Treasury: Peter Pontikis FCPA investigates how central banks responded to the sub-prime crisis that erupted in the USA last year
When the sub-prime crisis arose last year, the response by the world's premier central banks was almost immediate.
The Bank of England bailed out liquidity-strapped major mortgage lender Northern Rock to the tune of US$48 billion.
The US Federal Reserve cut both its prime inter-bank funds rate and its penalty discount rate by 50 basis points on 18 September. The European Central Bank cancelled an intended rate hike and actively provided liquidity in excess of US$200bn to the markets a figure over and above that provided by the Bank of England and the US Federal Reserve. Incidentally, this sum dwarfed even the worst-case scenario of defaults in the sub-prime market.
At the time of writing (late last year) most of the world's equity markets had recovered most, if not all, their 15 to 20 per cent losses recorded over the previous one to two months and in some cases (the US and Australia being of note) have actually registered new highs.
Additionally, for all the anguish about the US housing market, the US labour market and the US consumer appear immune to the sub-prime-lent housing market.
Indeed, it's the same situation in Australia. According to Reserve Bank figures in its September 2007 report, while there have been rises in mortgage stress in some pockets of western Sydney and Melbourne, delinquencies (according to the deputy governor of the reserve bank Ric Battelino) remain at historic lows.
This is not to say that the Reserve Bank has sat idly by as the credit fears of August and September crested. The bank provided liquidity to banks and the financial markets because local investors have also suffered losses.
While the response of the market and regulators appears to have had its desired effect, the implications of this credit shock will linger on. The US sub-prime debt market will almost inevitably face increasing news of fresh defaults. Into 2009 some $25bn a month in debt is due for resetting at higher interest rate levels. This almost guarantees that problem loans will continue to spasmodically grab the financial headlines in the quarters to come.
Corporations will also feel the need to lock in longer-term funding solutions in preference for the shorter-dated and erstwhile 'cheaper' funds.
The whole crisis reminded treasurers of the premium value of, and the avoidance of, concentrated risk of funding sources both at a point of origin and on a timing basis. As one Hong Kong-based structured finance dealer said: 'For the foreseeable future (one to two years) we will see a 'back to basics' return to financing.'
Bill Shields, a director of Queensland Treasury Corporation, saw the whole sub-prime crisis as a lack of supervision of the non-bank financial sector payments system (including off-balance-sheet funding activities of the banks).
He believes there was a lack of timely and hard post-crisis data that would have kept regulators and the market better informed. The crisis was more about confidence in the provided information and awareness of risk as much as it was about cost of credit. At the very least risk corporates' management functions and financial services providers will need to analyse the impact on their businesses and reassess their assumptions, policies and procedures in the light of this event.
Domestic Australian banks will need to acclimatise their balance sheets to the higher cost of funding as investors demand a higher margin for risk. Banks will continue to switch their funding sources to domestic markets, away from the bruised US asset-backed commercial paper and collateralised debt obligation (CDO) markets.
Non-bank lenders have been particularly hard hit, and will have more ongoing problems with competitive implications. Unlike banks they do not generally have a loyal deposit base where they can channel funds to their borrowing customers. In essence, they are obliged both to borrow relatively higher wholesale funds rates (charged to non-banks) and to pass them on in their entirety to a price-sensitive borrowing public.
Whether the banks will necessarily benefit from their non-bank competitors' woes remains to be seen. In practice the banks also have to cope with a parallel increase in borrowing costs, while at the same time they need to switch, and access, cheaper sources of funding.
One prominent domestic interest rate strategist suggests that a steep learning curve for young players is pushing the cost of domestic bank bill funding to a + 40 per cent margin over cash for even premium bank names. They recently averaged slightly higher than .010 per cent as banks switched sources.
From a risk management point of view the credit crunch of August and September was as much about funding or liquidity risk as it was about actual credit defaults. Arguably, the problem of the whole sub-prime debt and more general CDO and asset-backed funding space was the lack of liquidity in these instruments, both from an investor and issuer perspective.
It has highlighted the need for closer attention to the concept of funding risks and the stresses that are possible on funding lines. As the crisis shows, credit and liquidity are not just separate and additive risks, but are in fact correlated and multiplicative risks by nature.
