In Search Of New Risk Assessment Tool

All books of the Finance Management categorically mention that there is risk associated with fixed expense. Financial leverage measures the risk associated with fixed expense. Companies do get bankrupt if it does not able to meet its fixed expense such as interest cost etc. Fixed return instrument is considered least risky among all types of investment instruments. Nonetheless, all major economic crisis in first quarter of 21stcentury has taken place because of heavy investment in fixed income securities. For example, 2008’s global economic crisis has its roots in securitization (fixed income instrument) market and recent failure of Silicon Valley Bank is also result SVB’s high proportion of investment portfolio was in treasury bonds and government backed mortgage securities.

What are risk of fixed income investor? How this risk of investment in fixed income become so significant that investors are getting bankrupt? To answer these questions we need to get in details of 2008’s global economic crisis and failure of Silicon Valley Bank.

Global Economic Crisis of 2008:-

ü The home loan portfolio of defaulters of home loan on different commercial banks’ balance sheet were pooled together and sold to Special Purpose Vehicles (SPVs) on discounted price with following purpose: -

· To liquidate the bad loans on the bank’s balance sheet. So that, bank can increase its commercial lending activity.

· To assure that defaulters get their loan financed by other sources so that their ownership of the property should continue.

ü SPV generated money from institutional investors by creating securitization instrument:-

· SPV got in agreement with the defaulter that they (defaulters) will pay EMI on increased interest rate.

· Increased interest rate was charged to the defaulters because now their credit rating is low because of earlier EMI default.

· SPV created a debt instrument Collateralized Debt Obligation (CDO) against those loans and sold it to institutional investors.

· This instrument did receive rating from credit rating agencies.

· Investors got a very lucrative investment instrument i.e., a high yield debt instruments backed by the mortgage of real estate.

ü Creation of a long cycle of appreciation in real estate price:-

· Loan defaulters are getting refinanced their loan from other sources and not losing ownership of the house resulted in increased real estate demand.

· Act of ceasing defaulters’ property and selling those property to recover loan was stopped by banks thus supply of real assets also decreased.

· Both above reasons resulted in a long cycle of appreciation in price of real estate.

ü Rapid correction in real estate price after a more than a decade cycle of continuous appreciation :-

· After a long (i.e. more than a decade) cycle of continuous appreciation in price real estate became unaffordable for the buyers this resulted in decreased demand.

· Decreased demand initiated correction in market price.

· Real estate price correction was too sharp and accelerated.

· Market price of mortgage backing the CDO drastically decreased ultimately resulted in drastic decrease in market price of CDO.

· Ultimately demand for CDO dried away resulting in heavy loss in investment value.

ü Overall impact on global economy:-

· Lot many bankers incurred unbearable heavy loss and banking industry changed forever. Lehman Brothers went bankrupt. While Merrill Lynch, AIG, Freddie Mac, Fannie Mae, HBOS, Royal Bank of Scotland, Bradford & Bingley, Fortis, Hypo and Alliance & Leicester had to be rescued.

· There was unprecedent increase in unemployment.

· Panic sentiment got triggered in the market and ultimately resulted in global economic crisis.

ü Exposed drawback of Securitization Market:-

· There was no explanation of the mechanism to assure that defaulters of loan at less interest rate will be able to pay EMI after increased interest rate.

· There was no explanation of the mechanism that followed by credit rating agencies in providing credit rating to the debt instrument created through pooling of loans of individual defaulters.

· There was no information about the regulatory development brought to regulate this new debt instrument CDO.

· Overall, there were no transparency either about parameter evolved for credit rating of this new debt instrument or the precautionary initiative taken by the regulatory bodies.

v The outcome of above event is that CDO type of investment instrument require a new risk measurement tool because existing popular tools of risk measurement such as default risk, interest rate risk etc. are not appropriate.

Failure of Silicon Valley Bank (SVB) :-

ü Changed macroeconomic factors:-

· High inflation cropped in economy due to geo-political issues such as Ukraine’s war etc.

· Rapid increase in interest rate took place to tame inflation.

· Interest rate in the US was almost 0% (i.e. 0% to 0.25%) before March 2022. Since then, it has been increased 10 times to reach current range of 5% to 5.25%

· Market price of treasury bonds and government backed mortgage securities declined in response to increasing interest rate.

· Policy of quantitative tightening was also implemented to tame inflation.

ü SVB’s Balance Sheet structure:-

· A large proportion of investment was in treasury bonds and government backed mortgage securities.

· High levels of uninsured deposits were there on liability side.

ü Managing panic sentiment:-

· Depositors withdraw pressure suck out liquidity of the bank.

· Additional cash was required to handle depositors withdraw pressure.

· Suffered a loss of $1.8 billion after selling securities worth $ 21 billion.

· Unrealised loss on treasury bonds and government backed mortgage securities could not have created problem if the investment was held forward up to maturity of the investment.

· After disclosing the loss to the public, SVB attempted to raise new capital.

· Effort of raising new capital were more damaging as SVB’s customers in the venture capital community further got concerned about the bank liquidity condition.

· Ultimately curtain was brought down.

v Outcome of the analysis of SVB’s failure was that large proportion of overall investment portfolio getting allocated to fixed income instruments may be risky particularly when one do not have control on the liabilities side of the balance sheet. SVB was bankrupt because it could not able to manage interest rate risk. SVB could not able to manage its asset and liabilities. Apart of that author believe that we need to have a tool to calculate risk because of high proportion of investment portfolio getting allocated to fixed income securities. Similar to the financial leverage that measure risk due to high proportion of fixed expense on cost sheet, we should develop a mechanism to assess risk associated with high proportion of investment portfolio getting allocated to fixed income securities. In particular, it will help us assessing performance of Banks, Mutual Funds, Investment Banks and other financial institutions.

Considering above cases, we should develop a mechanism to measure risk associated with the financial instrument of fixed return by taking effect of untransparent credit rating, under developed regulatory frame work and proportion of fixed return instrument being high on the balance sheet.