Page 2 of 3 US government throws oil on fire
By Henry C K Liu
As I wrote three years ago (see
The repo time bomb, Asia Times Online, September 29, 2005):
As
with other financial markets, repo markets are subject to credit risk,
operational risk and liquidity risk. However, what distinguishes the credit
risk on repos from that associated with uncollateralized instruments is that
repo credit exposures arise from volatility (or market risk) in the value of
collateral. For example, a decline in the price of securities serving as
collateral can result in an under-collateralization of the repo. Liquidity risk
arises from the possibility that a loss of liquidity in collateral markets will
force liquidation of collateral
at a discount in the event of a counterparty default, or even a fire sale in
the event of systemic panic. Leverage that is built up using repos can
exponentially increase these risks when the market turns. While leverage
facilitates the efficient operation of financial markets, rigorous risk
management by market participants using leverage is important to maintain these
risks at prudent levels.
In general, the art of risk management has been trailing the decline of risk
aversion. Up to a point, repo markets have offsetting effects on systemic risk.
They can be more resilient than uncollateralized markets to shocks that
increase uncertainty about the credit standing of counterparties, limiting the
transmission of shocks. However, this benefit can be neutralized by the fact
that the use of collateral in repos withdraws securities from the pool of
assets that would otherwise be available to unsecured creditors in the event of
a bankruptcy. Another concern is that the close linkage of repo markets to
securities markets means they can transmit shocks originating from this source.
Finally, repos allow institutions to use leverage to take larger positions in
financial markets, which adds to systemic risk.
A crisis emerges
In the structured finance market, a separate crisis was emerging, exacerbated
by problems in the repo market. In March 2008, the Federal Reserve created a
new facility to swap up to $200 billion of its Treasury securities for
hard-to-trade mortgage-backed securities held by investment banks. A week
later, the Fed took over $29 billion of investment bank Bear Stearns'
obligations to prevent a chaotic failure of the firm and to enable its takeover
by JPMorgan Chase with loans from the Fed discount window and by limiting
potential loss to JPMorgan Chase to $2 billion. The Fed also opened its
discount window to investment banks, making it the first time since the Great
Depression that non-banks had been allowed to borrow from that window.
And in July, the Fed agreed to lend to Fannie Mae and Freddie Mac from its
discount window should it "prove necessary". In the same month, another
government arranged "shotgun marriage" induced Bank of America to acquire
Merrill Lynch at a fire sale price of $50 billion. On September 18, the Federal
Reserve pumped another $105 billion into the banking system.
Credit rating agencies may play a key role in structured finance transactions.
Unlike a "typical" loan or bond issuance, where a borrower offers to pay a
certain return on a loan, structured financial transactions may be viewed as
either a series of loans with different characteristics, or else a number of
small loans of a similar type packaged together into different loans called
"tranches". Credit ratings often determine the interest rate or price ascribed
to a particular tranche, based on the quality of loans or quality of assets
contained within that grouping.
Companies involved in structured financing arrangements often consult with
credit rating agencies to determine how to structure individual tranches of
debt so that each receives a desired credit rating to certify its risk
exposure. For example, a firm may wish to borrow a large sum of money by
issuing debt securities. However, the amount is so large that the return
investors may demand on a single issuance would be prohibitive. Instead, it
decides to issue three separate bonds, with three separate credit ratings: A
(medium low risk), BBB (medium risk), and BB (speculative), using the rating
system of Standard & Poor's. The firm expects that the effective interest
rate it pays on the BB-rated bonds will be more than the rate it must pay on
the A-rated bonds, but that, overall, the amount it must pay for the total
capital it raises will be less than it would pay if the entire amount were
raised from a single bond offering. This is the basic principle of structured
finance: the squeezing of financial value out of unbundling of debt.
As the transaction is devised, the firm may consult with a credit rating agency
to see how it must structure each tranche - in other words, what types of
assets must be used to secure the debt in each tranche - in order for that
tranche to receive the desired rating. The structure is such that the credit
rate of any one tranche will change if the credit ratings of other tranches at
the riskier end change. This could cause triple-A rated tranches to be down
rated in a down market.
