In a luxurious chateau in Alsace, France, eight years ago, a top financier made a confession: Some of the complex financial instruments being pumped out by the world's biggest investment banks were potentially "toxic."
Top regulators were left in no doubt of the perils hiding in the financial system after the two-day summit aimed at finding and disarming the "bombs" waiting to explode.
The warning proved to be prescient. About a year ago, one of these bombs exploded. The ensuing credit crunch could lead to a complete redrawing of the financial map and may even herald the end of globalization.
ILLUSTRATION: MOUNTAIN PEOPLE
The toxic instruments highlighted by the banker were collateralized debt obligations (CDOs). Little was known of them when this regulatory teach-in was taking place, but since then banks have embraced them as a way of shifting debt off their balance sheets, enabling them to lend more. They have been bought enthusiastically by many investors across the financial system. As they began to blow up last year, there was mayhem at banks and brokers on Wall Street, which, in turn, sent shock waves through the world's financial markets.
CDOs are the villains of the market turmoil. Before they unravelled, however, they fueled easy credit and economic growth in many developed economies.
Britons amassed a record £1.4 trillion (US$2.77 trillion) in debt - more than Britain's GDP - as banks loosened their lending criteria. Millions of Americans with poor credit histories who might not otherwise have bought their homes were granted subprime mortgages.
But as gridlock gripped the markets, the repercussions have been painful. A record number of Americans are having their homes repossessed. Britons are finding it tougher to obtain credit and home loans. The damage is still being quantified, but it is already far-reaching. British bank Northern Rock was nationalized by an embarrassed government. The US Federal Reserve orchestrated the rescue takeover of investment bank Bear Stearns. Rogue traders were found at French bank Societe Generale and Swiss bank Credit Suisse.
`Old-fashioned banking'
Financial regulators now talk of a return to "old-fashioned banking," in which banks grant loans only to clients they know and from resources already available. It is starting to happen.
Last week in Britain, First Direct - part of HSBC - withdrew all mortgages apart from those for existing customers, while other lenders are demanding bigger deposits before handing out home loans. The US is redrawing the regulatory landscape for its financial services industry - as it last did after the Great Depression - and the British Financial Services Authority (FSA) is hiring 100 new regulators. Some bankers concede that fear is stalking the financial system and that markets have become so complicated that it is difficult to work out exactly what is going on.
Terry Smith, who 20 years ago was the City of London's top-rated banks analyst and is now chief executive of the money-broker Tullett Prebon, admits that calculating banks' vulnerabilities is harder now.
"I could tell you Barclays' [bank] sensitivity to a 1 percent move in interest rates," Smith said of the situation 20 years ago.
These days, the straightforward business of taking in deposits and lending the money out to others has become more sophisticated through the use of financial engineering such as CDOs.
Howard Davies, who heard the warning about CDOs in Alsace in 2000, first warned London about the toxic nature of some financial instruments in January 2002, when he was chairman of the FSA.
"One investment banker recently described synthetic CDOs to me as 'the most toxic element of the financial markets today,'" he told a City of London audience. "When an investment banker talks of toxicity, a regulator is bound to take a heightened interest."
Six years on, Davies is director of the London School of Economics and modest about his ability to claim that he was one of the first to foresee the events of last summer, when these CDOs proved their toxicity. He declines to identify the banker and launches into a lengthy description of what was worrying him. The distilled version is that insurance companies were buying products they did not understand because they were attracted by the higher returns on offer. Little attention was paid to any potential risk because the rewards were so attractive. He describes these CDOs as "naive capital."
His remarks at the time were aimed at insurance companies. But it is clear that investment in CDOs and other complex derivatives were much more widespread. The business had boomed from when the first CDO was said to have been issued in 1987 by bankers at the now defunct Drexel Burnham Lambert. In 20 years, the size of the market was estimated to have reached US$2 trillion.
