Friday, October 17, 2008

I Bank Crisis. Why?

B School Grads dream of joining I Banks. Suddenly with the meltdown, we find that many respected I banks have evaporated and some are on the brink.

This paper attempts to analyze some of the probable reasons.

Financial Over-Leveraging - when loan and investment books are significantly larger than its capital. With $ 25 billion, some I banks were doing business of more than $500 billion. Leveraging is good. Over- Leveraging is bad, very bad.

Disclosure Issues – Many I Banks even in its last conference call with investors, gave no clue that it was actually on the brink.

High-Risk Nature of the Loans and Investments - I Banks play advisory role but slowly over the years, their proprietary books have multiplied. They also organize big loans for their clients for funding acquisitions. At times, they take positions, only to hive off the securities to other clients. In a crisis, they may not get the opportunity to down-sell such positions.

I Banks started buying mortgage loans from other banks, and then packaged them to sell bonds against the loan pool. Often they added cash to make the loan pool more attractive, so that the bonds can be sold at a higher price. By selling these structured bonds, it raised money and freed capital. But when homebuyers started defaulting, these bonds lost their value. It all began like this, and then the virus spreads across markets.

Sub-Prime to Prime - When an I Bank faces a redemption pressure, and if it sells the mortgage-backed bonds, whose prices have fallen, it will not raise as much as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since the bank starts dumping these assets, prices of these assets also dip. This is when the crisis spreads from subprime to prime.

Strange Accounting of Complex Derivatives - All banks are required to mark-to-market (MTM) their investments. So, a drop in price leads to the MTM loss. Many of the instruments are over-the-counter derivatives, which are struck on a one-to-one basis between two parties. For a complex derivative a bank does construct a model, and feeds the available market price of these variables in the computer, to arrive at what the market price of the derivatives could or should be. This is an artificial model-generated price. This is called the mark-to-model against mark-to-market.

Illiquid Instruments - An MTM loss can be provided only if there’s a ‘market’. When there is no market, the bigger problem is how does one provide for the losses. The trouble is when the bank actually goes out to sell the derivatives, it discovers that there are no takers. And, even if there are buyers, they are willing to pay just a fraction. In other words, there is a sea of difference between the price that is being offered in the market and the high artificially-generated price thrown up by the computer model. Once there is a financial crisis of this magnitude, banks may refrain from lending to each other, fearing that the money would get stuck, compounding the crisis. So, when the bank ends up selling the instrument or unwinding these complex derivatives, the loss suffered is far in excess of the mark-to-model loss. Such extra losses on multiple of securities and multiple portfolios can wipe out the capital of the bank.

Contributed By:
Prof. J. N. Mukhopadhyay
(Globsyn Business School)

Reference: The Economic Times