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A special report on the future of finance
In Plato's cave

Jan 22nd 2009
From The Economist print edition
Mathematical models are a powerful way of predicting financial markets. But they are fallible

Illustration by S. Kambayashi

ROBERT RUBIN was Bill Clinton’s treasury secretary. He has worked at the top of Goldman Sachs and Citigroup. But he made arguably the single most influential decision of his long career in 1983, when as head of risk arbitrage at Goldman he went to the MIT Sloan School of Management in Cambridge, Massachusetts, to hire an economist called Fischer Black.

A decade earlier Myron Scholes, Robert Merton and Black had explained how to use share prices to calculate the value of derivatives. The Black-Scholes options-pricing model was more than a piece of geeky mathematics. It was a manifesto, part of a revolution that put an end to the anti-intellectualism of American finance and transformed financial markets from bull rings into today’s quantitative powerhouses. Yet, in a roundabout way, Black’s approach also led to some of the late boom’s most disastrous lapses.
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Derivatives markets are not new, nor are they an exclusively Western phenomenon. Mr Merton has described how Osaka’s Dojima rice market offered forward contracts in the 17th century and organised futures trading by the 18th century. However, the growth of derivatives in the 36 years since Black’s formula was published has taken them from the periphery of financial services to the core.

In “The Partnership”, a history of Goldman Sachs, Charles Ellis records how the derivatives markets took off. The International Monetary Market opened in 1972; Congress allowed trade in commodity options in 1976; S&P 500 futures launched in 1982, and options on those futures a year later. The Chicago Board Options Exchange traded 911 contracts on April 26th 1973, its first day (and only one month before Black-Scholes appeared in print). In 2007 the CBOE’s volume of contracts reached almost 1 trillion.

Trading has exploded partly because derivatives are useful. After America came off the gold standard in 1971, businesses wanted a way of protecting themselves against the movements in exchange rates, just as they sought protection against swings in interest rates after Paul Volcker, Mr Greenspan’s predecessor as chairman of the Fed, tackled inflation in the 1980s. Equity options enabled investors to lay off general risk so that they could concentrate on the specific types of corporate risk they wanted to trade.

The other force behind the explosion in derivatives trading was the combination of mathematics and computing. Before Black-Scholes, option prices had been little more than educated guesses. The new model showed how to work out an option price from the known price-behaviour of a share and a bond. It is as if you had a formula for working out the price of a fruit salad from the prices of the apples and oranges that went into it, explains Emanuel Derman, a physicist who later took Black’s job at Goldman. Confidence in pricing gave buyers and sellers the courage to pile into derivatives. The better that real prices correlate with the unknown option price, the more confidently you can take on any level of risk. “In a thirsty world filled with hydrogen and oxygen,” Mr Derman has written, “someone had finally worked out how to synthesise H2O.”
Poetry in Brownian motion

Black-Scholes is just a model, not a complete description of the world. Every model makes simplifications, but some of the simplifications in Black-Scholes looked as if they would matter. For instance, the maths it uses to describe how share prices move comes from the equations in physics that describe the diffusion of heat. The idea is that share prices follow some gentle random walk away from an equilibrium, rather like motes of dust jiggling around in Brownian motion. In fact, share-price movements are more violent than that.

Over the years the “quants” have found ways to cope with this—better ways to deal with, as it were, quirks in the prices of fruit and fruit salad. For a start, you can concentrate on the short-run volatility of prices, which in some ways tends to behave more like the Brownian motion that Black imagined. The quants can introduce sudden jumps or tweak their models to match actual share-price movements more closely. Mr Derman, who is now a professor at New York’s Columbia University and a partner at Prisma Capital Partners, a fund of hedge funds, did some of his best-known work modelling what is called the “volatility smile”—an anomaly in options markets that first appeared after the 1987 stockmarket crash when investors would pay extra for protection against another imminent fall in share prices.

The fixes can make models complex and unwieldy, confusing traders or deterring them from taking up new ideas. There is a constant danger that behaviour in the market changes, as it did after the 1987 crash, or that liquidity suddenly dries up, as it has done in this crisis. But the quants are usually pragmatic enough to cope. They are not seeking truth or elegance, just a way of capturing the behaviour of a market and of linking an unobservable or illiquid price to prices in traded markets. The limit to the quants’ tinkering has been not mathematics but the speed, power and cost of computers. Nobody has any use for a model which takes so long to compute that the markets leave it behind.