Criticism surfaced in the wake of large losses in the collateralized debt
obligation (CDO) market that occurred despite being assigned top ratings by the
credit rating agencies. For instance, losses on $340.7 million worth of CDOs
issued by Credit Suisse Group added up to about $125 million, despite being
rated AAA or Aaa by Standard & Poor's, Moody's Investors Service and Fitch
Group.
The rating agencies respond that their advice constitutes only a "point in
time" analysis, that they make clear that they never promise or guarantee a
certain rating to a particular tranche, and that they also make clear that any
change in circumstance regarding the risk factors of any particular tranche
will invalidate their analysis and result in a different credit rating. In
order words, the risk structure is dynamic and systemic. In addition, most
credit rating agencies do not rate bond issuances upon which they have offered
rating structure advice, unless a firewall exists to avoid potential conflict.
Complicating matters for structured finance transactions, the rating agencies
state that their ratings are opinions regarding the likelihood that a given
debt security will fail to be serviced over a given period of time, and not an
opinion on the volatility of that security and certainly not the wisdom of
investing in that security.
In the past, most highly rated (AAA or Aaa) debt securities had characteristics
of low volatility and high liquidity - in other words, the price of a highly
rated bond did not fluctuate greatly day-to-day, and sellers of such securities
could easily find buyers. However, structured transactions that involve the
bundling of hundreds or thousands, or even millions, of similar (and similarly
rated) securities tend to concentrate similar risk in such a way that even a
slight change on a chance of default can have an enormous effect on the price
of the bundled security.
This means that even though a rating agency could be correct in its opinion
that the chance of default of a structured product is very low under normal
market conditions, even a slight change in the market's perception of, and
aversion to the risk of that product can have a disproportionate effect on the
product's market price, with the result that an ostensibly AAA or Aaa-rated
security can collapse in price even without there being any actual default or
changes in significant chance of default. This possibility raises significant
regulatory issues because the use of ratings in securities and banking
regulation assumes incorrectly that high ratings correspond with low volatility
and high liquidity.
Fed supports money market mutual Funds
The US Federal Reserve on October 21 announced it would create a Money Market
Investor Funding Facility (MMIFF) to support a private-sector initiative
designed to provide liquidity to US money market investors. MMIFF will finance
up to $540 billion in purchases of short-term debt from money market mutual
funds to shore up a key pillar of the US financial system.
MMIFF will provide senior secured funding to a series of special purpose
vehicles to facilitate an industry-supported private-sector initiative to
finance the purchase of eligible assets from eligible investors. Eligible
assets will include US dollar-denominated certificates of deposit and
commercial paper issued by highly rated financial institutions and having
remaining maturities of 90 days or less. Eligible investors will include US
money market mutual funds and over time may include other US money market
investors.
The implosion of Enron eight years ago was caused by "special purpose vehicles"
which were early incarnations of present-day "conduits" backed by phantom
collaterals. Enron's collapse was a high-profile event that briefly brought
credit risk to the forefront of concern in the financial services industry.
Collateral management rose briefly from the Enron ashes as a critical mechanism
to mitigate credit risk and to protect against counter-party default. Yet in
the recent liquidity boom, collateral management has again been thrown out the
window and rendered dysfunctional by faulty ratings based on values "marked to
theoretical models" that fall apart in disorderly markets. (See
The rise of the non-bank financial system, Asia Times Online, September
6, 2007).
Money market funds are facing severe redemption pressures since the financial
crisis deepened last month, forcing them to raise cash by scaling back their
short-term lending to banks and selling their holdings of commercial paper.
This retreat has contributed both to a freeze in the interbank market and a
steep decline in activity in the commercial paper market, which has made it
difficult for banks and companies to raise short-term funds.
The Fed move on October 21 highlights the extent to which policymakers are
concerned about US money markets, even as inter-bank lending rates dropping
slightly. Policymakers are also worried that moves to prop up US banks may have
undermined money funds, which compete with bank savings accounts.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