It boomed between 2004 and last year, but its demise has been rapid. Last week, the Bank for International Settlements - the central bank for central bankers - reckoned that the market for certain types of asset-backed CDOs was likely to disappear entirely. Alliance & Leicester
Richard Banks, director of wholesale banking at Alliance & Leicester in Britain, is one unlikely to lament their demise.
After Alliance & Leicester wrote down £185 million in losses, Banks said: "We regret it ... This has got to be regretted."
In 1999 when Alliance & Leicester - once seen as a safe haven from such risky investments because of its roots as a building, or mutual, society - dipped its toes into CDOs, it believed this would "diversify the asset mix" and improve returns on investments.
Wall Street banks that make Alliance & Leicester look like a minnow must have their regrets too. They reaped profits from selling these CDOs in the good years. But near the end of last year, Merrill Lynch, Citigroup and Bear Stearns - which collapsed into the rival firm JP Morgan Chase - had to admit the extent of their problems.
The key player in CDOs, Merrill Lynch, was forced in the space of two weeks in October to increase write-down from exposure to these instruments by US$3 billion to US$7.9 billion.
Then Merrill chief executive Stan O'Neal said: "We made a mistake. Some errors of judgment were made in the business itself and within the risk-management function."
O'Neal was out of a job a week later. Merrill has since increased its write-down to US$25 billion.
O'Neal was only the first of the bank bosses to go. Only last week, Marcel Ospel, one of the most respected and long-standing figures in European banking, agreed to leave UBS after it announced 12 billion Swiss francs (US$12 billion) in losses in the first quarter of this year after a stunning SF19 billion write-down for CDO and subprime losses. Ospel's head is unlikely to be the last.
The banks are providing the most dramatic illustration of the impact of CDOs. But insurance companies are revealing their exposure to the products, too, and the US company Bristol Myers Squibb has shown that the crisis has spread to the corporate sector after writing down the value of investments related to the subprime mortgage crisis by US$275 million.
In Britain investors are unlikely to escape unscathed. An example of the credit crunch on an investment that may be regarded as a relative safe haven for investors is the money market fund run by Threadneedle, which data provider Trustnet says is the biggest of its type in Britain and the only one to show a negative return. It has invested in instruments issued by Standard Chartered's off- balance sheet vehicle Whistlejacket and collateralized loan obligations, in the CDO family. The company blames the credit crunch in general, rather than the loan investments, for the performance.
TOXIC ELEMENT
To offer his explanation, the director of a bank brandishes a pen and few sheets of paper, drawing a CDO and all the different tranches that it comprises. It helps illustrate the point that Davies was making all those years ago. At the bottom of the pile is the riskiest tranche - the parts that are almost worthless, the toxic element that the banker had warned regulators about at the beginning of the millennium.
This is what Davies was worried about and where the insurers could be accused of investing "naive capital."
"My concern is that there were people with naive capital who were buying the bottom tranches, not realizing just how risky they were," Davies said. "My point was not that the total of CDOs were toxic, but that the bottom bits were particularly toxic."
Hence his reluctance to claim credit for spotting the extent of the crisis. Now on the audit committee at the Wall Street bank Morgan Stanley, Davies has a front-row seat to watch how "the toxicity has spread up the ladder."
Relying on high credit ratings from the rating agencies and investors who were not too concerned to explore the risks involved, investment bankers were able to pull off their piece of financial engineering by selling on CDOs to other investors - rival investment banks, insurance firms and pension funds.
It is what FSA chief executive Hector Sants has called the "originate and distribute model."
In theory, pushing CDOs and other cleverly engineered products around the financial system spread the risk. But in practice it made it difficult to work out where the explosions were going to occur. But until August, it had become so easy to sell on the risk that many investment banks were relaxed about it. The banker with the pen and paper reckons that the traders responsible for selling on the CDOs started to allow some of them to remain on their books, confident they would soon be able to pass them on. As difficult as it may be to comprehend, the Bank for International Settlements (BIS) said last week that demand for certain types of CDOs was so high last summer that firms were able to transfer more subprime risk to investors than actually originated in 2005 and 2006.
