Monday, July 30, 2007
Market insight: What risk managers have learnt since the shock of 1998
By Michael Gordon
Published: July 19 2007, FT
Will the troubles in the US subprime market pass by as a little local difficulty – or will they start a rout across capital markets and bring to an end the great bull run in a broad range of asset classes? That’s the big question faced by those in capital markets right now.
Can history teach us anything on this score? Well, it’s certainly worth looking at the collapse of Long-Term Capital Management in September 1998. The near-demise of this mammoth hedge fund marked a turning-point for credit markets, hitting brokers and banks hard.
The debacle is less than a decade ago, but banks were smaller and less diversified firms in those days and so less able to absorb large shocks. Also, their risk management systems were not as well developed as they are now. When further risks emerged in Russia, the banks and brokers were not well-placed to handle the fallout.
The credit quality of the lending banks started to slip, triggering concerns about systemic risk. Spreads on swap instruments – proxies for banking liquidity that involve investors exchanging assets or an exposure to a cash flow – widened, which in turn put additional pressure on financial companies. As the liquidity crisis deepened, asset prices began to fall sharply. When the crunch ultimately came, there was a severe dislocation in asset prices.
The extent of this turmoil is neatly illustrated by the performance of investment banking stocks at the time. Sector shares tanked, losing a large chunk of their value in just a few weeks. Spreads widened, indicating a contraction in banking liquidity.
Wind forward to today. Does the collapse of confidence in the US subprime market have any similarities to the LTCM affair? Well, many of the weaknesses of the banks and brokers that emerged in 1998 have since been addressed. They are larger, more diversified institutions. They have also invested a great deal in risk management. Overall, the banks look far more resilient.
In addition, the banks have shifted much of the underlying credit risk into the hands of other investors. By parcelling up the risk through instruments such as collateralised debt obligations that are then sliced and sold to investors, the bulls argue that risk has been spread so widely that a single large failure can be absorbed more easily: the impact would be a thousand small dents rather a big hole.
Sure, there have been some justified concerns about the pricing of debt to support leveraged buy-outs, as well as worries about the volume of such lending. But, overall, corporate credit quality remains good. And the credit quality of banks has held up so far. The ratings agencies may move shortly to reassess CDOs, but the investment banks have seen no deterioration in their own ratings.
That's probably why there have been fewer concerns about systemic risk this time round. Some credit asset prices have corrected but broad liquidity remains sound. The bulls argue that what we are seeing is an orderly repricing of risk. Now take a look at the share prices of the investment banks. There has been no great sell-off as there was in 1998.
So is it really different this time? Have product innovation and industry consolidation helped create greater resilience across the financial system? Perhaps. But the bears will argue that while the banks may have insulated themselves against serious defaults, another group of investors now bears risks that are so complex in their structure that few really understand the implications.
They'll be less than happy when the music stops. And any credit meltdown is likely to hurt banks anyway. The bears also argue that CDOs and other innovative structures have, in fact, made the financial system less resilient because of their complexity and lack of transparency.
So far the markets have taken bad news in their stride, easily digesting the problems at two Bear Stearns hedge funds. But there is a strong sense in many quarters that the party is coming to an end. The subprime woes look a good candidate for the party-pooper, but if history teaches us anything it is that the biggest threats to markets are rarely the obvious ones.
*The writer is chief investment officer at Fidelity International ¶ 11:40 PM
Published: July 19 2007, FT
Will the troubles in the US subprime market pass by as a little local difficulty – or will they start a rout across capital markets and bring to an end the great bull run in a broad range of asset classes? That’s the big question faced by those in capital markets right now.
Can history teach us anything on this score? Well, it’s certainly worth looking at the collapse of Long-Term Capital Management in September 1998. The near-demise of this mammoth hedge fund marked a turning-point for credit markets, hitting brokers and banks hard.
The debacle is less than a decade ago, but banks were smaller and less diversified firms in those days and so less able to absorb large shocks. Also, their risk management systems were not as well developed as they are now. When further risks emerged in Russia, the banks and brokers were not well-placed to handle the fallout.
The credit quality of the lending banks started to slip, triggering concerns about systemic risk. Spreads on swap instruments – proxies for banking liquidity that involve investors exchanging assets or an exposure to a cash flow – widened, which in turn put additional pressure on financial companies. As the liquidity crisis deepened, asset prices began to fall sharply. When the crunch ultimately came, there was a severe dislocation in asset prices.
The extent of this turmoil is neatly illustrated by the performance of investment banking stocks at the time. Sector shares tanked, losing a large chunk of their value in just a few weeks. Spreads widened, indicating a contraction in banking liquidity.
Wind forward to today. Does the collapse of confidence in the US subprime market have any similarities to the LTCM affair? Well, many of the weaknesses of the banks and brokers that emerged in 1998 have since been addressed. They are larger, more diversified institutions. They have also invested a great deal in risk management. Overall, the banks look far more resilient.
In addition, the banks have shifted much of the underlying credit risk into the hands of other investors. By parcelling up the risk through instruments such as collateralised debt obligations that are then sliced and sold to investors, the bulls argue that risk has been spread so widely that a single large failure can be absorbed more easily: the impact would be a thousand small dents rather a big hole.
Sure, there have been some justified concerns about the pricing of debt to support leveraged buy-outs, as well as worries about the volume of such lending. But, overall, corporate credit quality remains good. And the credit quality of banks has held up so far. The ratings agencies may move shortly to reassess CDOs, but the investment banks have seen no deterioration in their own ratings.
That's probably why there have been fewer concerns about systemic risk this time round. Some credit asset prices have corrected but broad liquidity remains sound. The bulls argue that what we are seeing is an orderly repricing of risk. Now take a look at the share prices of the investment banks. There has been no great sell-off as there was in 1998.
So is it really different this time? Have product innovation and industry consolidation helped create greater resilience across the financial system? Perhaps. But the bears will argue that while the banks may have insulated themselves against serious defaults, another group of investors now bears risks that are so complex in their structure that few really understand the implications.
They'll be less than happy when the music stops. And any credit meltdown is likely to hurt banks anyway. The bears also argue that CDOs and other innovative structures have, in fact, made the financial system less resilient because of their complexity and lack of transparency.
So far the markets have taken bad news in their stride, easily digesting the problems at two Bear Stearns hedge funds. But there is a strong sense in many quarters that the party is coming to an end. The subprime woes look a good candidate for the party-pooper, but if history teaches us anything it is that the biggest threats to markets are rarely the obvious ones.
*The writer is chief investment officer at Fidelity International ¶ 11:40 PM
