Nov 12, 2007 03:04 PM

Economist: Super Fund, Super Folly

By Andy Xie, guest economist to and a board member of Rosetta Stone Advisors Limited

In addition to the surprise 50 bps rate cut by the Fed on Sept 18, the concept of a Super Fund, supported by the US Treasury, that would buy illiquid sub-prime securities has boosted investor confidence. Global stock markets have reclaimed the highs that were reached before the sub-prime crisis. I believe that the Fed rate cuts will not hold the slide of the US housing price, which would trigger a consumption-led recession in 2008, and that the Super Fund will not fly despite the Treasury support. Global stock markets believe wrong that the US economy would sail through the sub-prime crisis without a recession. When they are proven wrong, global stock markets would adjust downwards, possibly by 10-15%. However, as emerging economies have put enough money on the side for rainy days, they will continue to spend despite some export slowdown, and emerging economies will do well in 2008. Hence, emerging markets may perform well after the US recession-induced correction.

There are many structured investment vehicles (SIV) that have supported demand for sub-prime securities. These are special investment vehicles set up by banks or hedge funds to borrow money through issuing short-term commercial papers (loans due in 270 days or less) to buy securitized sub-prime mortgages or other high-risk debt instruments. The investors that own these vehicles put in some equity capital to decrease the risks to the investors in the commercial papers that they issue. The rating agencies rate these commercial papers to signal investors what risks they take. The ratings for these commercial papers are much higher than the debt instruments that the SIVs buy. The rationales are (1) that the equity investors suffer losses first and (2) that diversification, i.e., these funds buy many high-risk debt instruments that in theory are not correlated in default risks, decreases the overall default risk of the fund. The profit for the SIVs is the interest rate difference between the commercial papers and the sub-prime mortgages.

These funds are essentially banks that borrow short-term money and lend longer-term to risk borrowers. Banks pay people interest for their deposits and lend the money to businesses or households at higher interest rate. For the profit from the interest rate difference, banks take credit risk (their borrowers may go bankrupt) and duration risk (depositors can take back their money anytime, but their borrowers return on a fixed schedule). A bank can get into trouble for two reasons. First, many borrowers can default at the same time and their capital is not adequate to cover the losses. Second, depositors want to take money out at the same time and they don’t have all the cash to meet their obligations. The two often happen at the same time. When bad news on a bank’s lending quality leaks out, its depositors panic and want to take their money back. A bad loan crisis can quickly turn into a liquidity crisis.

For example, Northern Rock, a British bank that specializes in mortgage lending, went into a liquidity crisis in September. It is a sub-prime lender in the UK. The US sub-prime crisis sparked concerns about the UK sub-prime lenders. Northern Rock couldn’t borrow in the interbank market. As the news leaked out, its depositors panicked and began mass-withdrawing money, which was the UK’s first bank run in 140 years. The bank run forced the Bank of England-the UK’s central bank to bail it out.

The nature of a banking crisis just forces governments to bail out the banks, as panic by depositors will snowball into a liquidity crisis and bring down the whole economy. Hence, governments regulate tightly what banks can and cannot do. The most important regulation is the requirement of capital equal to 8% of deposits. SIVs are banks without depositors. Instead, they obtain funds from issuing commercial papers. They profit the same way as banks by taking on credit and duration risk. Instead of governments, rating agencies are their effective regulators, as the ratings determine what interest rate the buyers of the commercial papers demand.

As I have written here before, the rating agencies hold more responsibility for the current credit crisis than anyone else. The rating agencies are semi-regulatory agencies but are for profit businesses. They have powerful incentives to risk their reputation for profit. The rating agencies were offering standardized cookie-cutter products for rating such commercial papers. After the first job, the cost for follow-on works is minimal. It is not wrong for rating agencies to make money. Otherwise, how could they support themselves? The problem arises when they stretch truth for profitability. The fatal assumption they make in rating the SIVs is on the diversification benefit from pooling mortgages together. The sub-prime products are viable if property price continues to rise. This macro assumption that underpins the market cancels most of the diversification benefit from pooling. What the rating agencies have done may be fraudulent. I think they could be sued by investors.

