.html 25 Financial Armageddon and the Re-pricing of
Collateralized Debt, John Mauldin, 20 September, 2008.
www.marketoracle.co.uk/Article6364.html 26 Such as the big five investment banks, namely, Bears
Sterns, Lehman Brothers, Merrill Lynch, Morgan Stanley, or Goldman Sachs 27 Financial Armageddon and the Re-pricing of Collateralized
Debt, John Mauldin, 20 September, 2008.
www.marketoracle.co.uk/Article6364.html 28
http://www.nakedcapitalism.com/2007/11/cdos-ticking-time-bomb.html 29 Credit Default Swaps : Evolving Financial Meltdown and
Derivative Disaster Du Jour, by Dr. Ellen Brown, Global Research, 11 April,
2008, www.webofdebt.com 30 The Financial Tsunami has not reached its Climax — Credit Default Swaps : Next Phase of an Unravelling
Crisis, by F. William Engdahl, 5 June, 2008 31 2007 Year End Market Survey,
http://www.isda.org/statistics/recent.html 32 2001 Year End Market Survey,
http://www.isda.org/statistics/recent.html 33 Credit Default Swaps are a Valuable Invention, But Largely
Unregulated, Charles R. Morris, 10 June, 2008, The Washington Independent 34 Credit Default Swaps are a Valuable Invention, but Largely
Unregulated, Charles R. Morris, 10 June, 2008, The Washington Independent 35 The Financial Tsunami has not reached its Climax — Credit Default Swaps : Next Phase of an Unravelling
Crisis, by F. William Engdahl, 5 June, 2008 36 The Financial Tsunami has not reached its Climax — Credit Default Swaps : Next Phase of an Unravelling
Crisis, by F. William Engdahl, 5 June, 2008 37 Warren Buffet in 2002 Chairman’s letter to Berkshire Hathway Inc shareholders 38 The Financial Tsunami has not reached its Climax — Credit Default Swaps : Next Phase of an Unravelling
Crisis, by F. William Engdahl, 5 June, 2008 39 Notably, the U.S. banking major, J.P. Morgan Chase remains
by far the largest seller and buyer of CDS 40 The Financial Tsunami has not reached its Climax — Credit Default Swaps : Next Phase of an Unravelling
Crisis, by F. William Engdahl, 5 June, 2008 41 namely, Bears Sterns, Lehman Brothers, Merrill Lynch,
Morgan Stanley, and Goldman Sachs 42 Such as, Ambac, MBIA, FGIC 43 The Real Reason for the Global Financial
Crisis . . . the Story No One’s Talking About, by Shah Gilani, Consulting Editor, Morning
Monitor. http://www.marketoracle.co.uk 44 The Real Reason for the Global Financial
Crisis . . . the Story No One’s Talking About, by Shah Gilani, Consulting Editor, Morning
Monitor. http://www.marketoracle.co.uk 45 Warren Buffet in 2002 Chairman’s letter to Berkshire Hathway Inc shareholders 46 Refers to Charlie Munger, Vice-Chairman, Berkshire Hathway
Inc 47 An international organisation which fosters international
monetary and financial cooperation and serves as a bank for central banks 48 Shareholders equity of $44 billion of an outstanding
mortgage credit and guarantee business book of $2.89 trillion — Fannie Mae 2007 Annual Report 49 Shareholders equity of $26.7 billion on an outstanding
mortgage credit and guarantee business book of $2.10 trillion — Freddie Mac 2007 Annual Report 50 Merrill Lynch 2007 Annual Report 51 Lehman Bros 2007 Annual Report 52 Bear Stearns 2007 Annual Report 53 Morgan Stanley 2007 Annual Report 54 Goldman Sachs 2007 Annual Report 55 Lee Pickard, quoted by Julie Satow in the New York Sun, 18
September, 2008 — http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130 56 Either as writers or as trading positions in their
proprietary book 57 Credit rating 58 Financial system : shock absorber or amplifier ?
By Franklin Allen and Elena Carletti, BIS Working Papers No 257, July 2008,
(www.bis.org) 59 Rising Risk of a Systemic Financial Meltdown : The 12 Steps
to Financial Disaster by Nouriel Roubini, 12 February, 2008,
http://www.marketoracle.co.uk/Article3677.html 60 The financial turmoil of 2007–? : A
preliminary assessment and some policy considerations, by Claudio Borio, BIS
Working Paper 251, March 2008 (www.bis.org) 61 The financial turmoil of 2007–? : A
preliminary assessment and some policy considerations, by Claudio Borio, BIS
Working Paper 251, March 2008 (www.bis.org) 62 http://www.marketoracle.co.uk/Article3677.html 63 The Sunday Times, 21 September, 2008 64 Global Financial Stability Report, International Monetary
Fund, April 2008, chapter 2, Structured Finance — Issues of Valuation and Disclosure 65 ibid Annexure 2.1, The World According to GAAP, Kenneth
Sullivan 66 "Against The Gods" The Remarkable Story of Risk,
by Peter L. Bernstein, 1996, (John Wiley), pg. 334 67 ibid pg. 329-330 68 ibid pg. 335-336 69 The Sunday Times, 21 September, 2008 70 Great Depression, by Robert J. Samuelson in The Fortune
Encyclopedia of Economics 71 "Against The Gods" The Remarkable Story of Risk,
by Peter L. Bernstein, 1996, (John Wiley), pg.334 72 Source : Global Financial Stability Report,
International Monetary Fund, April 2008, Table 2.1, pg. 65 |
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