The idea behind quantitative finance is to manage risk. You make money by taking known risks and hedging the rest. And in this crash foreign-exchange, interest-rate and equity derivatives models have so far behaved roughly as they should.
A muddle of mortgages

Yet the idea behind modelling got garbled when pools of mortgages were bundled up into collateralised-debt obligations (CDOs). The principle is simple enough. Imagine a waterfall of mortgage payments: the AAA investors at the top catch their share, the next in line take their share from what remains, and so on. At the bottom are the “equity investors” who get nothing if people default on their mortgage payments and the money runs out.

Despite the theory, CDOs were hopeless, at least with hindsight (doesn’t that phrase come easily?). The cash flowing from mortgage payments into a single CDO had to filter up through several layers. Assets were bundled into a pool, securitised, stuffed into a CDO, bits of that plugged into the next CDO and so on and on. Each source of a CDO had interminable pages of its own documentation and conditions, and a typical CDO might receive income from several hundred sources. It was a lawyer’s paradise.

This baffling complexity could hardly be more different from an equity or an interest rate. It made CDOs impossible to model in anything but the most rudimentary way—all the more so because each one contained a unique combination of underlying assets. Each CDO would be sold on the basis of its own scenario, using central assumptions about the future of interest rates and defaults to “demonstrate” the payouts over, say, the next 30 years. This central scenario would then be “stress-tested” to show that the CDO was robust—though oddly the tests did not include a 20% fall in house prices.

This was modelling at its most feeble. Derivatives model an unknown price from today’s known market prices. By contrast, modelling from history is dangerous. There was no guarantee that the future would be like the past, if only because the American housing market had never before been buoyed up by a frenzy of CDOs. In any case, there are not enough past housing data to form a rich statistical picture of the market—especially if you decide not to include the 1930s nationwide fall in house prices in your sample.
Illustration by S. Kambayashi

Neither could the models take account of falling mortgage-underwriting standards. Mr Rajan of the University of Chicago says academic research suggests mortgage originators, keen to automate their procedures, stopped giving potential borrowers lengthy interviews because they could not easily quantify the firmness of someone’s handshake or the fixity of their gaze. Such things turned out to be better predictors of default than credit scores or loan-to-value ratios, but the investors at the end of a long chain of securities could not monitor lending decisions.

The issuers of CDOs asked rating agencies to assess their quality. Although the agencies insist that they did a thorough job, a senior quant at a large bank says that the agencies’ models were even less sophisticated than the issuers’. For instance, a BBB tranche in a CDO might pay out in full if the defaults remained below 6%, and not at all once they went above 6.5%. That is an all-or-nothing sort of return, quite different from a BBB corporate bond, say. And yet, because both shared the same BBB rating, they would be modelled in the same way.

Issuers like to have an edge over the rating agencies. By paying one for rating the CDOs, some may have laid themselves open to a conflict of interest. With help from companies like Codefarm, an outfit from Brighton in Britain that knew the agencies’ models for corporate CDOs, issuers could build securities with any risk profile they chose, including those made up from lower-quality ingredients that would nevertheless win AAA ratings. Codefarm has recently applied for administration.

There is a saying on Wall Street that the test of a product is whether clients will buy it. Would they have bought into CDOs had it not been for the dazzling performance of the quants in foreign-exchange, interest-rate and equity derivatives? There is every sign that the issuing banks believed their own sales patter. The banks so liked CDOs that they held on to a lot of their own issues, even when the idea behind the business had been to sell them on. They also lent buyers much of the money to bid for CDOs, certain that the securities were a sound investment. With CDOs in deep trouble, the lenders are now suffering.

Modern finance is supposed to be all about measuring risks, yet corporate and mortgage-backed CDOs were a leap in the dark. According to Mr Derman, with Black-Scholes “you know what you are assuming when you use the model, and you know exactly what has been swept out of view, and hence you can think clearly about what you may have overlooked.” By contrast, with CDOs “you don’t quite know what you are ignoring, so you don’t know how to adjust for its inadequacies.”

