future shocks in the financial world

FORUM 1 Future shocks in the financial world IBY JASON LEONG I reliably quantify losses. to allow monolines to sell credit.de. It is the ability of primary bond if they let the insurers fail, they will handguns. - Don Coileane, The Godfather Kerviel caused Societe Generale (SacGenl to lose US07.1 billion [aboutFM22.89 billionl. It seems that he knew how toaverridethe risk mntmlsystems, hildthepmswords of other employees and built up a massive iangpositlon, which was down about US12.2 billion by thetimesmGen management found out. I t is interesting to note how a single trader by the name of Jemme up to, they quickly tried to close his trades -on the worst trading day inrecent memory. And when it was linked to US subprime mortgages could reach US1400 billion. AIG has written US178 billion of credit default swaps on credit debt obligations [CDOs), which protect the purchaser from a CDO's failure to pay. It wouid be interesting to know who is on the other side of AIG'8 bet. This is because the real firework~ start when there is a major default an swaps. In ail likelihood, at least for now. AIG can cover that loss. 1 will be palnlul and it may have to raise capital, but for now, it can do so. However, there are US$45 trillion of credit default swaps out there. A default on a mere 10% wouid cause an economicdisaster The probability of this happening is increasing. through which CDS could be issued to banks for mortgage-backed securities. The move into insuring securitised bonds was spectacularly lucrative for the monolines. MBIA's premiums rose from USS235 million in 1998 to USS998 million in 2007. Year-on-yearpremiums last year increased 140%.Then dong came the US subprime moflgage crisis and the music stopped for the monolines. As the mortgages wlthirl bonds from the banks defalllted - subprime mortgages written in 2006 were already defaulting at a rate 0120% by January 2008 the monolines were forced to steo in and cover the payments. On Feb 3, 2008, MBlA revealed USf3.5 billion In writedowns and other chsrg- k& at present They have written about US$125 billion of protection on ''senior tranehes" of CDOs, aecording ta data from Standard & PDOI'S. There are countless other hedge funds out there that have leveraged to the hilt instruments that have not heel) marked to market. The same goes for banks and insur- raising in the banking and brokerage industry. If you think the banks are in a will trigger a claim. That claim will not be paid because the hedge fund . . that claim as part of its hedge. The problem in this scenario is that the banks have the same balance sheet . ~ ~~ " have balance sheets that are iiterslly 40 times their shareholders' e q u i ~ ty. They also own three times their equity in what is known as "Level 3 assets" those that cannot be accuratelv orieed. and cannot even be .. estimated based on a model. Hence, the ominous sign is that on Jan 14,2008, the Federal Deposit Insurance Carp's (FDIC) website began posting the rules for reimbursing depositors in the event of a bank failure. The FDIC is required lo "determine the total insured amount - Leeson, who b r o u a t the LOO-year- But whois insuring these betsiThis oid Baring3 Bank its knees: is done through Ghat is known as Askedfor his opinion, Leesonsaid: monoline insurance, which is used "Haven't they learnt anything!'' To date, US stocks have lost about u s f i . 5 trillion fmm their high in October 2007. Worldwide, stocks are off "financial auarantors" but thev are about US$5 trillion. Some ~uggest that it was the very . tO cold iceberg. ., really do not know how to price, yet .. surance regulator They had given their insurance guarantee to enable the AAA-rated about the problems at s a c ~ e n but securitisation of over USS2.4 trillion ; the US rederai Reserve got caught by worth of ABS. The Association of Fisurprise. The Fed held an emergency nancial Guaranty Insurers (AFGI) is federal open market committee me& the trade association of the insurers ine ahead of its schedule and made and reinsurers of municipal bonds a "shock and awe" 0.75% rate cut and ABS. On its website, it is stated and theu followed it up with anoth- that: "A bond or other security iner 0.5% cut. sured by an AFGl member has the Critics of the Fed felt that by re^ unconditional and ineweable guarsponding to the volatiiity in the stock antee that interest and principal will markets with the rate cuts showed be paid on time and in full in the a misunderstandine of its mandate event of a default." as it is using its limited ammuni~ But these main monoline insurtfoll to intervene in equity prices. ers are hardly household names ACA Financial Guaranty Corp, Ambae Assurance, Assured Guaranty . . Corp, Bluepoint Re Ltd, CIFG, Finan" porting growth), not guaranteeing dai Guaranri Insurance Co, Financial stock prices. Security Assurance, MBIA Insurance And, having been rewarded for its Corp, PMI Guaranty Co, Radian Aspast tantrums, the market will now set Assurance Inc, RAM Reinsurance Co and XL Capital Assurance. Onemightask thequestion, "Who insures these 11 monoline insurers Fed will probably lower the interest that have guaranteed biiiions or trilrate by another 0.5% at thenext Fed lions in payment flows over the past meeting on March 18, and thereaf- five or so years of the ABS finanter quarterpoint rate cuts in April cial revolulianV No one, yet, is the and June. Does this mean that the short answer Pdvluvidu ~raiuing now complete? is For the monoliner, guaranteeing Did the Fed simply panic and acted such bonds seemed risk~free,with irrationally? Or does the Fed know average default rates running at a of something else that is feslering in the financial system? One indication of more future shocks in the financial world came was not uncommon for a monoline to insure risks 100 to 150 times the - .. is 'modemising its current business processes and procedures for determining deposit insurance coverage in the event of a failure of one of the largest insured depository institutions': The implicatiou is clear - the FDlC has begun a "death watcY on the many banks that are currently drowning in their own red ink. The problem for the FDlC is that it has never supervised a bank failure that exceeded 175,000 accounts. Today, some of the large banks have more than sn miilian depositors, which will make the FDIC's job nearly impassible in the event of a financial meltdown. The FDIC's chairman Shieia Bair warned that "as of Sept 30, there were 65 institutions with assets of USS18.5 billion on its list of 'prablem'instilutions"'dltho~gh shewouid not give names. So, what does ail this mean? It means there's going to be an uuprecedented wave of bank d o s u e s in the US and that people who want to hold on to their life savings are going to have to be extra~vigilanl as the situation cantinues to deteriorate, And it is deteriorating quickly. Right now, many of the country's large& investmem banks are holding . . . " . - in value. As these assets wear away the bank+ capital, the likelihood of default becomes greater . . " ingpmbabllity a f a 'catastrophic' financial and economic outcome, that auditor found that faulty accountmg may have understated losses on same holdings. AIG's auditors found "material weakness" in its accounting for the contracts and AIG cannot tees of US1550 billion. In 1998, the New York State Insurance superintendent's office, the only regulator of monolines, agreed - . . " growing financial losses and a financial meltdown make the recession even more severe. That in why the Fed has thrown caution to the wlnd and taken averya-sive approach I3 to risk manamnent." International Building,home toAlG... mcIndiratlon d s M m shock i the n finanrkirwrld camefreeAIG,theworld'd'l~rge~f imurer bya~et~.whid,rtatatd i hat audltafound thatlaulv nininininiming may hahemdedttfed IIIII~ n n hhldlngs TheA-kan - Jason Leo% is executive dimtor at mddy Schulwit Camu!lmfs Sdn Bhd