Tuesday, December 9, 2008

The banking crisis

Steve Hanke has done an interesting report in Malaysiakini in his piece entitled The banking crisis. His report describes various scenarios being experienced in various jurisdictions in the Asia-Pacific region.

To add another angle to the phenomenon that Hanke has described, we should look a little deeper into the nature of banking and finance.

It is very important to remember that banks and financial institutions exist to make profits. Their economic role as financial intermediaries is to accept money deposits and to lend the money by imposing an interest charge.

In their role as lenders, banks require collateral. The most common form of collateralisation is property or landed assets.
It is, therefore, no wonder that the current global financial crisis began with a property-related collapse.

When central banks permit easy credit and lending, banks will tend to support the property development and housing sector. It is easy to collateralise such loans. This fuels of the housing and construction boom that leads to a bubble.

When the bubble bursts as they inevitably do, because everything is cyclical, there is a financial crisis.

It does not help that the conventional wisdom over the past 30 years, is to create new financial products which are derived from primary financial products such as housing loans.

The secondary financial product from housing loans is the mortgage-backed security. This is where Fannie Mae and Freddie Mac came into the picture. In Malaysia, we have Cagamas. At this level things are still okay actually.
The real problem of unwieldiness comes when banks create even sexier derivatives over and, above, the mortgage-backed securities. In the US, they invented the collateralised debt obligation (CDO) and credit default swap (CDS) as new, sexy financial instruments.

While mortgage-backed securities are basically bonds that allow banks to have more liquidity to provide eve more lending, this secondary market is still easy to monitor.

But, when it gets to the level of CDOs and CDSs, things get really hairy. As I have said in earlier postings, there is no risk management algorithm, even with multiple Cray supercomputers, that can predict risk outcomes at the level of CDOs and CDSs given the fact that such products are exposed to so many variable factors.
Anyone with a rudimentary understanding of algebra or any mathematical equations will know that if there are too many variables in the equation, it becomes more and more difficult, if not, impossible, to arrive at a specific result.

That, is a very good reason why, to reverse-paraphrase the character Gordon Gekko in the movie Wall Street, greed (or, profits) - for the want of a better word - is not good. But, we'll leave that for another time.


satD said...

hi bro de minimis..

biggest problem is the input to the valuation models in credit risk...probability of default which is measured as an annual data point so in order to "back test" the validity and performance one would need at minimum say 250 data point..this imply that we need 250 years of observation ....maybe in the year 2250 then only that question will be answered....Data on Underlying portfolio is also very poor which does not help risk modelers to effectively simulate portfolio pay off...so if MBS is difficult to value... this problem is then compounded into CDO and CDO squared structures.....

On default swaps CDS...this i think is a regulatory mistake arising from issuance of BASEL II whereby institutions were rushing to “transfer credit risk out” so that their risk capital requirement is lower..at the same time this market is still an unregulated market globally whereby regulators are at odds whether to classify it as an insurance contract or not.....if it does then there should be minimum capital requirement to the writter of CDS which would kill the market completely.....the complete absence of regulators invited ‘liquidity catalyst” who are lowly capitalised hedge funds to enter the market....imagine buying your insurance from Co ABC with 100K capital do you think he will make good on your claim....the market then move from physical delivery to ‘cash settled” contracts which then lead to ‘excessive’ speculative activity driving the market to 60 Trillion USD greater than the GDP of Planet Earth...no different than your typical ponzi scheme...another biggest anomaly of this market is the CDS spread embeds the counter party risk which make the true value of the default of the reference entity hard to judge...hence now the talk of creating the central counter party to the CDS market.....i say someone was sleeping at the switch and we are paying for their carelessness..probably for the next few generation......

tks for droppin by earlier...

de minimis said...


You certainly demonstrate a keen knowledge of rarefied finance. You have described the likely roots of the problem quite clearly. And, underlying what you have described is the "profit paradigm".

This is something we will need to examine at some time soon.

satD said...

perhaps over some teh tarik...with the great walla.....i love his tinyurls.... :)

walla said...

i'll be delighted and honoured to meet the incomparable satD too!

satD said...

ok set d ball...but there's a small logistical nightmare..me in Jakarta....will give u folks a buzz when i'm in town

de minimis said...

bro satD

Any time you are back to menziarahi kampung KL, give us a holler. We go minum teh tarik. I belanja :D