Now that the world has moved far beyond any of the scenarios that the CDO issuers modelled, investors’ quantitative grasp of the payouts has fizzled into blank uncertainty. That makes it hard to put any value on them, driving away possible buyers. The trillion-dollar bet on mortgages has gone disastrously wrong. The hope is that the trillion-dollar bet on companies does not end up that way too.

Almost as damaging is the hash that banks have made of “value-at-risk” (VAR) calculations, a measure of the potential losses of a portfolio. This is supposed to show whether banks and other financial outfits are being safely run. Regulators use VAR calculations to work out how much capital banks need to put aside for a rainy day. But the calculations are flawed.

The mistake was to turn a blind eye to what is known as “tail risk”. Think of the banks’ range of possible daily losses and gains as a distribution. Most of the time you gain a little or lose a little. Occasionally you gain or lose a lot. Very rarely you win or lose a fortune. If you plot these daily movements on a graph, you get the familiar bell-shaped curve of a normal distribution (see chart 4). Typically, a VAR calculation cuts the line at, say, 98% or 99%, and takes that as its measure of extreme losses.
Tail spin

However, although the normal distribution closely matches the real world in the middle of the curve, where most of the gains or losses lie, it does not work well at the extreme edges, or “tails”. In markets extreme events are surprisingly common—their tails are “fat”. Benoît Mandelbrot, the mathematician who invented fractal theory, calculated that if the Dow Jones Industrial Average followed a normal distribution, it should have moved by more than 3.4% on 58 days between 1916 and 2003; in fact it did so 1,001 times. It should have moved by more than 4.5% on six days; it did so on 366. It should have moved by more than 7% only once in every 300,000 years; in the 20th century it did so 48 times.

In Mr Mandelbrot’s terms the market should have been “mildly” unstable. Instead it was “wildly” unstable. Financial markets are plagued not by “black swans”—seemingly inconceivable events that come up very occasionally—but by vicious snow-white swans that come along a lot more often than expected.

This puts VAR in a quandary. On the one hand, you cannot observe the tails of the VAR curve by studying extreme events, because extreme events are rare by definition. On the other you cannot deduce very much about the frequency of rare extreme events from the shape of the curve in the middle. Mathematically, the two are almost decoupled.

The drawback of failing to measure the tail beyond 99% is that it could leave out some reasonably common but devastating losses. VAR, in other words, is good at predicting small day-to-day losses in the heart of the distribution, but hopeless at predicting severe losses that are much rarer—arguably those that should worry you most.

When David Viniar, chief financial officer of Goldman Sachs, told the Financial Times in 2007 that the bank had seen “25-standard-deviation moves several days in a row”, he was saying that the markets were at the extreme tail of their distribution. The centre of their models did not begin to predict that the tails would move so violently. He meant to show how unstable the markets were. But he also showed how wrong the models were.

Modern finance may well be making the tails fatter, says Daron Acemoglu, an economist at MIT. When you trade away all sorts of specific risk, in foreign exchange, interest rates and so forth, you make your portfolio seem safer. But you are in fact swapping everyday risk for the exceptional risk that the worst will happen and your insurer will fail—as AIG did. Even as the predictable centre of the distribution appears less risky, the unobserved tail risk has grown. Your traders and managers will look as if they are earning good returns on lower risk when part of the true risk is hidden. They will want to be paid for their skill when in fact their risk-weighted returns may have fallen.

Edmund Phelps, who won the Nobel prize for economics in 2006, is highly critical of today’s financial services. “Risk-assessment and risk-management models were never well founded,” he says. “There was a mystique to the idea that market participants knew the price to put on this or that risk. But it is impossible to imagine that such a complex system could be understood in such detail and with such amazing correctness…the requirements for information…have gone beyond our abilities to gather it.”

Every trading strategy draws upon a model, even if it is not expressed in mathematical symbols. But Mr Phelps believes that mathematics can take you only so far. There is a big role for judgment and intuition, things that managers are supposed to provide. Why have they failed?

