A V Rajwade: When risk becomes uncertainty - II

Ill-liquidity transforms measurable price risks into unmeasurable uncertainty.

Our Banking Regulation Act defines banking as the business of accepting deposits for the purposes of lending. While a significant portion of the business of global banking falls within this broad definition, the more glamorous, venturesome and profitable part of banking consists of "trading" in assets ("Proprietory Trading: Risks and Rewards," Business Standard, June 8).

In fact, in so far as trading goes, the dividing line between banks and hedge funds has become thin in recent years. For one thing, major investment banks dominate the business of acting as "prime brokers" to the hedge funds "" lending money and securities, acting as counterparties to derivatives, and so on. In this role, the banks obviously are privy to the trading strategies of hedge funds and, howsoever strong and impenetrable in theory the Chinese walls between prime broking and proprietary trading, it would perhaps be naïve to believe that the latter is uninfluenced by the knowledge gained in the former. They are often trading in the same assets "" currencies, bonds, derivatives, equities, and so on.

If banks' proprietary trading parallels hedge fund trading, the funds have made inroads in the lending business, often willing to fund high risk-high reward loans, for example, financing leveraged buy-outs (LBOs) or investing in Collateralised Debt Obligations (CDOs). Currently, investment banks are sitting on something like $300 billion of LBO loans, which they are unable to sell. The recent crisis in the CDO market resulting from a large number of defaults in sub-prime mortgages, has strained, to some extent, the traditional close ties between prime brokers (investment banks) and their hedge fund clients. Hedge funds can earn high returns only by leveraging; as the CDO market became illiquid and prices crashed, the lenders called for more margins and, wherever it was not forthcoming, resorted to force sell the pledged assets.

Yet another dimension of the hedge fund-bank relationship is that most of the major investment banks, and a few of the large commercial banks, are themselves managing hedge funds. As may be recalled (see "The third big loss," World Money, July 2), the sub-prime market became headline news when two hedge funds managed by Bear Stearn, an investment banking firm, collapsed as a result of exposures to that sector. Another fund managed by Goldman Sachs has also come into trouble and Goldman has been forced to invest capital in it. Managers of the fund claim that the price falls in the sub-prime mortgage derived securities, was a "25 standard deviation event," which should occur once in, say, a 100,000 years. The Goldman managed fund apparently experienced such price falls several days in a row, an obvious manifestation of auto regression and fat tails, and the point I made last Monday: ill-liquidity transforms measurable price risks into unmeasurable uncertainty.

If the mortgage market crisis has affected some investment banks, and many specialised mortgage lenders, the American commercial banking system, headed by the likes of Citi, Morgan, BankAm, and so on, has been largely unscathed. On the other hand, in what was something of a surprise to me, several commercial banks in Europe (and in Australia, China, Taiwan, and others) have been affected by the problems of the sub-prime mortgage market in the US. While there was a recent spat between Barclays and HSBC, two of the world's leading banks, about lending money in the interbank market, the system most affected seems to be the German banks where at least two have had to be bailed out.

The trouble started with liquidity problems for the so-called "conduits," structured investment vehicles, or "SIVs," and "SIV-lites" (all off- balance sheet investment funds in increasing order of credit and asset liability risks) managed by banks: the aggregate size of such funds is $1,200 billion. Such funds often invest in AAA-rated CDOs, financed from Asset-Backed Commercial Paper (ABCP). CP is, of course, the cheapest source of short-term funding, generally backed by a line of credit from the sponsoring bank. As confidence in the sub-prime mortgage market and its derivatives vanished, the SIVs found it difficult to roll over the maturing CPs, and had to take recourse to the bank lines. Since the amounts involved were disproportionately large in the case IKB and SachsenLB, two German banks, they had to be rescued by state-controlled banks/financial institutions.

It is worth spending a minute pondering over the hierarchy of troubled banks "" the least affected were American commercial banks; some European commercial banks faced problems of one kind or another; but the worst affected were the German state-owned banks. Is there some lesson in this?

avrajwade@gmail.com