Standard financial theory suggests that risks should be borne by those who understand it best (and are hence able to take steps to hedge for it or mitigate it). But reality, as is borne out by the sub-prime crisis, seems to suggest exactly the opposite!
The latest annual report of the Bank for Internatonal Settlements (BIS) says, "By the time crisis hits it is far too late. It is well before then that people make mistakes. Usually, moreover, it is not those responsible for the mistakes who suffer, but everybody else."
The BIS notes: “There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking...Moreover, should liquidity dry up and correlations among asset prices rise, the concern would be that prices might also overshoot on the downside.”
Modern financial theory also claims that diversification of portfolio results in the reduction of risk. There can be no better example of portfolio diversification than some of the marvellous products of financial engineering like Collateralized Debt Obligations (CDOs). But despite the proliferation of such instruments, instead of reducing it, systemic risk in the global financial system appears to have increased.
Modern banks have also learned to hide away their risks in off balance sheet entities like Special Purpose Vehicles (SPVs) or Structured Investment Vehicles (SIVs), hedge funds, private equity funds etc. These off-balance sheet entities take on the loans issued by banks, and thereby free them to do more lending and assume ever more risk. This cascade of increasing risk is compounded by the fact that the banks are supported by very little equity capital, or very thinly capitalised, much less than that owned by many private equity firms.
About how the financial innovations of recent years has landed the entire financial system in a soup, Paul Krugman writes, "The innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized."
Gillian Trett writing in the FT, Draining away: four problems that could beset debt markets for years, argues that contrary to popular belief, the financial engineering of the past decade has not done much to diversify risk. He writes, "But the feverish financial innovation seen this decade has enabled banks to turn corporate and consumer loans into securities that have then been sold all over the world. Until recently it was presumed that this innovation had made banks stronger than before, because they had passed credit risk on to others. Consequently, regulators and investors tended to presume that the main threats to stability in the modern financial world came not from banks but risk-loving players such as hedge funds. Recent events have, however, turned these assumptions on their head. Although some hedge funds have run into problems, their losses have generally not posed any wider systemic threat. Instead, share prices of the banking groups have slid as it became clear that banks had offloaded less risk from their books as investors and regulators had presumed. Indeed, the interbank market is gripped by fears that more banks could soon tumble into crisis, as they run out of capital with which to write off loans. Sectors that had been widely ignored in recent years because they seemed utterly safe and dull - such as bond insurers, money market funds and structured investment vehicles - are also beset by a loss of confidence."
Nouriel Roubini, in an article, The Dark Matter of Financial Globalization, has blamed securitization for the increase in risk. Securitisation is the process by which lenders pool their loans into shares with or without structured tranches, and raise money in the capital markets. The banks and other lending institutions are therefore able to take out the credit risk from their books. They are backed by assets like mortgages, commercial and retail loans, credit card debt etc. Mortgage backed securties form over 80% of the market in asset backed securities.
It allows banks to remain in the mortgage business as originators and intermediaries without taking too much of the interest-rate, term and liquidity risks on to their own highly leveraged books. These risks are in turn transferred on to those investors who want longer-term, higher-yielding assets. By increasing liquidity it ensures that the riskier borrowers have access to more credit than before.
It sought to shift the risk of term-transformation (borrowing short to lend long) out of the fragile banking system on to the shoulders of those best able to bear it. What happened, instead, was the shifting of the risk on to the shoulders of those least able to understand it. What also occurred was a multiplication of leverage and term-transformation, not least through the banks’ “special investment vehicles”, which proved to be only notionally off balance sheet.
Despite the complexity of securitization transactions and instruments, the two fundamental concerns are the same - the quality of the underlying loan collateral and the pricing of this risk. Securitization, by transferring the loans from the balance sheets of the originating banks, encourages moral hazard by way of irresponsible lending. This can be reduced only by an incentive structure which prices the risk accordingly.
