Tuesday, September 23, 2008

Murkier it gets

Growing complexities in financial instruments are making regulation tougher and increasing the risk quotient
If necessity is the mother of all inventions than greed has to be the mother of all necessities. On May 18, 1986 Ivan Boesky – the king of junk bond (high yielding debt) gave a speech at the University of California at Berkeley’s Business School, which also happens to be his Alma Mater. He said “I think greed is healthy,” he told his enthusiastic audience. “You can be greedy and still feel good about yourself.”

Greed has been the epicentre of all frauds, misappropriation, manipulation and what not… from the time man existed on the Earth to the recent Société Générale fraud. The recent instance in Société Générale reminds us of Gordon Gekko, a character loosely based on Ivan Boesky in the movie Wall Street in which he says, “The public’s out there throwing darts at a board, kid, I don’t throw darts at a board; I bet on sure things.” The 31-year-old trader, Jerome Kerviel, who worked on Société Générale European equities derivatives desk was accused of taking ‘massive fraudulent’ positions to the tune of $75 billion in 2007 and 2008 on European equity market indices, leaving them with 4.9 billion euros of losses. Kerviel joined SocGen in 2002 and was trading in one of the ‘most basic’ financial instruments in the ‘most complex’ world of derivatives contracts. What Kerviel did and possibly could have done raise serious questions on growing complexities of financial markets and lacking regulation or risk management practices. From basic derivatives to complex junk bonds and most sophisticated sub-prime mortgage-fame Collateral Debt Obligation (CDOs), all led to some of the biggest financial frauds of all time. CDOs are basically pooling of bonds, loans or credit-default swaps & using their income to pay investors interest. According to Alan Greenspan, CDOs butchered the sub-prime market.

Similar was the case with junk bonds or for that matter all structured products, which tend to have short life. Their basic premise was on more leverage, which only delayed the inevitable write-offs. By 1990, of 104 small companies that had been involved in public issues of Milken’s junk bonds, 24% defaulted on their debt or were bankrupt. “Many companies financed M&As through junk bonds and carrying interest rates as high as 20%, in turbulent times like the ongoing one, there are chances of future default,” says Agost Benard, primary credit analyst at S&P. Junk bond data is disappointing too. In January, junk bonds dropped an average 2 cents on the dollar. An additional 7 cents would create losses of about $50 billion, based on the $709 billion of debt in Merrill’s high-yield index. “There must be a limit as to how many you can create, and we’re way past that limit as far as I am concerned” says Alan Greenspan. Recently, European Central Bank President Jean-Claude Trichet too called for an examination of risk management practices at financial institutions.

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Source :
IIPM Editorial, 2008
An IIPM and Professor Arindam Chaudhuri (Renowned Management Guru and Economist) Initiative
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