Exibições: 109

Comentário de Oswaldo Conti-Bosso em 30 janeiro 2009 às 11:38
Caro Alexandre e navegantes,

A Economist tem uma reportagem especial sobre O Futuro das Finanças. Na qual esse artigo é um entre oito. Para quem deseja entender as finanaças de amanhã, um bom começo.

SPECIAL REPORT: The future of finance
Comentário de Alexandre César Weber em 30 janeiro 2009 às 21:42
Collateralised debt obligations
Toxic waste

Mar 13th 2003
From The Economist print edition
Investors, issuers and rating agencies wake up to yesterday's excesses

IN JULY 2001 six Barclays investment bankers dined at Petrus, a posh restaurant in London's St James's. They were so pleased with their ability to make money—for themselves and their bank—that they spent £44,000 ($66,000) on expensive wine and cigars. Most have since left Barclays, but the memories of that dinner and the deals that made it possible still haunt the bank—and its unfortunate clients.

Alongside Petrus, other Latinesque names such as Flavius, Corvus, Nerva and Tullas are the cause of the hangover; so are Dorset, Taunton and Savannah. These are all fancy titles for investments known as collateralised debt obligations (CDOs). CDOs are a clever way of exploiting anomalies in credit ratings. A number of loans or debt securities payable by various companies are put into a pool, and new securities are issued which pay out according to the pool's collective performance. The new securities are divided into three (or more) levels of risk. The lowest, equity tranche takes the first loss if any companies in the pool default. If enough losses eat that up, the next, mezzanine level suffers. The most-protected level, the senior tranche, should still be safe, unless the collective pool has severe losses.

Given the poor performance of companies in America and Europe over the past three years, and some spectacular defaults and frauds at once highly-rated companies, it is hardly surprising that many CDO debt pools have suffered. It takes only a couple of defaults in a pool of 100 companies to destroy the equity tranche. Downgrades of investment-grade corporate bonds in America were a record 22% last year, according to Moody's, a rating agency, and it recorded bond defaults of $160 billion worldwide. The equity and mezzanine tranches of many CDOs have suffered severe losses; some have been wiped out. Even senior tranches, usually rated AAA, have been downgraded because losses may yet reach them.

Flavius, Dorset et al are extreme examples. Barclays issued over $3.5 billion of CDO bonds between 1999 and 2001, of which $2.9 billion were rated AAA by Fitch, a rating agency. Today, only $128m of the bonds survive as AAA. In the meantime the underlying debtors have defaulted on at least $120m, and the value of bonds rated below investment grade has ballooned from $196m to over $1 billion. Last week Fitch put these issues on negative credit watch because of further concerns about deterioration.

Barclays has done no deals since August 2001. But more recent CDO issues arranged by the three most active banks, Deutsche Bank, J.P. Morgan Chase and BNP Paribas, have seen a similar downward trend. A report by Moody's released this month shows that only a handful of recent CDO deals have withstood the slide towards lower ratings and a weakening of the extra collateral supposed to make the senior tranches safer.

Many insurance companies that invested in CDOs, or sold guarantees to enhance the rating of the senior tranches, have had a rude shock. In America, insurers have for the first time had to mark-to-market paper losses on their CDO portfolios. Some have lost their appetite for CDOs altogether. Others that gobbled up early deals are pulling out. One is Abbey National, a British retail bank, which built up a £3.8 billion ($6.1 billion) CDO portfolio, and itself issued a CDO that included such credits as Enron and WorldCom.

The investment banks that constructed these CDOs, and the rating agencies that gave them their initial high ratings, are feeling defensive. This is now a huge business. There may be $1 trillion of CDOs outstanding. Securitisation of credit is one of the few bits of investment banking that continues to generate big fees—for arranging deals and for managing the pools of assets. The top arrangers and managers last year may have earned around $1 billion apiece in revenues. They do not want to kill the goose that lays the golden egg.

But many investors have been burned. Not even the arrangers predicted the storm that would hit the credit markets. Nor did they foresee that CDOs do not behave in step with the corporate credit market, especially the synthetic CDOs, constructed from derivatives rather than underlying credits, and the managed CDOs, in which managers can intervene daily to rebalance the portfolio. Often, their interest conflicts with that of some classes of investor.