The buyers of the commercial papers are guilty too. They invest other people’s money but share in the profits. Hence, they have powerful incentives to take excessive risk. If the investments work out, they become rich. If the investments fail, they at most lose their jobs. What rating agencies offer are covers for them to take excessive risks. They can tell their investors that they are buying highly rated products.

The financial institutions that put capital into the SIVs were hiding risks that they were taking through such off-balance sheet vehicles. As discussed above, governments tightly regulate banks as they have to bail them out in case of failures. By definition, banks want to take more risk if they can hide it from government regulators. The off-balance sheet vehicles are accounting loopholes that allow banks to do so. Now we must bring in the other major player in the credit bubble, accounting firms.

You may recall that the collapse of Enron that brought down a major accounting firm, Arthur Andersen. The problem there bears striking similarities to the SIV problem. Enron was essentially a commodity trader masquerading as an energy firm. As it was classified as an energy firm, it wasn’t subject to banking regulations like commercial or investment banks and could take on more risks without being noticed. But, its business was identical to a proprietary commodity trading desk as an investment bank. This is why, after its collapse, investment banks hired some of its employees. It also used off-balance sheet vehicles to hide the risks that it was taking and even manufactured earnings through such vehicles. After its collapse its accountant-Arthur Andersen, a firm founded in 1913 and one of the big five collapsed. The big five became big four.

Like rating agencies, the big accounting firms are semi-regulatory agencies. Markets depend on their opinions to assess the financial health of listed firms. Their shares, bonds, or derivatives trade on the words of accounting firms. Hence, accounting firms have enormous power over their clients. They explored such power by setting up consulting firms to obtain businesses from their clients in non-accounting services. After the Enron collapse, this conflict of interest rate was noted by the US government, and the subsequent regulatory changes forced them to divest such non-accounting businesses. Accounting firms, however, have other conflicts. They get paid more for more accounting services. When a bank sets up off-balance sheet vehicles, their accountant must offer opinions on if such vehicles can be accepted as so. Knowing that they will get paid more for similar works in future if they say yes, the bias is inevitable.

Rating agencies and accounting firms feature prominently in most financial scandals. The reason is that they are for profit but perform regulatory functions. The temptation always exists that they would compromise for more profits. After a scandal, they become cautious for a period but will probably come back to the old ways again. Their behavior is an important factor in financial cycles. But, because governments cannot be accountants or rating agencies, the world probably needs to live with such financial follies from time to time.

The SIVs essentially hide the risks that banks take to make their profits. It is a deliberate effort to mislead financial markets that would have discounted their earnings more severely against the risks that they were taking, i.e., their shares deserved lower P/E ratio. In addition to the inherent incentive of banks to take more risk unnoticed, the CEO incentives played a bigger role in the sub-prime bubble. The CEOs of top financial institutions receive enormous incentives to boost their earnings. In particular, they receive big amounts of stock options that would be worth billions of dollars if their share prices reached certain levels. Hence, they always have powerful incentives to take more risks for bigger profits. For example, if a business has a 50-50 chance to succeed and, if successful, earns 100% return. A normal businessman would ignore such an opportunity as, discounted by winning odds, it doesn’t earn money. A CEO of a major bank may pursue that. If the outcome is a failure, his stock options would still be worthless like before. If the outcome is successful, his stock options could be worth much more due to higher earnings and, hence, higher share prices. Of course, financial markets know such possibilities and scrutinize what risks a bank takes carefully to determine the prices for its shares or bonds. This is why the big banks set up the SIVs to hide their risk taking activities from financial markets.

