Friday, 11 September 2009

An Anniversary with Moral Lesson

11th September 2009

The Malta Independent - Friday Wisdom

This weekend will be the first anniversary of the collapse of Lehman Brothers who filed for bankruptcy late on Sunday, 12 September 2008. This sent global financial markets into a practical freeze changing the illiquidity problems faced by large international banks into a much more serious insolvency problem.

In biblical terms we speak of the divide between before and after Christ. In financial market terms this divide will probably be before and after Lehman.

Lehman’s collapse created a systemic dysfunction of the financial markets and when the problem of a single institution migrated to the whole system. When this happens it is likely that the main originator of the problem is the regulator rather than the institution. It is the regulators who have responsibility for the whole system and it is their responsibility to set the rules and to monitor and enforce their execution to ensure that no single institution becomes a risk to the whole system.

So the Lehman’s collapse, whilst obviously remaining the primary and direct responsibility of their management who drove the iconic investment bank to the wall, is also a certified failure to the inadequacy of the regulatory regime in the US. Having had a good warning signal six months earlier when the same fate was served on Bear Stearns, who had to be rescued in a panic engineered and state sponsored takeover by JP Morgan Chase, the regulators did not show sufficient enthusiasm and urgency in getting a detailed account of the interconnections and risks involved if the problem of Bear Stearns had to move to the next weakest link leading to a grave systemic risk.

With hindsight it looks almost unbelievable that this time last year, as the US Treasury Secretary was taking the decision that a Bear Stearn’s type of state sponsored takeover deal for Lehman Brothers, as requested by potential suitors Barclays and Nomura, was not on the cards as this would create moral hazard and as he had no real approval to risk taxpayers money on such arrangements ( no such compunction was shown in engineering the Bear Stearns deal) he had no proper knowledge of the consequences of such a decision.

These consequences did not take long to emerge. And the critical nexus was the world’s largest insurance company AIG who as an insurance company, irrespective of the fact that it had a strong and critically important financial products divisions, was not regulated by any of the Federal Regulators but by a small state insurance regulator who had no resources to control the entire world-wide ramification of AIG.

Whilst AIG plea for rescue loans was rejected outright in the crucial week leading to the Lehman collapse on the basis that it was not a financial institution and was not under the responsibly of any Federal Regulator, the tune quickly changed the day after Lehman filed for bankruptcy. The regulators were ‘surprised’ ( proving that they were sleeping at the wheel in the pre -Lehman years) to find that AIG had insured billions upon billions of bank bonds and toxic mortgage bonds through what is technically known as Credit Default Swaps (CDS). If AIG were to default on such CDS’s many of the critically important banks that had exposure to such bonds and toxic assets but were not reserving capital against them on the basis of the hitherto AAA guarantee of AIG, will instantly fall into the soup leading to world-wide financial system collapse.

With or without Congress authority, the Federal Reserve had to operate at the limit of its own role and rules to give emergency loans to AIG so that it can continue to honour its CDS obligations and avoid a wholesale systemic financial collapse. Eventually the US government had to use specially voted emergency funds to recapitalise AIG and bring it practically under State ownership and control.

The Lehman debacle has brought the reality of an untenable situation where profits are privatised and losses get socialised.

There is a moral lesson in all this for us in Malta. Thankfully our banking system was liquid and solvent enough to absorb the crisis effects with relatively little damage. However, over the last year we have seen an untypical interest by Maltese corporates to raise long term funding on the bond capital markets. Lower interest rates engineered by the ECB to cushion the crisis and the general liquid state of our economy gave bond issuers an incentive to switch from fluctuating interest rate bank borrowing to fixed interest long term borrowing on the capital markets.

Currently we are seeing three separate bond issues almost simultaneously floated on the market one of them coupled with an equity IPO. This is all well and good as it adds volume, depth and breadth to local capital markets.

My worry is that the local market is not sophisticated enough to take informed decisions on the suitability of such bonds for retail investors’ particular requirements and many investors are guided solely by the coupon on offer without seeking professional advice to place such coupon in the context of the risk involved.

There is no financial investment without risk. The impression many investors have that bonds are a perfect substitute to bank deposits irrespective of the quality of the issuer is wrong and regrettably our regulators are not doing enough to ensure that the retail market is well informed of this fact, and that in the absence of local bond rating mechanism investors should at least seek professional advice prior to parting with their money.

In this context, our political leaders would do well to exercise a measure of restraint not to substitute themselves for a rating mechanism by giving overt or tacit endorsement to corporate bond issues by untimely visits to the issuer organisation. President Abela’s visit to Palm City project co-owned by Corinthia during his recent visit to Libya was criticised in the local press as an inappropriate endorsement for Corinthia bond issue currently on the market. This was a bit of an unfair criticism as it is normal for the Head of State to visit local investments when visiting a foreign country and the Bond issue has nothing to do with the Palm City project per se, which has been funded by a bond issue under a different corporate name in the past.

Not the same defence can however be made to Prime Minister Gonzi’s visit to Melita Cable this week when he visited their Malta HQ and gave them a solid positive endorsement. At a time when Melita are launching their first corporate bond on the local market it is easy for the unsophisticated retail investor to interpret the prime minister’s endorsement as equivalent to a rating agency investment grade certificate.

Considering the untold damage that would befall the local capital markets if, God forbids, there is ever a default on any corporate bond in public subscription, politicians should be more ethical in allowing their personality to be used for marketing purposes during the launch of such bond issues. There is nothing wrong in a prime minister visiting and encouraging local private corporates undertaking investments for the benefit of the local economy, but the timing must be judiciously chosen not to send unintended messages to local investors.


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