A paper by Robert Van Order, On the Economics of Securitization: A Framework and Some Lessons from U.S. Experience, offers a detailed analysis of the securitization market. The article puts the issue in perspective thus,
"Broadly speaking there are two models for funding loans: the portfolio lender model, which typically involves banks or other intermediaries originating and holding the loans and funding them mainly with debt, most often deposits, and the securitization model, which involves tapping bond markets for funds, for instance by pooling loans and selling shares in the pools. A central issue with securitization is that while securities markets are efficient sources of funding, they also involve agency costs because bond market investors are often at an informational disadvantage relative to other traders."
The risk transfer chain for securitization works something like this. The ability to transfer instead of holding risks, coupled with assymmetric information, increases the moral hazard of irresponsible lending. Unlike in the past when the extent of risk and the bearer of risk was easy to identify, complex financial instruments like CDOs have dispersed risk deep and across the system, making identification impossible. This makes it difficult to restructure or reschedule debt, thereby restricting one of the main levers of managing financial meltdowns.
There are three eaxmples which highlight how the financial complex transactions and sophisticated instruments, actually gave only an illusion of risk transfer. One, is the complex inter-relationship between the Wall Street Banks and the hedge funds and other alternative investment strategy vehicles. In the US, three investment banks - Goldman Sachs, Morgan Stanley, and Bear Stearns - dominate the prime brokerage, which provides hedge funds their finance (raised from high net worth individuals and other institutions) and also lend them shares for shorting. The fact that these three act as brokers for 60% of all the hedge fund assets is itself a cause for concern arising out of lack of diversity. What is more disconcerting is that these banks may actually be taking back all the risks they purport to sell away. Consider the example of credit derivatives. Banks owning corporate bonds buy credit default swaps (CDS) to hedge against defaults. But if the swap is purchased from a hedge fund, which itself depends on the Bank for loans, then we have effectively no transfer of risks!
Second example of risk not adequately hedged is the potential conflict of interest between the regular trading desks of the investment banks and the prime brokerage arms. The prime brokers who work closely with the hedge funds, are likely to have valuable information about the positions taken by the hedge funds. This leaves the door open for the prime brokers to share this information with the trading desks.
The third example of risk being scattered within the same organization, while giving the impression of diversification, was the Kilo Funding, pioneered by Bear Stearns. Kilos were CDOs issued by Bear Stearns, which sought to tap the short term money market funds, by offering higher than regular interest, and a "liquidity put" guaranteeing the full repayment, issued through a Wall Street Bank. The money was in turn used to provide cash for the hedge funds owned by Bear Stearns and also buy ABS from the Bank itself and the hedge funds. The entire risk was localised within Bear Stearns and the Wall Street Bank!
Andrew Leonard highlights the role of hedge funds, with limited expertise in insurance and risk management, in selling Credit Default Swaps on everything from corporate default swaps to subprime CDOs, as insurance against defaults. Even worse, the hedge funds were selling protection to investment banks that were their own sources of credit. In other words, they were borrowing money from the same banks that they were insuring against bond default. So if the default occurred, they'd have to make good their own lender.
Andrew Leonard also makes a very forceful case for regulating financial markets, so as to limit the uncontrolled dissemination of risk, "The events of the past year have demonstrated precisely what can and will happen when you don't have well-regulated markets. Left essentially to themselves, the best and brightest of Wall Street proved that they were unable to properly price or manage risk, and instead, through their incessant striving for higher yields created massive incentives for all kinds of irresponsible behavior, from the borrower who lied about their income to the bank that repackaged loans into fancy new securities to the agencies that rated those securities."
The last word on risk management in modern financial markets should go to Frank Partnoy (agains thanks to Andrew Leonard), "In the long run, "risk" is being sold off by people who know best how to evaluate it to people who don't know what they're in for."
Update
Ben Stein has a trenchant critique of the way short sales and traders have wreaked havoc on the financial markets. He writes, "The losses in United States markets alone are on the order of about $2.5 trillion in recent weeks. How can a loss of roughly $100 billion on subprime — with some recoveries sure to come as property is seized and sold — translate into a stock-market loss 25 times that size?"
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