WEEKEND READ: Mapping our sub-prime epidemic
The sub-prime crisis which emanated from the US in 2007 has had profound effects around the world and is continuing to provide new insights into financial interlinkages and risk management issues.
Financial institutions, corporates, investors, borrowers, and financial authorities in most countries have been affected – often significantly and dramatically. As the crisis has evolved, new channels of transmission of effects have become apparent, as have the undesirable implications of inadequate transparency arising from complex financial products and practices, and inadequate risk management.
Although the Australian economy (but not the stock market) has (to date) proven quite resilient to the international turbulence, there have been a significant number of high profile non-bank financial/investment companies experiencing severe distress induced by the sub-prime crisis.
While the banking sector has remained generally unscathed, the widening of credit spreads in international wholesale markets induced by the crisis is being gradually transmitted to retail loan markets through the relatively heavy reliance by Australian banks on wholesale market funding and the importance of securitisation.
Non-bank financial/ investment companies have been affected by the crisis, directly through lack of liquidity in traditional funding markets and indirectly through turbulence in equity markets. In fact, a major source of transmission has proven to be via equity markets, and the resulting turmoil in those markets has exposed the prevalence of a range of practices of dubious merit – prompting calls for a re-examination of the merits of delegation of market regulation by official regulators to the Australian Securities Exchange.
Two types of channels for international transmission of crises, such as has occurred with the US sub-prime crisis, can be distinguished. One type is “common shocks” whereby financial sectors in different countries are concurrently affected by the same development. The other takes the form of “spillover effects” or “contagion” whereby the impacts of the shock on the US financial market and economy are subsequently transmitted elsewhere.
The common shocks take two forms. One is the existence of exposures of both US and international investors and financial institutions to increased default risk of securities linked to the US sub-prime market. This has been of importance in the transmission of effects to Europe with many notable instances of write-downs of the market value of asset portfolios.
The second common shock, reflecting the integrated nature of international investment markets, is the marked increase in risk aversion and liquidity preference of investors worldwide. Again, this was noticeable in European markets, both in interbank markets and in wholesale debt markets.
One type of spillover or contagion is via “real economy” effects such as international transmission of aggregate demand and trade flow effects from the impact of the crisis on the US economy. The actions of financial market participants may speed up these effects. For example, the sensitivity of equity market prices, and thus the cost of capital, to changed economic growth projections may be relatively rapid.
A second type of spillover effect arises from the interrelationships of global debt and equity markets. For example, changes in asset prices in one market will be transmitted to other markets internationally by resulting portfolio adjustments by intermediaries and investors.
Similarly, shocks to liquidity and asset quality in particular markets will lead to balance sheet adjustments by banks, fund managers and others operating internationally. These effects may be transmitted by asset market adjustments or by financial institutions (banks). In the former case, changes in market prices provide rapid (perhaps overshooting) signals of effects, whereas the opacity of the banking sector means that public information about effects may be more delayed and reflected in announcements about asset value write-downs and provisioning. In general, interaction between adjustments in asset markets and actions of intermediaries plays an important role in generating and transmitting financial fragility and creating systemic crises because of the important role of liquidity.
The Australian financial sector
A cursory look at the structure of the Australian financial system suggests that it would be significantly exposed to the effects of the US sub-prime crisis which have destabilised international securitisation and debt markets and had significant impacts for managed funds, hedge funds, and investors. First, Australia has a large securitisation market, estimated to be $A270 billion at 30 September 2007. With 78 per cent residential mortgage backed securities and 8 per cent asset backed paper, Australia was ranked as the second largest (outside the US) issuer of asset backed securities in September 2007.
Second, the funds management sector (driven by compulsory private pension contribution arrangements) is the fourth largest in the world, with $1.2 trillion in funds under management at 30 September 2007. Virtually all of the funds under management are sourced domestically, and around 30 per cent invested internationally.
Third, there is no special regulation of hedge funds, which are able to market their offerings to retail investors, and Australia has the largest hedge fund sector in Asia. As well as unlisted funds management vehicles, there were a number of hedge funds, as well as a number of CDOs, listed on the Australian Stock Exchange available to retail investors (including via self managed pension funds).
Fourth, while the domestic corporate bond and commercial paper markets (excluding securitisation) are relatively small, Australian corporate bond issuers rely relatively heavily on international markets.
Fifth, the Australian banking sector, where the biggest four have a market share of Australian resident assets of 65 per cent, has relied quite heavily on both offshore and domestic wholesale funding relative to domestic retail deposits. At 30 June 2007, the retail domestic deposits of the biggest four banks accounted for only 18.4 per cent of assets on their Australian books.
The potential for the Australian financial system to experience a financial crisis would also appear to have been substantial, based on leading indicators of exposure identified in prior research. One is asset price inflation. Like the US, house prices had escalated quite rapidly for several years, with housing affordability declining to its lowest levels ever. Similarly, the Australian stock market had been on a bull run for four years with the S&P 200 accumulation index in June 2007, some 145 per cent higher than four years previously. In the debt markets, credit spreads had also declined markedly.
