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The Worm in the Big Apple ( 0) Printer friendly page Print This
By Michael C. Feltham
Axis of Logic
Sunday, Jun 6, 2004

Editor's Note:  Mr. Feltham originally submitted this article to Axis of Logic on June 6, 2004.  Since then, Mara Der Havanesian corroborated Mr. Feltham's insights in When Bankers' Bets Go Bad published in Business Week on June 14, 2004. - LMB

June 6, 2004 - Harold Wilson, the British Labour Prime Minister during the 60s to the early 70s, coined a memorable expression: "A week is a long time in politics."

It seems, that this neat turn of phrase, might also be turned to global finance in general and more particularly, American financial institutions, presently.

A phenomenon of contemporaneous international money markets, is the tactic of massive lending on what is termed, "Name Only" conditions of security.

Simply, when banks seek funds, often, these are secured through the money markets on the basis of no security, but the credibility of the - bank - obligor (borrower).

Normally, such transactions are used to balance the borrowing and lending bank's "money book"; or in other words, their current position. However, it is normal in any financial system for the regulating body, such as the Federal Reserve, to impose what are called "Liquidity Ratios", which predicate the level of a bank's "On Balance Sheet" commitments to its secure capital base and reserves and thus it ability to lend.

Bu using what are termed "Off Balance Sheet" products, the strictures of such reserves can be circumnavigated.

Such apparently laisse faire insouciance, is a fulcrum of modern capital market operations.

Huge obligations are exchanged, daily, as globalised trade and thus money movements have expanded, exponentially. Today, markets work 24/7.

Modern communications, including SatCom have created a global financial village, where dealers can cover their "positions", with an increasing host of participating players.

However, since the quantum law of entropy can be as readily applied to financial transactions as physics, there is nothing for nothing.

A more worrying aspect of modern financial engineering, has been the exponential growth of "Derivatives", or derivs, in the parlance.

I could take a guess, along with a multitude of other analysts, at the true downside risk potential of global derivs. It would be totally and wholly meaningless, since the reality is that no one actually knows or can accurately quantify the value.

Derivatives are arcane financial instruments, such as interest rate swaps, hedges, loan swaps and so on. They are a totally contrived methodology of reducing risk exposure, or seeking to gain forward advantage by arbitrage.

The underlying worst case position, is that if various contingencies came into play, then the Western financial system would collapse: completely.

In essence, therefore, it is truly impossible for any supervising body to accurately estimate the majority of financial institutions' total risk exposure and therefore, to ensure that adequate liquidity ratios are operational.

At this point, it is perhaps worth remembering the salutary lesson of a certain Mr John Meriwether and his brain child, Long Term Capital Management LLP.

Meriwether left Saloman Brothers a star of the markets. Just a few short years later, in 1998, his vision was a shambolic, insolvent nightmare, which threatened to bring the US banking world to its knees.

What Meriwether did, was to assemble a group of financial "Rocket Scientists" in the countryside, at Greenwhich, and attempt to beat the markets at their own game. Within his team, he had the services of two Nobel Laureates in Economics.

These worthy gentlemen devised a scheme, whereby they tracked the divergence of disparate financial products and decided that there was a healthy arbitrage position between them.

Probably, owing to his earlier record, Mr Meriwether attracted huge inflows of funds for management.

Unfortunately, despite huge number crunching exercises, the optimal computer modelling facilities and the expenditure of much brainpower, the margin moved away from their positions. No problem! Throw more money into the pot!

It was all a bit like a compulsive gambler in a casino, playing roulette. Back one colour at evens. During the course of modern gambling history, many have sensed the touch of genius upon themselves and, suddenly realised, a bit like Aristotle, a simplistic truism. Eureka! If you double your stake on an evens shot, eventually you must win, or at least cover your position!

Despite the apparently immutable math of Poisson's Theorem and other higher level calculation devoted to the ratios of chance, such as Binomial Distribution, some days, the little ball doesn't follow the rules.

Long Term Capital Management had one of those bad hair days!

