Has the Federal Reserve calmed the global debt market or signalled a bigger problem? Justin O'Brienassesses the implications of re-pricing the securitisation of risk
The global ramifications of problems in the sub-prime (ie, high risk) mortgage market were first thrown into stark relief by a blue-chip French-based investment bank. In a statement on August 9th, BNP Paribas tipped already febrile equity markets into a dangerous tailspin. The bank froze withdrawals from three specialist investment funds because of what it termed "a complete evaporation of liquidity in certain segments of the US securitisation market".
The evaporation contributed to a financial Armageddon, respected commentator Jim Cramer said two days later on CNBC, the business news broadcaster. Unease in the US has since mutated into full-scale global contagion. The sub-prime problems - essentially rising defaults on low documentation loans provided to those with partial or negative credit ratings - have displaced private equity as the public face of excessive leverage. In reality both are symptoms of a wider problem: securitisation.
Securitisation involves transferring non-liquid asset pools, such as mortgages or corporate loans, into more tradable products. The impact of individual default is minimised by its insertion into a larger pool of similar assets.
For the initial provider of capital, securitisation has the added advantage of unblocking assets that may otherwise be required to remain on balance sheets under capital adequacy requirements. The combination of lower risk and immediate value extraction proved exceptionally alluring to US and international investors alike.
Securitisation is now integral to many firms' business strategy and the products populate many institutional investment portfolios. Hence the global nature of the crisis now emanating from the US.
The risks of this kind of financial engineering are not new, but he problems first identified in a small component of the US mortgage market have spread much faster and more virulently than expected. All of the gains this year in the S&P 500 index in New York were wiped out in trading last week. Stock exchanges from Sydney to London experienced comparable declines.
The re-pricing of risk has instilled fear and distrust in equal measure. Suspicion reached such dangerous levels that even the inter-bank overnight money market temporarily evaporated.
The Federal Reserve, the European Central Bank and the Reserve Bank of Australia injected more than US$100 billion into the markets, with the New York Federal Reserve alone buying $30 billion of the mortgage-backed securities that are at the centre of the maelstrom. Further negative news exacerbated the situation.
In the Cold War argot of CNBC's Jim Cramer, the escalation imperative was tipping dangerously to "Mutually Assured Destruction". This forced the Federal Reserve to cut its discount rate to banks by half a percentage point.
Within hours Deutsche Bank was availing of the facility, seen in the past as an indicator of mismanagement. By last Monday, the problems intensified. More than 80 per cent of the short-term financing obligations on that day could not be refinanced.
Given the global nature of the crisis, it was inevitable that the problems would spread to Europe and specifically to Ireland, which has emerged as one of the key regional centres for hedge fund and securitisation trading. Three conduit investment funds had amassed such significant losses that a €17.3 billion credit line had to be put in place by the German savings bank association to stave off the collapse of Saxsen LB, the State Bank of Saxony.
It appears a truly systemic problem is emerging, but it is not surprising to the central bankers or close observers of the markets. The looming conflagration over excessive leverage was signalled repeatedly earlier this year; warnings that were routinely ignored.
The market's failure to inculcate the value of restraint appears to demonstrate, as Strange predicted, pathological tendencies. Diagnosis of the malaise leaves two critical questions unresolved. How could the markets get the fundamentals of risk so wrong? How could a system designed to minimise risk actually spread it?
At the operational level, a profound miscalculation of the likelihood or salience of risk factors resulted in suboptimal design. The producers, financiers and consumers of a highly leveraged variant of the American dream failed to appreciate the dynamics of integrating desire, delusion and greed with lower opportunity costs.
Excess liquidity generated huge risk distortions. Arbitraging the difference between the cost of debt and rising house and commodity prices along with manufacturing profits led to abnormal returns that were enhanced exponentially by the power of leverage.
The process and its rationale percolated throughout society. From the boardrooms of Manhattan to the inner cities of the US, no barrier to lending was imposed. Just as low-documentation loans became pervasive in the sub-prime market, multi-billion dollar lines of credit were extended with little or no covenants. In part, this could be justified because the underlying debt was securitised and on-sold in the form of esoteric financial instruments known as "collateralised debt obligations" (CDOs).
The debt repackaging was, in turn, fundamentally mis-priced by rating agencies. Despite the inherently unstable nature of its core ingredients, the reconfigured parcels were provided with implausible and unsustainable credit rankings.
Institutional actors, precluded by governance mandates from holding products with a less than investment-grade valuation, followed hedge funds into products in which the ownership of economic risk was, at best, unclear. The faith placed in these products and the ratings system now appears unwarranted.
The credit freeze symbolises a profound climate change in global markets. Only a matter of months ago traders and those providing corporate advisory services were speculating (and salivating at) the possibility of a $100 billion buyout. Recent data from UBS suggests that more than $218 billion in committed funds remain non-securitised from the top five investment banks. Major deals are unravelling with alarming speed.
Investment banks are more willing to pay break-up fees than proceed with non-economic loans for which no secondary competitive market currently exists. In the UK, debt offerings for fundamentally sound corporations, such as the pharmaceutical chain Boots, have been pulled amid increasingly fraught attempts to renegotiate terms.
With corporate valuations slipping, reliance on much vaunted financial skills to manufacture the appearance of good performance will be treated with much greater scepticism. Engineering a winning strategy in the global financial casino has just become much more problematic.
• Justin O'Brienis professor of corporate governance at the Centre for Applied Philosophy and Public Ethics (an Australian Research Council-funded special research centre) in Canberra.