The BIS said that "a few fundamental tenets of sound financial judgment appear to have been violated."
The banks' own risk models - used widely across the industry and created to meet regulatory requirements - failed to identify CDOs as risky. This is because major trading houses are required to use a value-at-risk (VAR) system to analyze the value of products on a daily basis. They are scrutinized by bank bosses, who focus on the biggest risks at the top of the list and pay less attention to those at the bottom.
As a result, bosses failed to notice CDO positions. Volatility is a key component of VAR and because the volatilities for certain types of CDOs appeared to be low, they were towards the bottom of the sheets handed up to boardroom bosses.
The banker said: "The historic volatility of the senior tranches of CDOs was very low. So at a senior level, lots of banks didn't know they had any. On the whole, the stuff was moved off trading books to other investors, but teams started to get lazy because the CDOs were perceived to be very low VAR."
THE HUMAN EYE
Eric Knight, a veteran fund manager whose Knight Vinke investment house is pushing for change at HSBC, raised concerns about banks' ability to work out what is going on in a letter to HSBC's management.
"It is salutary to remember that state-of-the-art risk-management systems at leading banks such as UBS, Credit Suisse and Societe Generale were unable to prevent the occurrence of substantial unexpected losses, much to the embarrassment of their boards," he wrote.
No matter how sophisticated the statistical models, humans with specialist knowledge do better, Knight said.
"However complicated the product, the best risk-management system is the eyes. I like to look in the eyes of my managers, and they to look in their people's eyes," he said.
Another bank director tries to explain that the way the markets have begun to operate has made it more difficult to run a bank. There are investors who want the CDOs and other instruments to fail because they will make more money. In the world of high finance - populated by mathematical geniuses rather than bankers - products were created that paid out if the CDOs went into default.
This may seem perverse to those outside the financial markets, but traders will usually bet on anything. These products were largely bought by hedge funds, who will do best if the defaults happen. Whereas some high-profile hedge funds have failed because of the credit crunch, many may prosper.
So there is a fresh problem for bankers dealing with struggling clients. Ordinarily they would fight hard to help them, but now find themselves in a position where it makes sense to allow them to go under because another part of the bank had a "short" position in their stock. In other words, they are betting that the company will run into trouble.
Sants admits that he believes this modern era of banking is unlikely to be restored when the current market turmoil has ended.
Banks, he said, will start to "behave, as it were, more like banks behaved in the past."
They may not have much choice - the credit crunch has made it harder to raise funds on the money markets to lend to customers or to create intricate financial products in the way they were able to during the boom.
So the credit crunch may lead to a return to banking basics. Regulators are expected to get tougher and the market for CDOs is probably dead.
The banks have only themselves to blame as they are reluctant to do business with each other. Banks fear their rivals may be holding CDOs that they have not revealed. The value of these holdings is eroding rapidly.
Banks do not want to lend money to each other because they are hoarding funds for themselves and worried that their rivals may not be able to pay them back.
The price of uncertainty in the markets is best illustrated by the stubbornly high level of the London interbank offered rate, at which big financial institutions lend to each other. It should almost match the official Bank of England base rate of 5.25 percent, but is closer to 6 percent.
Privately at least, banks are also preparing for demands from regulators to raise capital to bolster their balance sheets. To some extent, this has already begun. Sovereign wealth funds have already ploughed billions of dollars into financial firms in the US and Europe. Investors are certainly braced for this eventuality - and many welcome it.
Robert Talbut, chief investment officer of Royal London Asset Management, said: "I believe that banks will need to strengthen their capital ratios. That's clearly being driven by the demands of regulators. All parties want the banks to look more solid. Without strong banks, we can't get out of this current credit position."
Stronger banks should start to do business with each other again and help kick-start the moribund financial markets. But the credit crunch is not over yet. As Smith points out, the complex structure of the financial system will remain. Big corporations are also major players in the financial markets and unregulated.
"Porsche has a finance director who runs a hedge fund," Smith said. "They make far more from their financial trading than they do from trading cars."
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