Thursday, August 16, 2007

Turmoil tests system that spreads risk

From the FT Today:

Turmoil tests system that spreads risk

By Krishna Guha in Washington and Gillian Tett in London

Published: August 14 2007 18:59 | Last updated: August 14 2007 18:59

The turmoil in financial markets is providing the first serious test of the new securities-based global financial system – and of claims that it is inherently superior to the traditional bank-based systems it is gradually displacing around the world.

Most mainstream economists have long preached the benefits of the securities-based Anglo-American model, in which banks originate loans but sell them on to investors, rather than keeping them on their books.

The argument is that by slicing up risk in ever more sophisticated ways and dispersing it widely, securitisation made the financial system more resilient, as well as more efficient. In particular, it was supposed to shift risk away from the banking system, insulating the flow of finance to households and businesses from even large credit losses.

The new system sailed through its first tests – the General Motors and Ford credit downgrades in 2005, and market reversals in the spring of 2006 and February this year. But these were small. As one international economic official says: “Now we have the stress test everybody agreed is necessary to give us more understanding about how these products and markets will fare in adverse conditions.”

The official says the system did succeed in dispersing credit risk widely. But, he adds, the wide distribution of risk has itself created unforeseen problems. “Right now there is huge uncertainty as to where risk resides.”

The realisation of losses has also been dispersed over time, with different institutions marking their portfolios to market in different ways – ensuring a continued stream of bad news that has undermined confidence.

“The issue right now is that grenades keep going off all over the place, and no one knows where the next one will be,” says a senior policymaker.

This uncertainty has contributed to a rapid drying up of liquidity, in particular in markets for complex structured credit products.

The Achilles heel of any markets-based system is its reliance on liquidity and exposure to liquidity risk.

Most investor business models assume that it will always be possible to sell tradeable securities on to another buyer at the right price. Without active secondary markets, investors cannot value their portfolios – a development that has forced some financial institutions to freeze access to funds invested in asset-backed securities.

A freeze-up of liquidity is particularly dangerous for the market-based system because of the prominent part played by leveraged investors such as hedge funds. This makes the system vulnerable to a downward spiral of margin calls, in which banks trying to reduce their exposure to risk force troubled hedge funds to liquidate their assets – causing losses to other funds invested in similar securities.

So far the worst fears of a downward spiral have not been realised, but distress is clearly being transmitted through, and possibly amplified by, the hedge fund community.

Furthermore, the market is discovering that the securities-based system was not as good at distributing risk away from the banking sector as it appeared to be. Whereas a month ago the focus was all on hedge funds, banks are now in the spotlight. Prominent institutions such as Goldman Sachs and Bear Stearns have been forced to inject billions into troubled hedge fund subsidiaries to contain the damage to the parent company’s reputation.

Banks have been obliged to honour contingent credit lines to troubled entities. Others are having to take risks held in off-balance sheet investment vehicles back on to their balance sheets after being unable to refinance them in the market. This repatriation of risk back to the banking system raises the possibility that market events will affect the flow of credit to the real economy.

Some central bankers and regulators ponder whether the dispersion of risk in an opaque manner could even have reached the tipping point where it contributes to instability rather than mitigates it.

Others, though, think this is much too bleak a conclusion. The US at least has benefited from the global dispersion of subprime losses. No big institution or set of institutions looks likely to go under, in stark contrast to the Savings and Loan crisis in the 1980s.

The information problems in markets, these officials believe, are intense now but will abate over time.

“It is surely a lot better to have risks spread out and not be able to quickly identify them than to have it all concentrated in one or two large banks,” says Ken Rogoff, a professor at Harvard and former chief economist of the International Monetary Fund.

A senior policymaker adds: “It is a process of adjustment and education.” If he is right, the learning process may be painful but the system will emerge from its travails in better shape.

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