In the Barclays case the investors have become particularly disgruntled. These are not retail buyers but supposedly sophisticated investors, some of whom issue bonds themselves. Their beef is that the deals were not transparent: Barclays did not tell investors, or the rating agencies, enough about how the assets were being managed. Barclays says it has reviewed its procedures and did nothing contrary to the terms of the deals. It may simply be that both Barclays and investors were over-optimistic. There was an unfortunate concentration of risk in sectors that turned bad, such as aircraft leasing, prefabricated housing, and even investment in other CDOs.
As the exotic CDO market matures dealers see less advantage in keeping it opaque

As this exotic market matures dealers see less advantage in keeping it opaque. Last month the recently-formed CDO committee of the Bond Market Association in New York ran a conference on CDO risk management. It will set up a sister committee in London. Rating agencies are being more candid about their mistakes and their poor record of predicting CDO behaviour. Some three-quarters of new deals may now be performing the useful function of credit-risk transfer rather than simply ripping out fees, says one risk manager.

CDOs of CDOs, or “CDO-squareds”, are becoming a secondary industry. That is because some tranches of CDOs, even those still rated AAA, are being touted at a discounted price as low as 92 cents on the dollar. Careful analysis of the assets can reveal that they are steeply underpriced. It is possible to construct new CDOs out of the debris that can yield around 8% and still merit a AA rating from a friendly rating agency. Yet if there is more trouble in the credit markets, these could end up being just as disastrous for investors. In the meantime, the reconstruction experts can still afford to dine at Petrus.
Comentário de Alexandre César Weber em 30 janeiro 2009 às 23:44
The credit markets
In the shadows of debt

Sep 21st 2006
From The Economist print edition
Business is being reshaped by a massive borrowing binge, but much of it is unseen, unregulated and little understood

IN THE mid-1990s Spain's “King of Bricks”, the construction magnate Rafael del Pino, received a most unusual commission. His company, Ferrovial, was hired to work with Frank Gehry, a Los Angeles-based architect, to build a work of art: Bilbao's stunning titanium-skinned Guggenheim Museum, which dapples the waters of the Nervión river.

Mr Gehry, with his shock of Einstein-white hair, was a stickler for detail. No two parts of the 24,000 square metre (258,000 square foot) leviathan could be the same—or even symmetrical. The museum's cavernous halls would embrace one of Bilbao's gritty industrial-era bridges. And it had to project a sense of peace, an image the Basque authorities badly needed to send to the world.

Less than a decade later, Ferrovial, flush with the success of its Basque masterpiece, is engaged in engineering wizardry of a different sort—finance. This summer it obtained huge, privately issued loans to buy control of BAA, the world's largest airports operator and owner of London's Heathrow, Gatwick and Stansted airports. Though Ferrovial was much smaller than BAA, the consortium it led beat buy-out specialists, such as Goldman Sachs. Of the £16.4 billion ($30 billion) it paid for BAA, more than half was borrowed.

Ferrovial is among a growing number of companies exploiting a sophisticated grasp of the debt markets to make acquisitions that only a few years ago would have seemed impossible. “The market has changed,” says Richard Bartlett of Royal Bank of Scotland, one of Ferrovial's main creditors. “Twelve or 24 months ago this would have been a very challenging deal to pull off.”

Indeed, the market has changed so fast that regulators are not sure if it is spinning out of control. On one hand, innovations in the credit markets have helped to provide a remarkable period of stability in the world's financial system. In recent years, markets have lived through the end of the internet bubble, the collapse of Enron, the terror attacks of September 11th 2001, debt downgrades in the car industry and a stampede out of risky assets in May and June. Any one of these might once have triggered a financial crisis. But none did.

Cheap and liquid financing has enabled companies to make more efficient use of their balance sheets, potentially boosting returns to shareholders and allowing managers to concentrate on profits and cashflow. Despite the increased lending, banks have increased the cushions of capital that they rely on to be a safeguard.

On the other hand, as the debt and derivatives markets have grown out of all recognition, they have moved increasingly into the shadows. Regulators worry that some of the complex financial instruments conjured up around the lending and borrowing of money—worth trillions of dollars—may sow the seeds of the next financial crisis.

