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Stock Market Activities of the Banks and Modern Global Crises




WILSON ERVIN, the chief risk officer at Credit Suisse, a large Swiss bank, cannot pinpoint the precise moment he knew something was up. But signs of the gathering subprime storm in America started to trigger alarms in late 2006.

Data from the bank’s trading desks and from mortgage servicers showed that conditions in the subprime market were worsening, and the bank decided to cut back on its exposures. At the same time Credit Suisse’s proprietary risk model, designed to simulate the effect of crises, signaled a problem with the amount of risk adjusted capital absorbed by its portfolio of leveraged loans. It duly started hedging its exposure to these assets as well. Mr Ervin could not have guessed at the sheer scale of what was coming. For nine months now, banks have been in a panic: hoarding cash, nervous of weaknesses in their own balance sheets and even more nervous of their counterparties.

More damaging still, money-market funds have steered clear of banks as well. The drying-up of liquidity not only created havoc in the backrooms of the financial system. It also wrecked the front door, thanks to the dramatic collapse of Bear Stearns, an 85- year-old Wall Street investment bank that in March. The Federal Reserve offered emergency was bought for a song by JPMorgan Chase funding to the investment banks for the rest time since the 1930s, and there were bank bail-outs in Britain and Germany too.

The economic effects are set to be just as striking. According to a study of previous crises by Carmen Reinhart of the University of Maryland and Ken Rogo of Harvard, banking blow-outs lop an average of two percentage points off output growth per person. The worst crises reduce growth by five percentage points from their peak, and it takes more than three years for growth to regain pre-crisis levels. With so much at stake if the banks mess up, regulators and politicians are now asking fundamental questions. Should banks be allowed to take on as much debt? Can they be trusted to make their own assessment of the risks they run? Bankers themselves accept the need for change. We’ve totally lost our credibility, says one senior European banker.

To regain trust, banks will not need to be totally bomb-proof. Safe banks are easy enough to create: just push up their capital requirements to 90% of assets, force them to have secured funding for three years or tell them they can invest only in Treasury bonds. But that would severely compromise their ability to provide credit, so amore realistic approach is needed. Thisspecial report will ask how banks shouldbe run and regulated so that the next timeboom turns to bust the outcome will beless miserable for all concerned.If the crisis were simply about thecreditworthiness of underlying assets, that question would be simpler to answer.

The problem has been as much about confidence as about money. Modern financial systems contain a mass of amplifiers that multiply the impact of both losses and gains, creating huge uncertainty. Standard & Poor’s, one of the big credit rating agencies, has estimated that financial institutions’ total write-downs on subprime-asset-backed securities will reach $285 billion, more than $150 billion of which has already been disclosed. Yet less than half that total comes from projected losses on the underlying mortgages. The rest is down to those amplifiers.

One is the use of derivatives to create exposures to assets without actually having to own them. For example, those infamous collateralised debt obligations (CDOs) contained synthetic exposures to subprime-asset-backed securities worth a whopping $75 billion. The value of loans being written does not set a ceiling on the amount of losses they can generate. The boss of one big investment bank says he would like to see much more certainty around the clearing and settlement of credit-default swaps, a market with an insanely large notional value of $62 trillion.

The number of outstanding claims greatly exceeds the number of bonds. It’s very murky at the moment. A second amplifier is the application of fair-value accounting, which requires many institutions to mark the value of assets to current market prices. That price can overshoot both on the way up and on the way down, particularly when buyers are thin on the ground and sellers are distressed.

When downward price movements can themselves trigger the need to unwind investments, further depressing prices, they soon become self-reinforcing. A third amplifier is counterparty risk, the effect of one institution getting into trouble on those it deals with. The decision by the Fed to offer emergency liquidity to Bear Stearns and to facilitate its acquisition by JPMorgan Chase had less to do with the size of Bear’s balance sheet than with its central role in markets for credit-default and interest rate swaps.

Trying to model the impact of counterparty risk is horribly challenging, says Stuart Gulliver, head of HSBC’s wholesale banking arm. First-order effects are easier to think through: a ratings downgrade of a monocline bond insurer cuts the value of the insurance policy it has written. But what about the second-order effect, the cost of replacing that same policy with another insurer in a spooked market?

The biggest amplifier of all, though, is excessive leverage. According to Koos Timmermans, the chief risk officer at ING, a big Dutch institution, three types of leverage helped propel the boom and have now accentuated the bust.

First, many banks and other financial institutions loaded up on debt in order to increase their returns on equity when asset prices were rising. The leverage ratio at Bear Stearns rose from 26.0 in 2005 (meaning that total assets were 26 times the value of shareholders’ equity) to 32.8 in 2007.

Second, financial institutions were exposed to product leverage via complex instruments, such as CDOs, which needed only a slight deterioration in the value of underlying assets for losses to escalate rapidly. And third, they overindulged in liquidity leverage, using structured investment vehicles (SIVs) or relying too much on wholesale markets to exploit the difference between borrowing cheap short term money and investing in higher-yielding long-term assets. The combined effect was that falls in asset values cut deep into equity and triggered margin calls from lenders. The drying-up of liquidity had an immediate impact because debt was being rolled over so frequently.

That is not to suggest that the credit crunch is solely the responsibility of the banks, or that all of them are to blame. Banks come in all shapes and sizes, large and small, conservative and risk-hungry. Alfredo Sáenz, the chief executive of Santander, a Spanish retail giant, recalls attending a round-table of European bank bosses during the good times at which all the executives were asked about their strategic vision. Most of them talked about securitization and derivatives, but when it was Mr Sáenz’s turn, he touted old-fashioned efficiency. He did not get any questions.

There were ‘clever’ banks and ‘stupid’ banks, he says. We were considered one of the stupid ones. No longer. Beyond the banks, a host of other institutions must take some of the blame for the credit crunch. The credit-rating agencies had rose-tinted expectations about default rates for subprime mortgages. The monolines took the ill-fated decision to start insuring structured credit. Unregulated entities issued many of the dodgiest mortgages in America.

And no explanation of the boom can ignore the wall of money, much of it from Asia and oil-producing countries, that was looking for high returns in a world of low interest rates. It is indisputable that the global glut of liquidity played a role in the ‘reach for yield’ phenomenon and that this reach for yield led to strong demand for and supply of complex structured products, says Gerald Corrigan, a partner at Goldman Sachs.

Many blame the central banks: tougher monetary policy would have encouraged investors to steer towards more liquid products. Others blame the investors themselves, many of whom relied on AAA ratings without questioning why they were delivering such high yields.

Out of the current turmoil may come some good, in the shape of a more sophisticated understanding of risk, a more transparent system of securitisation and a greater awareness of the incentives embedded in pay structures, as well as a new approach to regulation that ties capital and liquidity requirements to the risks banks take throughout the cycle. Just do not expect it to produce a permanent solution to the problem of financial excess.

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