Why financiers have missed the new monster

As the guy I met on a train from Kassel to Frankfurt the other day explained to me, and Tett confirms, 'billions in loans are about to expire in the next 10 days, with even more next month'. So it's not just the imminent repricing of retail mortgages, or the 300 billion debt pipeline which triggered all the panic in august, it's the need for money to refinance these semi-hidden, but pervasive (corporate) loans that the banks are clenched up waiting for and which may topple some of them.

Ben

Why financiers have missed the new monsterBy Gillian TettPublished: September 7 2007 03:00 | Last updated: September 7 2007 03:00

Generals are trained to fight the last war. So, too, with financiers. In the past decade - or ever since Long-Term Capital Management imploded - the banking world has devoted commendable effort to worrying about hedge fund collapses.

But while risk managers have been obsessively watching hedge funds, another problem has been brewing, unnoticed - conduits and structured investment vehicles.

For though few observers outside the halls of high finance had heard of SIVs until this summer (let alone their mutant cousin, SIV-lites), these vehicles are now throwing global money markets into a panic.

In particular, what investors have suddenly realised in recent days is that not only have financiers created these vehicles on a startling scale this decade but they have also done so using an appalling funding mismatch.

Most notably, while these vehicles typically invest in long-term assets that tend to be illiquid, they finance themselves with asset-backed commercial paper that typically lasts just three months. This summer, however, investors in the ABCP market have gone on strike. Thus conduits and SIVs are now suddenly calling on bank liquidity lines instead.

And this - unsurprisingly - is now triggering a sense of panic. After all, some tens of billions of dollars worth of ABCP funding is due to expire in the next 10 days, with even more next month. And while it is unclear how much of that will be converted into bank liquidity lines, the prospect of rising cash demands has prompted the banks to grab (and hoard) whatever short-term finance they can find.

But if this saga is striking, what is truly shocking is that the risks posed by this funding mismatch have gone so unnoticed, for so long. Never mind the fact that even a first year economics student could see that creating ABCP vehicles in this way looked a bit odd. Until recently it appears that few policymakers, bankers or investors had ever factored the prospect of an ABCP strike into their models at all.

Perhaps that was because they were too busy worrying about those hedge funds. But I would guess it was also because the existence of these (largely off-balance sheet) vehicles has been demoted to a footnote, at best, in the published accounts of banks. Or as one policy maker admits: "Nobody had imagined a scenario where the money markets froze up like this. It just wasn't in the stress testing models."

No doubt there will be some bitter recriminations about this in the future. I would bet, for example, that regulators may start rethinking the wisdom of letting banks construct all these vehicles that are off their balance sheets (and thus partly hidden) but still deeply affiliated to a bank.

The tax status of these vehicles may also face scrutiny, given that tax avoidance is one reason why this vehicular finance has flourished. Regulators should also face hard questions about their own, implicit role in encouraging the trend: after all, a key reason why such conduits have flourished is that it has been cheaper for banks to hold AAA rated paper in such vehicles, than on a bank balance sheet, under capital adequacy rules. Ratings and regulatory arbitrage, in other words, has driven the game. Last, but not least, I expect credit rating agencies to come under fire. These agencies have always insisted that their ratings only measure the likely default rates of instruments or institutions, not their liquidity risk or market values.

But while that stance may be fair when assessing corporate bonds, it does not necessarily work when you rate vehicles, such as conduits, whose health depends on liquidity issues. That suggests the rating agencies may soon be forced to rethink their ratings of such vehicles.

However, these issues are for the medium term. Right now, the truly pressing issue is whether the financial system will be able navigate the current money market freeze, as ABCP paper matures, without producing any more bank failures. It will emphatically not be easy. No wonder some senior bankers describe the mood in the financial world as an echo of the darkest days of the LTCM hedge fund crisis - albeit with a new set of financial monsters that have suddenly leapt out from the shadows to shock us all.

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