It took massive support from major banks, to avoid the ensuing financial meltdown.

In the early 80s, Continental Illinois Bank became the tenth largest in the World: dependant upon how one measured it, of course.

Managers were encouraged to adopt a gunslinger mentality towards their loan book. Oil and gas leases seemed an excellent bet. Little normal banking prudence was exercised and pretty soon, Continental Illinois were riding high.

Now, a banks' loans fall into two categories: performing and non-performing. Obvious, really.

However, as the oil and gas lease business tanked, Continental were exploiting the realities of the then, building global money market, to vainly prop up the un-performing loans, which like Topsy, grew and grew.

An ancient and intelligent rule of banking, is that one never lends long and borrows short. In other words, it is a very dangerous practice to borrow short term and lend long term, particularly where the borrowing is floating rate interest and the lending is fixed. In good times, interest rates are low and term loans are normally granted at those low rates, plus the bank's "Turn" or percentage of profit on the deal.

Continental Illinois, however, were using this then fairly new and highly dangerous phenomenon of borrowing against their name only. Each day, their money dealers went into the markets and "Rolled Over" (renewed) billions of short-term debt.

Their oil and gas loans, however, were long-term and fixed: worse, they had been fixed at rates that rapidly became under market!

As so often happens when we are stretched, some extraneous random event trips us up.

A Japanese journalist picked up some scuttlebutt that Continental were rocky. He telexed this back to Tokyo and sought intelligence. Quickly, this information found its way out into the banking community.

Since the Asian market opens first, the jungle drums had been beating and Japanese bank after Japanese bank refused the roll-over and called their funds. Same in Hong Kong: same in Australia. Bad news travels fast and when the London markets opened, all the bank lenders also called their funds.

Once the US market opened, it was all but over! In 1984 it collapsed.

In the final event, Paul Volcker, then Chairman of The mighty Federal Reserve had to step in. He rapidly met with his opposite number at the FDIC (Federal Deposit Insurance Corporation) and together, with the help of major US banks, Continental Illinois was declared insolvent and the Fed took over day to day operations.

Later, Volcker was asked why he acted so rapidly and aggressively. "Simply," he said, "As if we had not stepped in, the ultimate domino effect that so many people have feared for so long, would have occurred and wiped out the Western financial system."

The hidden problem with the current banking world, is simple: since the majority of global banks, are inextricably inter-twined with cross-obligations to each other, if one goes into massive default, then understandably, the others will be standing in line waiting for their money. The trouble is, that each bank has lent on to another. The "Money" is in fact illusionary: most of it is paper, pure and simple.

If one imagines that some external event, rapidly devalued the US dollar on the global currency markets, then it would be impossible for each and every Western bank to meet its positions and obligations. Each one would topple the next. Hence the term, Domino Effect.

Since 80s, ever more arcane instruments have been created to "hedge" financial risk or to gain some advantage.

A fairly new approach is called "Securitisation": simply expressed, this means agglomerating a debt position (credit cards, mortgages etc) and selling on the risk, for a percentage of the putative profit and thereby enlarging the prime lender's ability to take on board even more risk.

Various US financial operators have used such approaches to expand massively, in recent years. One US exponent in particular, has aggressively marketed its position in the UK, taking over day-to-day operation of old established financial institutions' credit card businesses. There is a huge and partially hidden downside to this, however. Britain, presently, is awash with unsecured, sub-prime floating rate consumer debt, expanded on the back of interest rates which are at an historically 45 year low.

This is a time bomb, waiting to explode, however, very much as it did in the early 70s and early 90s.

At the present time, US financial institutions are ubiquitous, spreading their dangerous tentacles around the globe, ever more hungry for a deal.

What is not being considered, however, is the frailty of the very US Dollar itself.

One cataclysmic extraneous event and the game changes - forever.

Who knows: I don't, since I am neither crystal ball gazer or soothsayer; merely a humble analyst. It might be an Al Quaeda strike at the main Saudi oil fields. An earthquake in China. Any contingent liability that bites the system in its butt.