Another indicator is the balance of payments position. The Australian economy has been dependent on a high rate of capital inflow to finance the long standing current account deficit which had run at over 5 per cent of GDP for the last five years.
Unlike the US, inflationary pressures (another adverse indicator) were emerging, threatening the inflation target ceiling of 3 per cent per annum used by the Reserve Bank. But other leading indicators of financial crises gave some cause for comfort. Output growth was strong and the government budget had been in surplus for a significant time.
Also different from the US was the exchange rate experience. Over June 2003 to June 2007, the AUD appreciated some 27 per cent against the USD from 66.7 to 84.9 (31 per cent against the Yen and 8 per cent against the euro). Underpinning this appreciation were two forces. One was the role of currency speculators engaging in “carry trades”, effectively borrowing at low Yen (or other currency) interest rates and investing unhedged in AUD assets. The second force was the development of the resources boom in Australia reflecting strong demand for resources from China and other emerging nations, and fuelling an appreciation of the currency.
The Australian experience
Although there was some immediate reaction in Australian financial markets to the emergence of the sub-prime crisis in mid 2007 reflecting a decline in confidence and increased uncertainty, the more noticeable effects have emerged gradually through the effects of corporate debt re-ratings, non-bank financial/investment company liquidity crises, an equity market collapse, and increasing credit spreads.
For some time, the “carry trade” had helped finance Australia’s current account deficit. Increased risk aversion, saw the unwinding of these positions lead to a dramatic fall in the AUD in early August 2007, which was subsequently reversed over the next two months as confidence about the longer run strength of the AUD due to the resources boom re-emerged.
Concerns about the potential exposure of Australian Banks to the sub-prime crisis together with increased liquidity preference, led to a substantial increase in the interest rate on short term bank paper relative to the official overnight cash rate, with the spread widening from around 10 basis points to over 30 basis points in August 2007.
Increased demand for liquidity by banks saw substantial increases in their overnight balances in Exchange Settlement Accounts at the Reserve Bank of Australia. Through repos in a wide range of already agreed acceptable securities (including bank paper), the RBA was able to inject liquidity adequate to meet increased liquidity demand while consistently hitting its cash interest rate target.
The Australian commercial paper markets are relatively small. Much Australian corporate short term borrowing is done by way of bank bill financing – banks accepting/endorsing a bill of exchange drawn by the corporate. At June 2007, commercial paper issued by corporates totalled $6 billion, contracting to $4 billion at November 2007. In comparison, bank bills on issue totalled $124.50 ($132) billion at June (Nov) 07 (of which $98 billion was for non-financial corporates).
The market for Asset Backed Commercial Paper (ABCP) market originating in Australia roughly doubled in size over three years to a peak of $72 billion in July 2007, with around $25 billion issued on-shore. In contrast to the USA, the underlying collateral was of high credit quality, with prime residential mortgages accounting for 44 per cent, prime RMBS for 16 per cent, and the rest spread over loans, leases, trade credit, receivables etc and very little in non-conforming/sub prime mortgages.
While Australian issues of ABCP into international markets fell following the seizing up of those markets, the domestic market increased in size from $25 billion in July 2007 to $34.9 billion at Nov 2007, having peaked in Sept at $39.3 billion. For example, between August and September 2007 on-shore issues of ABCP increased by $10 billion while off-shore issues decreased by $18 billion.
Over the longer horizon, the effects on Australian financial markets have been felt through a number of indirect channels. One has been the flow on effect of higher funding costs in international wholesale debt markets. The Australian banks have for some years financed a significant part of their domestic lending from international borrowing relative to domestic deposit markets. Gradually, the increased cost of such debt finance is being filtered directly into higher lending rates, and indirectly as competition leads banks to increase the rates they pay on deposits.
A second effect has been via some transfer of corporate and securitisation fund raising demands back to the domestic markets because of the higher cost and disruptions in international markets. Short term liabilities of securitisation vehicles on issue in Australia increased from $25 billion at end June 2007 to $39 billion at end September, while total liabilities on issue overseas fell from $97 billion in June to $84 billion at September and $80 billion at November. Long term asset backed securities issued in Australia increased from $126 billion at June to $135 billion at November. But since then, these markets have remained frozen.
A third effect has been the gradual widening of credit spreads, in line with those observed overseas. The spread over government debt on AA corporate debt has more than doubled from around 50 basis points in mid 2007 in line with developments overseas. There are also increased spreads applying in interbank markets with the spread between swap rates and government rates increasing substantially.
A fourth effect has been via the spillover of the sub-prime crisis onto equity markets and increased linkages between international equity markets.