The credit markets are the motor for three of the big trends of the decade and some people find them unsettling. First, companies are raising more and more capital through privately issued loan instruments, as opposed to public equity—such as selling stocks or issuing bonds, which can be openly traded. Private deals are harder for regulators and ordinary investors to keep tabs on.

Second, the lending is increasingly being orchestrated from outside the regulated banking industry, by hedge funds and other credit investors that are often supervised only indirectly, if at all. These are especially big in the booming market for credit derivatives, which are also traded outside public exchanges.

Third, although some of this capital is available to public companies, such as Ferrovial, most of it is being gobbled up by leveraged buy-out firms, which use the money to buy public companies and remove them from the stockmarket.

Central bankers and supervisors increasingly worry about the risks to financial stability that may be lurking in the complex debt instruments dreamt up by the finance industry. One of their biggest concerns is how much danger there may be to regulated banks from the faceless institutions they now do much of their debt trading with: hedge funds.

Regulators are beginning to ask themselves whether hedge funds are adequately monitored through the supervision of the banking industry. Pressure is growing on the banks to deal sensibly with their trading counterparties. Equally, some question whether over-zealous supervision may have had the perverse consequence of driving business and finance away from the public eye.

At the forefront of concerned regulators is Timothy Geithner, president of the Federal Reserve Bank of New York and one of the financial world's most powerful voices. In a speech in Hong Kong on September 14th, Mr Geithner praised the banking industry for becoming more robust, overseeing growth in the number and size of lending firms and innovating in credit instruments. These, he said, had “strengthened the efficiency and resiliency of the overall financial system.”

But he gave warning: “The same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by, and complicate the management of, very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the larger ones.”

For most regulators, the safest thing you can have to protect against such shocks is liquidity, and this has been abundant for years. But as the old adage goes, a banker is someone who lends you an umbrella when it is sunny and asks for it back when it starts to rain. Liquidity in the debt markets has an annoying habit of disappearing just when you most need it.

The main drivers of innovation in the debt markets have been the buy-out specialists. The private-equity firms seized on cheap credit to buy $300 billion of businesses in the first half of the year (see chart 1). If they carry on at that pace, they could theoretically beg and borrow enough money in 2006 to buy almost a fifth of all companies listed on America's NASDAQ, or nearly a quarter of Britain's FTSE 100. Citigroup, one of the cheerleaders of the borrowing boom, says buy-outs, foreign takeovers and debt-funded share buybacks have removed shares from stockmarkets, especially in Britain, faster than companies could issue them. The decline is still small and you can argue over which shares should count in the calculation, but Citigroup says this year is the first in more than 20 years that European stockmarkets have shrunk in this way.

Even companies avoiding the acquisition trail have raised borrowing levels to buy back shares—if only to keep private-equity groups at bay. Such buybacks surged to $117 billion in the second quarter, according to the Bank for International Settlements, compared with a quarterly average of $87 billion last year. Such is the extent of “shareholder enhancements”—share-boosting measures that increase debt on the balance sheet—that irate bondholders have begun to fight back. Activist shareholders are now competing against activist bondholders.

Egging borrowers on are bankers, who sometimes admit to lending amounts, as a multiple of underlying cashflows, that are against their better judgment. This, they say, is partly because the competition to provide credit is so fierce, however cheap it is. Since 2003, the after-tax cost of raising debt has been much lower than the cost of issuing shares, even in the more expensive high-yield market (see chart 2).

No longer do banks have a cosy monopoly on finance. Years of low interest rates and abundant liquidity have led investors to pursue higher-yielding assets, even if that means taking on greater risk. This means new firms, such as hedge funds, have flocked into the loan market, where they can super-size yields by investing in tranches of debt with a higher risk of default, and by borrowing from banks to buy those loans.

Also, the desire of pension-fund managers to buy long-term assets to match their payout commitments has led them into most parts of the credit market. Mutual funds and insurers have flocked in to diversify their portfolios and to spice up their returns.

According to Standard & Poor's Leveraged Commentary and Data, a part of the rating agency that tracks the loan market, credit-investment institutions backed by pension funds, mutual funds and insurance companies have mushroomed in recent years, replacing banks in loan-syndication deals.