What I do know, beyond doubt, is that the current system of financial engineering, with obligations and debts built on obligations and debts, into a multi-tier Tom Tiddler's Ground casino, where no one actually knows what the true downside risk is, becomes a very dangerous edifice built on sand, which is liable to come crashing down with devastating result.

Perhaps the most worrying aspect of this whole matter, is that those at the top, fail to actually understand or measure the risks of precisely what their organisation is exposing itself to.

This reality has been a feature of international finance, since the parallel markets started in the early 1970s. As new product after new product emerged, major banks and institutions felt a compelling need to be players: despite the singular fact that they failed to actually understand precisely what they were getting themselves into.

As an example, a plasterer's son, from a suburban town outside London, Nick Leeson, forged himself a career in buying and selling Asian futures for a major and very old established British Bank: Baring Bros. Now Baring's, Britain's oldest merchant bank, had been around since the1700s. Their illustrious track record included such coups as financing the Napoleonic war for the British government. They must have had just a tad of smarts to have survived that long, built up a dynasty and a vast capital base.

However, one so-called "Rogue Trader", blew the farm in a few short months, speculating - with their money: it's always easier to do it with someone else's! - on equity futures. As the market went the wrong way, south, Leason simply threw more funds into the pot. The rest is history. The worrying lesson, however, is quite how one young dealer, could be in the position, uncontrolled, un-audited, unchecked, to blow a whole bank! By February 1995, Leeson had committed Barings to half of the open interest in the Nikkei future market! And more!

In the late 1970s, I met a very pleasant Irish gentleman and in fact used his services for a project. Tim had been in charge of dealing futures for Rowntree, the British chocolate dynasty. In the early 70s, Tim and his team had become convinced that cocoa was going through the roof. He built up such a huge portfolio of positions, that when in fact, cocoa futures reversed, this almost destroyed one of Britain's oldest candy manufacturers. During the same period, dealers working for Lloyds Bank International at Lugano in Switzerland, decided unilaterally to build-up massive Forex (Foreign Exchange) positions, without authority and despite apparent executive safety controls. The resultant downside was huge and again, rocked the City of London and investors' confidence in Lloyds, then one of the so called, Big Four.

So, as with most of life, there is nothing new: what is deeply worrying, however, is the apparent continuing philosophy of lack of true risk analysis and worse, executive control over events at the sharp end. Particularly so, when financial engineering has reached the level of the purely esoteric.

In 1979, I journeyed to Mexico, to negotiate a huge loan with NAFINSA, on behalf of the Ministry of Tourism and Information. My opposite number was the then Deputy President, Guilleromo de la Llama. At that time, the President was Lopez Portillio.

PEMEX (Petroleous Mexicana) was just coming on-stream.

Despite much diligent seeking, I was unable to place the loan. However, within two short years, the world and his wife, in banking terms, was scrambling all over each other to establish branch offices in Mexico City and throw money at the government!

As history demonstrates with expensive hindsight, Mexico over-borrowed and defaulted.

Some few years later, I was discussing these affairs with my younger brother, who is an executive with a major Gulf Arab bank in London. We were amused that one of his young dealers, had stated that "We must get into Mexico: that's where it's all at!"

Perhaps, at this point, we can plagiarise Mr Wilson and say "That a week is a long time in financial markets!" More crucially, let's hope, for the global financial system, that the little ball is kind enough to observe the apparently immutable dictates of Poisson.

© Copyright 2004 by

Michael C Feltham FCEA, ACPA, FSPA
Shoeburyness, England

Michael C Feltham is a columnist for Axis of Logic.  By professional discipline, an accountant, who specialised in international finance and economic analysis in the 1970s. Until December 2001, he was an External Examiner and Moderator to Ashcroft International Business School at their Cambridge and Chelmsford faculties at MBA level. He writes widely on technical finance and economic matters. Michael is Founder and CEO of a software company and CFO of a New Media company.  You can reach Mr. Feltham at:


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