Risk: Lambs to the Slaughter

Risk: Lambs to the Slaughter

Financial markets have never been more unstable. The US dollar has dived against the yen. The NZ dollar has appreciated disconcertingly. British supermarkets are not selling our lamb. But financiers and investors seem to be acting like innocent lambs; dragged along by the momentum of financial flocks.

A cut in US interest rates by one-quarter of 1% has caused a euphoric reaction in world stock markets. Perhaps the punters are astute: time will tell. But the punters seem oblivious to the predators who in the guise of risk were engaged in an orgy of blood letting. Punters had deserted temporarily stock markets and had rushed to quality: driving the US 30 year bond to its lowest yield (4.69%) since its 1971 issue. Last week, the dollar collapsed in three days from Ľ135.80 to Ľ111.50. Many Japanese panicked and sold US bonds, so the 30 year bond reverted to a 5.08% yield. That huge swing in interest rates, going against the trend, will have embarrassed many funds.

Huge currency and interest rate changes, stretch to the limit the financiers who provide the risk-management hedging necessary for the operations of exporters, importers and business. Such are the global economy's vacillations, that Global Systemic Risk is now very high. 1998 could still make the 1929 crash seem like a minor correction. Mr. Greenspan, the Chairman of the Federal Reserve believed the bail out of Long Term Capital Management (LTCM) averted a meltdown, although his language is more modest, LTCM "could potentially have impaired the economies of many nations, including our own".

Rumours the LTCM is unwinding huge, delicate positions, still spooks some markets. The danger of a major failure is obvious. Several hedge funds are in difficulty; the $2 billion loss in a day by the Tiger Fund is but one example. Similarly the Bank of America has shamefacedly reported a loss of $100 million on its $1 billion exposure to hedge fund, D.E. Shaw and Co. Bank of America lost $330 million this quarter in trading income. Chase Manhattan disclosed that $3.2 billion were exposed to hedge funds. Merrill Lynch has made its first loss in a decade and is slashing jobs.

Before looking at the big Banks in greater detail, it is worth looking at non-American losses. The Japanese banks who are going to get some government support, have let more cats out of the bag, their bad loans Prime Minister Obuchi says, are "close to 100 trillion yen" (which is about NZ$1,600 billion, about 16 years of total NZ production). Bank of Japan's governor Masaru Hayami has almost admitted that the bad loans exceed the big 18 Banks' core-capital.

This terrible hemorrhage is due to investors dumping domestic investments and opting for foreign investments. It must be acknowledged that Japan's recession is so deep that it is more likely to drag down the global economy than stimulate it. The remainder of Asia is also suffering. Obviously Indonesia, Malaysia, the Philippines, South Korea, and Thailand are in deep recession. Most banking systems are following Japan's lead in being paralysed by bad loans. Standard and Poors bulletins make gloomy reading which will not be expanded on here. However, it should be noted that the collapse of Guandong International Trust and Investment Corp (Gitic) and its Hong Kong subsidiaries is terribly serious with the danger of rapidly widening repercussions.

Gitic borrowed US1.41 billion for initial capital. But it borrowed more and 80 Hong Kong Banks are exposed to losses of HK$11 billion in direct exposure and contingent guarantees. Another $3.5 billion was lent to Gitic's Hong Kong offshoots. The Japanese bank Dai-Ichi Kangyo guaranteed $750 for project financing a Guandong power station. There are many other deals. The Peoples Bank of China has suspended debt service payments for Gitic until January 6. Gitic'' bond holders are in limbo, and the Chinese government and its commercial arms will have difficulty in restoring foreign confidence and in issuing successfully future overseas debt issues. Gitic's demise, and the difficulties of Japanese, Korean, German and Hong Kong banks indicate the potential of systemic risk.

The US economy may be slowing quickly. Wall Street's losses could have devastating wealth effects on consumer spending. Americans have invested 45% of their assets in Wall Street, but their confidence in the durability of the virtuous circle of job creation, consumer and business confidence and surging wealth may be shaken, (as Marc Faber predicts in the Asian Wall Street Journal, Aug. 11). J.P. Morgan have predicted a recession in the US in 1998, a far cry from predictions of a robust 5% growth this year. Wall Street's growth is too often measured by the Dow, which measures 30 established companies with stellar earnings and solid finance. As of October 13, the Nasdaq is down 25% since July, and the Standards and Poor 500 has lost 16%. The Rundl 2000, a small company's index, peaked in April and has lost 35% subsequently.

Wall Street may not be in a bear mode, but it seems likely as mutual fund investors pulled out $11.2 billion in August. There is great nervousness, especially as former bullish commentators like Ralph Acampora are now bears. Lower earnings should depress stocks. Some Wall Street stocks will be depressed by further revelations of financial institutions exposure to hedge funds, and turmoil in airline and technology stocks. Few investors expect stability. Some expect a rise, others a fall. Any big fall could be increased by cascade and multiplier effects. Bad news could come from a bank reporting dramatic losses from its hedging operations.

The Economist (October 9) argues that banks speculate or "punt" as much money as the hedge funds, moreover, "many banks have followed similar strategies to LTCM". LTCM had $80 billion tied up in arbitrages on US Treasuries, the banks had $3 billion tied up in similar bets. Greenspan's action in saving LTCM was designed to save banks bets becoming more "loss-making" and potentially become quickly "insolvent". Although the big banks are well capitalized their on-going bets are extreme, and it is entirely possible, the Economist argues, at any given point, one bank is "on the brink of going under".

The banks are especially vulnerable because they use the VAR (value-at-risk) risk management model. But the VAR assumes markets are orderly places where crises and crashes are very rare. The VAR is not dependable in these turbulent days. Moreover, the VAR assumes convergence - that rates and spreads in different markets would narrow their differences - but spreads, e.g. in Treasuries, have recently widened. A more fatal flaw in VAR is that if things go wrong a losing position can be quickly liquidated - but when the dollar fell last week the exits got jammed with hedge funds and banks getting over-exposed and burned. With liquidity lessened, prices plunge, volatility rises forcing many punters to sell more than anticipated even in a worst-case scenario. The big banks are now spooked. Some may be seriously injured. The hedge funds are shadows of their former selves. Liquidity is collapsing as financiers perceive the risks they so recently discounted. So at heart, many markets are now in shock, even paralysis. Markets are not suitable places now for innocent lambs to gambol.

NEVILLE BENNETT

Christchurch, New Zealand
22 October 1998

Neville Bennett teaches "Japan and the World Economy" at the Canterbury Graduate School in New Zealand and writes a business column for the prestigious National Business Review. He is also a regular contributor to Le Metropole, www.lemetropolecafe.com and can be reached in New Zealand at 03-364-2086.

Also by Neville Bennett

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