In America they bought two-thirds of all leveraged loans issued in the first half of this year, up from 45% seven years ago. In Europe the growth has been stronger still. It had just three such institutions in 1999, a tiny share of the loan-syndication market. At the end of June there were 76, or 45%, of a much bigger market. This slice of the business has been seized from banks.
Credit where credit is due

Partly thanks to the shared risk, record-breaking deals have been done with hardly a hitch. Ferrovial's acquisition, which had many of the characteristics of a leveraged buy-out, came close to the size of the largest buy-out to be agreed ever (in nominal terms)—that of HCA, an American health-care provider. It agreed to be bought earlier this year by a team of private-equity groups for $33 billion.

Though interest rates and debt have both risen around the world, this has not yet led to more defaults. Rating agencies have lowered their projected default rates for several years; Moody's Investors Service says only 12 firms that it follows have defaulted this year, compared with 19 in the same period in 2005. The dollar volume of defaults is also much lower. That is partly why in the markets for corporate debt, the interest rates at which companies can borrow are almost as low as they have ever been, according to Citigroup.

Even when companies have run into trouble, the debt markets have just hiccuped and soldiered on. In May 2005 the bonds of the two largest and most actively traded issuers in the market, General Motors and Ford, were downgraded to “junk” status as the risk of default increased, leading to fears of a meltdown in the credit markets. But far from drying up, junk bond issues increased to more than $120 billion in 2005, nearly twice as much as in the depths of the lending drought after the telecoms crash in 2002. Such is the staying power of the market that CreditSights, a consultancy, wondered this summer whether it was fair to call high-yield bonds “junk” after all.

These rated corporate bonds—whether junk or not—used to be the height of sophistication. In the days of Michael Milken and Drexel Burnham Lambert in the 1980s, junk bonds helped reshape and modernise corporate America, no matter how unpopular they were at the time. But now they are being eclipsed by privately arranged loan transactions, especially “leveraged finance” (which carries a similar risk to junk bonds, but involves loans that are not publicly traded).

Leveraged finance is growing fast. According to Merrill Lynch, the leveraged-loan market in Europe is already larger than the junk-bond market—which, admittedly, was not very deep in the first place. In America the issuance of leveraged loans is growing much faster than high-yield bonds, though the overall amounts are still smaller. The debt includes second-lien loans, which have a floating rate and give creditors lower levels of security, but potentially higher returns. In the riskiest end of the credit spectrum are mezzanine finance and payment-in-kind notes. A bit like the more toxic end of mortgage finance, nobody knows how liquid they will be when the credit cycle turns.

On a global scale, the vast syndicated-loan market, including leveraged finance and more senior debt, is also growing more swiftly than public bond and share markets. Dealogic, a data provider, says global share issuance last year was a bit less than at its peak in 2000, at almost $600 billion and corporate-bond issuance was a bit higher than in 2000, at $685 billion. Loan volumes, meanwhile, soared from $2.3 trillion to $3.5 trillion over the same period.

More febrile still has been the popularity of newfangled derivatives with difficult names, such as credit-default swaps (CDSs). These are as complex as they sound. But they are also among the past decade's most important financial innovations—and a cause of both regulatory hand-clapping and hand-wringing. The International Swaps and Derivatives Association said on September 19th that the notional amount outstanding of credit derivatives rose by 52% in the first six months of the year to $26 trillion (see chart 3). That number would be far smaller if banks' positions were netted out for offsetting exposures. But less than a decade ago, the credit-swaps market barely existed.

Credit derivatives, which behave a bit like insurance contracts, allow investors to buy or sell cover against default by a borrower, and the price moves depending on perceptions about the borrower's creditworthiness. Increasingly, they are being pooled into collateralised debt obligations (CDOs), another form of investment vehicle that is growing as fast as a hedge-fund manager's bank balance.

Such products, known as “structured credit”, encourage liquidity, partly because they can be created out of thin air. They also allow banks to sell on the risk of loans turning bad, possibly enabling them to lend more. Robert McAdie, head of credit research at Barclays Capital, says the change has been profound—and for the better. After the dotcom boom, when heavily indebted telecoms firms were on their knees, banks had almost no way to hedge themselves. Now they do: “The use of credit derivatives has totally liberalised the debt market,” he says. “It has created an enormous shift in the risk profile of banks. It allows them to hedge against their risk and manage their regulatory and economic capital more efficiently.”
Hedges and hedge funds

On the other hand, a recent paper by researchers at the European Central Bank says part of the problem with CDSs is that they are used for speculation, as well as hedging. “We have introduced a new product, “insurance”, that appears to be used by people not looking for insurance. It is not the instrument[s] which [are] causing liquidity concerns but the way market participants may be using them.”