The SIVs made profits for banks that set them up in two ways. First, banks made billions of dollars in underwriting the securitization of sub-prime products. They created demand for their products by setting up such vehicles. They put in their capital to embolden the buyers of commercial papers who provided most of the funding for the sub-prime products. The capital from the banks in theory offered them a cushion against sub-prime default risk. As I wrote before, this cushion is not as meaningful as usually the case, the viability of the sub-prime products depended on property price rising, which is a macro risk that the capital could not offset. The banks could book the profits from the underwritings immediately to increase their earnings. In theory, the banks that sold the sub-prime products sold to themselves. The SIVs just performed an accounting trick to take the products off their balance sheets.

Second, as property price kept rising, the SIVs also netted income on the capital that the banks put in. The double sources of income made the sub-prime business very profitable. This is why so many banks bet so big in this business.

The losses that have surfaced relating to SIVs stem from the inventory of sub-prime products that have not been sold and the reduction of the asset value within existing SIVs. Merrill Lynch wrote off ＄8 billion in the third quarter of 2007 due to the former. More banks are likely to do so in future. The second source of loss is just beginning.

Even though the SIVs are really Enron’s, after the sub-prime crisis began, the US Treasury encouraged the involved banks to set up a Super Fund of ＄80-100 bn to buy illiquid assets from the SIVs that sat in these banks. These SIVs are funded by short-term commercial papers to fund purchases of sub-prime products. As their commercial papers mature, unless they can refinance, they have to sell the sub-prime products to raise cash to redeem the commercial papers. Otherwise, these SIV’s must declare bankruptcy. Of course, under the current circumstances, no one wants to refinance these SIVs. But, the market for sub-prime products is very thin also, as investors got burnt before and would be hesitant to buy even if these products are heavily discounted. The rating agency, Fitch, estimates that the SIV’s are now worth 70.9% of the capital initially invested. In an illiquid market, it is difficult to estimate the true value of an asset. One horrible practice that is coming out now is that the SIV owners estimate the value of assets themselves. As long as they didn’t have to sell, no one noticed it. The SIVs have assets with notional value of ＄320 billion. If these assets are sold together, they would get merely a fraction of it. That, in turn, could lead to crises as the banks that operate the SIVs. Hence, the possibility of a financial crisis in the US is significant.

To minimize the odds of such an outcome, the Treasury has been supporting the establishment of the Super Fund. The concept sounds good. But, if we look carefully, it doesn’t make sense. The fund is essentially a pool of money from the banks that operate these SIVs to buy the assets from them. How could we trust the prices of the transactions? They have incentives to exaggerate the prices to minimize their accounting losses. The rescue is essentially self-dealing, shifting money from one pocket into another to create an accounting phenomenon.

This mind game has already played wonderfully in stock market. Stock investors assume that the Super Fund would take care of the sub-prime mess for them and they could go on to push up share prices. But, credit experts are still very pessimistic of the future. Between the two, I would side with the credit experts. A rude awakening for the stock market is not far away.

The dotcom bubble, the Enron crisis, and, now, the sub-prime debacle reveal a fundamental challenge to the American society: the rich and powerful explore the loopholes in the system to exploit naïve investors for big profits but don’t pay for their sins afterwards. When their shenanigans threaten to bring down the economy, the government rushes to bail them out. Hence, these people are incentivized to sabotage the system for their own gains. Even when the top people are fired for their behavior that has cost investors billions of dollars, they still walk away with millions. Stanley O’Neal who presided over the debacle at Merrill Lynch was fired but received ＄160 million package on the way out

The confidence trick of the Super Fund idea won’t last for long. The financial institutions that created SIVs would have to disclose more and more losses. The heads of many big financial institutions, if not most, in the US would lose their jobs. Sadly, they would walk away with millions of dollars as golden handshakes. Their shareholders who have lost billions of dollars wouldn’t be so lucky. Millions of homeowners took sub-prime mortgages are going bankrupt and are losing their homes. No one is rescuing them.