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The micro origins

By Andrew Sheng (chinadaily.com.cn)
Updated: 2008-11-17 10:27

Between 2001 and 2007, these 15 LCFIs tripled their balance sheets and increased their leverage markedly. The true scale of their trading was even more dominant if one considered that many hedge funds comprised former staff of these LCFIs, which also acted as their prime brokers.

When there were occasional calls to regulate the hedge funds even by powerful regulators such as the French or Germans, the US and UK regulators were the first to point out that the hedge funds were best regulated by their prime brokers. This was acceptable as long as the prime brokers themselves were sound. As we have seen this was not always so.

What was also not widely known was that instead of widely distributing derivative risks outside the banking system, much of the risks were concentrated within the banking system. According to BIS statistics, only 19 percent of OTC trades were with non-financial customers.

In the CDS market, 2006 British Bankers' Association data reported that the banks were 16 percent net buyers of CDS "protection", whereas the net protection sellers comprised insurance companies 11 percent, hedge funds 3 percent, and pension funds 2 percent. Since hedge funds were never risk holders, they would sell their risks back to the primary dealer at the first sign of trouble.

We now know that the shadow banking system grossly disguised the true level of leverage, grossly underestimated the liquidity required to support the market, grossly misunderstood the network interconnections in the global markets and enabled the key players to over-trade with grossly inadequate capital.

For example, at the end of 2007, the five US investment banks had total assets of $4.3 trillion, but only equity of $200.3 billion or a leverage of 21.3 times. However, together they had notional off-balance liabilities of $17.8 trillion, implying further leverage of 88.8 times.

But of course, they were allowed in 2004 by an SEC rule change to exempt their net capital caps of 15 times to value their derivatives according to their own sophisticated risk models, thereby opening up the leverage limit. In practice, perhaps only management fully understood their true leverage, because Bear Stearns had to be rescued despite the SEC Chairman protesting that it had capital adequacy even at the last minute.

Over the years, network theory tells us that the hub is robust and efficient so long as the links (the members of the network) are continually feeding and benefiting from the hub. However, if there is any doubt about the counter-party risks of the hub, then the members of the network are likely to withdraw resources rapidly to protect their own interests. The failure of Lehmans destroyed the myth that any major market maker in global markets was too big to fail.

That failure will go down in history as the trigger that set off the systemic crisis worldwide. Although it had only $620 billion in assets, regulators grossly underestimated that at the time of failure, Lehmans had a total of $1.6 trillion worth of counterparty positions that became frozen.

Since Lehman accounted for nearly 14 percent of trading in equities in the London Stock Exchange and 12 percent of fixed income in New York and it also managed client assets for hedge funds and investor clients, the liquidity of its counterparties were immediately impaired on default.

The default of Lehmans also triggered huge increases in CDS premia, which meant that those who sold protection had to offer immediately greater collateral. AIG, which had $441 billion of CDS positions, had to provide $14.5 billion to bring total collateral posted to $31 billion in a matter of days. If AIG had not been nationalized by an $85 billion loan in exchange for 79.9 percent of its equity by the Fed, its failure would have set off contagion failure beyond imagination.

The default on Lehman bonds also caused money market funds to fall below their $1 par value, so that there were immediate withdrawals from the $3.4 trillion money market fund sector. If that sector had collapsed, the liquidity crunch in the US would have been catastrophic.

The irony of the Lehmans failure was that it was an effort by the high priests of free market fundamentalism to demonstrate to everyone that they were acting against moral hazard, to demonstrate that no investment bank is too large to fail.

The decision had an opposite effect – it triggered the panic that almost broke the markets. In demonstrating that those who practice bad behaviour can be allowed to fail, the effect was to tell the market that another and another may also be allowed to fail, so that the best strategy to protect oneself is to cut and run.

Perhaps the middle of a crisis is not the appropriate time to prove a philosophical point. The correct anti-moral hazard action is during normal times, to be exercised dynamically in scale as financial risks escalate. With Lehmans, a massive deleveraging operation began and unfettered finance began to implode.

To be continued...

The author is chief advisor at the China Banking Regulatory Commission and former chairman of the Hong Kong Securities and Futures Commission.

 

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