On September 11th, in its semi-annual Global Financial Stability Report, the IMF warned that such “structured credit products” were one of its main concerns, especially if financial markets take a turn for the worse and liquidity dries up.

The problem, broadly identified by many regulators, is that not a lot is known about how structured-credit products behave in unusual conditions. Even if they normally mitigate risks, they might suddenly magnify them when financial conditions seriously deteriorate. The products have been developed in a decade when interest rates have been low, the appetite for risk high and liquidity ample. It is easy to assume they are always a benign influence. But it is hard to know how they will react when hard times return.

Mr Geithner, whose role at the New York Fed makes him supervisor-in-chief of Wall Street, appears to take them particularly seriously. In his speech he said that leveraged firms trading credit instruments may well improve liquidity, pricing and diversification opportunities for investors, which should lead to lower risk and ultimately cheaper capital.

But there were problems monitoring the positions taken by firms, he added, which may pose risks to financial stability. Banks, for example, may not fully understand all the positions of a hedge-fund counterparty before lending to it, he said; hedge funds are not required to give this information publicly. Banks can model future risks, but reasonable people differ widely on where those risks lie. And policies to reduce the risks of failure at banks may cause moral hazard if they dull the incentive of individual firms to police their lending criteria.

Mr Geithner encouraged banks to deepen the margin cushion they extend to counterparties and sort out back-office processing of credit-derivative trades as short-term ways to shore up the system. He hinted that regulators might have to supervise large hedge funds directly, rather than indirectly, through banks.

But more scrutiny can be a double-edged sword. Some argue that the regulatory climate is partly what first drove public firms into private hands, encouraged the brightest bank employees to move to hedge funds, and spurred companies to borrow privately.

According to Jonathan Macey, a professor at the Yale Law School, the people who such regulation is supposed to benefit—ordinary, non-professional investors—are those most likely to miss out from the trend to raise capital privately. Of course, they can always take part via their pension funds—though that will be little comfort if the credit cycle ever becomes a crunch.
Comentário de Alexandre César Weber em 31 janeiro 2009 às 17:10
Ouro parece ter poderes mágicos também.

The Real Price of Gold

By Brook Larmer

No single element has tantalized and tormented the human imagination more than the shimmering metal known by the chemical symbol Au. For thousands of years the desire to possess gold has driven people to extremes, fueling wars and conquests, girding empires and currencies, leveling mountains and forests. Gold is not vital to human existence; it has, in fact, relatively few practical uses. Yet its chief virtues—its unusual density and malleability along with its imperishable shine—have made it one of the world's most coveted commodities, a transcendent symbol of beauty, wealth, and immortality. From pharaohs (who insisted on being buried in what they called the "flesh of the gods") to the forty-niners (whose mad rush for the mother lode built the American West) to the financiers (who, following Sir Isaac Newton's advice, made it the bedrock of the global economy): Nearly every society through the ages has invested gold with an almost mythological power.

Humankind's feverish attachment to gold shouldn't have survived the modern world. Few cultures still believe that gold can give eternal life, and every country in the world—the United States was last, in 1971—has done away with the gold standard, which John Maynard Keynes famously derided as "a barbarous relic." But gold's luster not only endures; fueled by global uncertainty, it grows stronger. The price of gold, which stood at $271 an ounce on September 10, 2001, hit $1,023 in March 2008, and it may surpass that threshold again. Aside from extravagance, gold is also reprising its role as a safe haven in perilous times. Gold's recent surge, sparked in part by the terrorist attack on 9/11, has been amplified by the slide of the U.S. dollar and jitters over a looming global recession. In 2007 demand outstripped mine production by 59 percent. "Gold has always had this kind of magic," says Peter L. Bernstein, author of The Power of Gold. "But it's never been clear if we have gold—or gold has us."


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