Re-intermediation is now in vogue as banks take loans back onto their balance sheets and partially reverse a previous popular trend of securitisations. Practices in the US such as 'sales' where the seller washes their hands of risks and often the buyer had the seller give the undertaking to maintain a quality of loans in a CDO structure will become practices of the past.
These sales of loans or disintermediation of loans replaced the bank with a series of middlemen. For instance the bank (lender) is supplanted by a broker, loan originator and servicer (who collects the loan's cash flow). Loan originators having little incentive to monitor the quality of loans.
This basic hazard in the CDO and sub-prime mortgage model has been acknowledged, and in future CDO structures will be simpler. Rob Mead of the Australian arm of PIMCO (the world's largest private sector bond fund manager) suggested this in a recent interview for Risk Magazine.
This means, in effect, that the person who sells the CDO should also be responsible for the end-to-end distribution of the underlying loan, effectively moving back to the historical lending model.
In a speech at the height of the credit troubles in mid-September, RBA boss Glenn Stevens observed the murky nature of risks in these financial instruments.
The general market consensus now indicates that as a consequence of the inherent financial risks associated with these products, there is a preference for more simplified structures, with increased transparency of risk transfer (in all its forms) to the end investor. This also reinforces the need for a closer scrutiny of previous shoddy mortgage lending practices in the US (if not globally).
The downfall of CDOs has definitely raised questions about how the credit rating agencies assign ratings and manage conflicts of interest. The stock markets have punished the parent companies of the main agencies Moodys, Fitch and S&P in recent quarters, with each of their holding companies losing on average 3040 per cent of their stock value into the nadir of the September equity market crashes.
In a situation similar to the aftermath of the Enron debacle at the start of this decade, where the accounting firms were required to restructure their auditing and advisory functions, there are calls for regulation of the rating agencies.
Although some of the suggested regulations seem heavy handed, with little guarantee that timely or accurate universally comparable measure of risk will necessarily be the outcome. But this does highlight a need to structurally separate agencies' advisory arms from their ratings function.
Chris Huhne ran Fitch Ratings' sovereign debt rating arm during the height of the Asian financial crisis of 1997. He says it is unfair to suggest the agencies have a conflict of interest. After all, they do not underwrite deals, nor do they put up their own capital.
He says it would be 'crazy to compromise their reputation and market goodwill for just a rating fee'. At the same time he acknowledges the agencies will need to produce at the very minimum honest post-mortems of their work on structured investments.
However, one thing that the crisis has shown is that the criterion of a sound credit rating is not a sufficient nor adequate substitute for an investor's own research. Idealised default probabilities between corporates, asset-backed securities and CDOs of the same rating have ironically tended to be inconsistent and differ from each other. For example, in 2006 a AAA CDO had the same probability of default as a AA+ bond.
As many otherwise-conservative Australian local government councils recently discovered, reliance on AAA ratings was not enough protection in this most recent crisis. Credit ratings do change and sometimes AAA credits default. Enron is the most recent standout case.
What this suggests is that past assumed correlations and default models are not, strictly speaking, comparable. The Reserve Bank's assistant governor Philip Lowe observed that correlations tend to cluster in times of crisis.
For corporate credit markets, the sharp jump in credit spreads represents a watershed in the credit cycle. Although the lows in relative corporate credit spreads were passed in late 2006, what is surprising is not the direction but the speed of adjustment upwards of the cost of borrowing over and above that charged by the Reserve Bank.
From now on, as the global expansion matures and enters its seventh straight year of growth, the cost of private sector borrowing should rise at a rate faster than that dictated by central banks as lenders jolted by the volatility of August and September last year demand and will likely receive an increasing margin for the price of their money.
Though neither the world nor its economic system ended, various financial markets and prices were dislocated for a time.
It will take time for the impact to be fully accounted for and recovered from. It is an industry learning experience for an otherwise still maturing CDO-structured product market.
The financial crisis of the third quarter of 2007 represents a timely reminder of the need for all participants investors, borrowers or intermediaries and indeed regulators for more rigorous in-house risk monitoring and management.
Closer monitoring of both credit and funding risks in all forms and from all its possible origins needs to be given due attention to ensure that financial risks undertaken are transparent and totally understood.
Peter Pontikis FCPA is the group treasury strategist for Suncorp Banking. The opinions stated in this article are his own.
Reference: February 2008, volume 78:01, p. 56 - 58
