The trigger for the bloodbath in the markets on Thursday was the announcement by the largest French bank, BNP Paribas, that it was suspending redemptions on three of its funds.
This is what the bank’s statement said: “The complete evaporation of liquidity in certain market segments of the US securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating.” Shorn of the jargon, what exactly did it mean? The bank was saying that: one, some parts of the credit market had shut down; two, there were no buyers for “certain assets” regardless of quality; three, credit ratings weren’t worth the paper they were written on.
The French bank’s statement that there was a “complete evaporation of liquidity” for anything tainted by association with US subprime mortgages spurred the European Central Bank (ECB) to offer unlimited amounts of credit, in its capacity as lender of last resort. But that action was interpreted by the markets as proof that the extent of the contagion was much worse than had been assumed and the result was a massive sell-off.
But is the contagion really that bad, despite all the reassuring noises being made by US Federal Reserve officials? Well, ECB’s action was intended to infuse liquidity into the overnight market, because inter-bank rates had spiked. That meant banks were not willing to lend to each other because they were worried about counterparty risk. Note that the French bank had invested in what it considered were investment grade securities rated AA and above. This wasn’t some junk bond that couldn’t be sold, but supposedly good quality paper. As BNP Paribas had pointed out, the assets couldn’t be sold “regardless of their quality or credit rating”.
As for the extent of the contagion, consider how instruments such as collateralized debt obligations are structured. Bankers pool together many risky loans to borrowers whose creditworthiness is highly suspect, label it “subprime” and then get rid of them from their balance sheets as fast as possible. They usually make several bundles of these securities, marketing them to investors with different appetites for risk. The rule for these bundles is that they get hit in different ways in cases of default. Assuming that the historical rate of default is, say, 2%, then one bundle, comprising around 3-6% of the total loan amount is packaged and sold to high-risk investors, on the understanding that they would be the first to be hit in the case of defaults.
A second tranche, say 10% of the loan, is sold as slightly below investment grade, again on the understanding that they would be exposed to defaults after the high-risk investors. The rest of the loan is then marketed as safe investment grade paper, because, under normal circumstances, defaults wouldn’t affect them. That’s the process by which loans well below investment grade are converted into investment grade assets.
But creating the collateralized debt obligations (CDOs) was only the first step. Other banks then got into the act and offered protection against the probability of defaults on these CDOs. These second-order derivatives, called credit default swaps, offered another income stream for the banks offering them. And finally, these credit default swaps, in turn, could be bundled, sliced up and sold as CDOs, creating third-order derivatives. Given the difficulties of unravelling these structures, it’s perfectly possible for investors several times removed from the original loan to hold a lot of tainted debt, without even realising it.
Hence the uncertainty among banks. As independent research outfit Bank Credit Analyst points out in a recent report, “We doubt that all the bad news is discounted as the rating agencies have not completed their review of CDOs that contain subprime or alt-A mortgage debt ( that is, expect more downgrades and mark-to-market losses).”
Perhaps the root of the problem is much deeper. The credit boom of the last few years had led to a desperate scramble to lend money, without paying much attention to the creditworthiness of the borrower. That usually happens in the late stages of every credit cycle. Sooner or later, as the business cycle turns, the weak borrowers start to default, non-performing assets rise, banks call in loans and credit gets squeezed. Hyman Minsky, one of America’s foremost financial economists, believed that every crisis prompted intervention by the authorities to prevent debt deflation. But this intervention, in turn, sowed the seeds of another crisis by prompting excessive risk-taking behaviour. His model accurately described the US savings and loan meltdown in the 1980s and the tech boom and bust. UBS senior economic adviser George Magnus has called the current meltdown a “mini Minsky moment”.
Why not a full-fledged one? Because derivatives spread the risk, so the impact on most individual entities is limited. There is also plenty of liquidity, Japanese interest rates are still very low and even in the US housing market, AIG says, total delinquencies in its $25.9 billion (Rs1.05 trillion) mortgage insurance portfolio were just 2.5%. In short, the hope is that the credit problems will soon be contained. But then, remember how the stages of a bear market go? It starts with denial that there’s anything wrong, changes to hope that it will soon be fixed, which rapidly develops into panic as the hopes get belied and then, finally, we have capitulation.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.