Lessons from the sub-prime debacle

Lessons from the sub-prime debacle


Use the best available tools to uncover risks that are not discovered by mathematical means, write WINSTON NGAN and CHEN JEE MENG


WHAT started out as a domestic US mortgage problem spread across the globe like a tsunami. Notwithstanding that Asian financial institutions, compared to their US and European counterparts, had more limited exposures to the US sub-prime market, the crisis reverberated in the Asian markets, triggering sell-offs in equity markets.


The chief perpetuator of the sub-prime debacle was collateralised debt obligations (CDOs). CDOs are pools of debt instruments, for instance, bonds or loans, which are repackaged into different tiers carrying various levels of risk. These are then sold to investors based on their risk appetite. These seemingly benign debt instruments, which were bought and sold on the premise that they diversified risk, were masking large exposures to highly risky debt, ie, loans to sub-prime borrowers.


In the case of the sub-prime debacle, the defaults were rapidly progressing into the higher quality tranches that are supposed to be buffered by diversification of the basket. The issue was that all the parties concerned grossly under-estimated the amount of losses that would occur on the CDOs’ assets. Given the ever-increasing delinquencies, investors quickly realised that many CDOs would not be able to pay back their own bond holders in full and liquidity in credit markets started to evaporate.


Despite millions being expended on implementing risk management systems in preparation of Basel II, what went wrong? If we are looking at perhaps uncovering some new-found risk insights, we will probably be disappointed, as the lessons learnt seemed to carry a strong flavour of plain old common sense.


To build up business volume, lax lending rules superseded the sine qua non of credit risk controls. From banks to investment houses to fund managers, the institutions involved did not pay attention to the quality of the loans. Amid the intricate structure of the whole supply chain, the inherent credit risk was virtually obscured, as the ‘I thought you had performed the due diligence’ mentality perpetuated from one layer to the next. In short, there is no substitute for fundamental credit analysis.


The risk management tools may not have factored in the requisite correlation factors along the passage of time. Indeed, was it not possible that the banks involved could have (i) applied the same credit analysis tools, (ii) originated loans through the same brokers, etc? What was perceived originally as one of low correlation may turn out to be highly correlated especially in times of market upheaval. Also, consider the possibility that the financial institutions could be using the same risk management/valuatio n models. Inadvertently, in times of market volatility, all the institutions read the same exit signals!


In addition, the risk professionals might have, in framing their analyses, considered only actual events due to data availability. As such, distressed scenarios that were reasonably possible based on market conditions but which had never actually occurred before, may not be considered. Any novice financial risk practitioner would tell you: ‘Be careful of the valuation of illiquid OTC instruments. ‘ Not surprisingly, the crisis re-highlighted the chasm between marked-to-model and marked-to-market.


Risk management practitioners must recognise that market valuations may be unreliable for certain types of structured finance instruments. This can be attributed to a host of reasons such as market illiquidity, and system limitations. Perhaps, instead of using point estimates of value, the risk practitioner could engage risk management strategies using ranges, to address and quantify the degree of uncertainty associated with the valuations.


In essence, financial engineering may not unveil all the inherent risks. Certain risks lie outside the radar of mathematical tools. Accordingly, risk practitioners should equip themselves with the best available mathematical tools and also techniques for uncovering latent risks that are not discovered by mathematical means.


Impact on Singapore financial sector


Singapore has come away from the sub-prime crisis relatively unscathed. Local banks have publicly disclosed that their total investment in CDOs amount to S$2.3 billion, of which 28 per cent contain some US sub-prime mortgages. The local banks’ exposure to US sub-prime mortgages is, therefore, small in relation to their capital base. In addition, the impact on the banks’ profitability might be limited in view that the positions are intended to be held to maturity. The final loss may be much smaller than the current market discounts.


Even amid current uncertainties, some believe that CDOs remain sound investment instruments if they are properly structured to achieve the desired returns and risk profile.


From an investment perspective, investors will probably have to contemplate increased market volatility in 2008, where solid returns are harder to come by. In the risk management arena, while we may see enhanced risk control practices, the issue, ie, whether we will learn from it will continue to linger on for a long time to come.


Source: Business Times


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