The Australian stock market had been riding on the back of a resources boom and while there was an initial downward response in August 07 to events in the US, initially it seemed as if stockmarket investors would be largely insulated from the effects of the sub-prime crisis. Early effects of the sub-prime crisis were felt by hedge funds Basis Capital and Absolute Capital which suspended redemptions in July 2007. In the equity market, the All Ordinaries Index reached a peak of 6456.7 on 20 July 2007 and a subsequent low of 5670.3 on 17 August 2007 and then rallied through November 2007. However in 2008 the Australian market has tanked, and since mid 2007, there has been a much greater correlation between daily movements in the Australian market with those overseas.
Aside from two hedge funds which were early casualties of the sub-prime crisis, listed companies most severely affected include the high-profile, large, non-bank financial/ investment companies: RAMS (RHG), Centro Property Group (CNG), MFS and Allco Finance Group (AFG) which suffered catastrophic price falls of between 50 and 90 percent from mid-August 2007 to early February 2008.
Although the specific reasons behind the share price falls for these cases are somewhat different, common elements are high leverage with large short-term borrowings, predominantly long-term illiquid investments, and complex financial structures including intra-conglomerate equity cross-holdings and debts. Much speculation exists about the role of speculators (such as hedge funds) short selling stocks in such companies whose principals have substantial levered investments exposed to margin calls.
These, and other events, have led to concerns about inadequate transparency and regulatory arrangements surrounding stock lending, margin lending and short selling in the Australian market. Many commentators have subsequently questioned the merits of the co-regulatory model in which responsibility for stock market supervision is largely ceded to the Australian Securities Exchange (itself a listed company) by the government regulator.
The equity market disruption in Australia has exceeded that of the USA, and has involved substantial wealth reductions for retail investors who have increased their exposure substantially in recent years. Over the seven years from June 2000 to June 2007, margin lending had increased from $6.5 billion to $36 billion outstanding (although two-thirds of this was under structured investment product arrangements involving capital guaranteed products).
In addition to this impetus to equity market investment, an expiry date of June 30, 2007 for investors to maximise benefits from recent tax changes to pension funding arrangements led to an explosion of contributions into pension schemes and largely into equity market investments.
Australian retail and other investors have also suffered losses directly through investments in structured products. A number of local governments invested in a CDO (known as Federation) and are subsequently suing Lehmann Brothers. Retail investors had access to hedge fund products such as the Absolute and Basis Capital funds which were early casualties of the crisis. ASX listed CDO style products and hedge-fund vehicles, had also attracted substantial investments from retail investors.
Some preliminary lessons
The Australian experience to date suggests a number of lessons and potential policy responses. Even though there is little evidence of poor lending practices (such as sub-prime lending) in Australia causing difficulties, the spillover effects have demonstrated a number of weaknesses in Australian financial markets.
First, it is apparent from the examples cited above that (at least) some companies had paid insufficient attention to liquidity risk management associated with debt funding practices. Although interest rate risk can, in principle, be hedged independently of the debt maturity structure and refinancing requirements, liquidity and basis risk associated with a name or market crisis can be substantial. Too heavy a reliance upon particular debt markets and too great a concentration of maturities can prove disastrous.
In contrast, the Australian banks have not experienced substantial liquidity problems, even though their opacity and concerns about potential exposures led to increased spreads in interbank markets and greater demand for liquidity. The system liquidity management facilities provided by the RBA enable banks to readily access cash through repurchase agreements in a wide range of securities, enhancing the liquidity of those assets in the general market place. Moreover, because the spread charged by the RBA between borrowing and investing overnight with the RBA is relatively large (50 basis points) there is an incentive for market participants to redistribute available liquidity within the banking system. Nevertheless, the heightened uncertainty saw significant increases in overnight Exchange Settlement Account balances.
Second, opaque and complex financial structures put companies at risk in periods of crisis when substantial uncertainty and risk aversion exists. The business models of financial-investment companies engaged in procuring real and financial assets for subsequent sale to investors in levered trusts managed by those companies has particularly been called into question. Intricate structures for executives’ shareholdings in parent and subsidiary companies, lack of independent boards and executives for subsidiary companies and questionable investment activities raise serious corporate governance issues.
Third, there have developed a range of unregulated practices in equities markets which warrant examination. Margin lending practices, securities lending and short selling arrangements have been found wanting in the equity market turmoil and have been acknowledged by the ASX as in need of review.
Finally, complex financial products have been marketed to retail (and other) investors whose ability to assess the risk involved is relatively low. Modern well-functioning global financial systems bring with them enormous potential for benefit to society, but also a need for the right public policy response to financial innovation. The recent events suggest that we are some way from finding the correct response.
Christine Brown and Kevin Davis are, respectively, associate professor of finance and Commonwealth group chair of finance at the University of Melbourne. Kevin Davis is director of the Melbourne Centre of Financial Studies.
This is an abridged version of a forthcoming paper to be published in the Journal of Applied Finance, a journal of the Financial Management Association.