Wednesday, July 2, 2008

Derivative trouble in Chinese banks?

The credit crisis that started in August of last year has clearly impaired the business model of the financial service industry. It has led banks to write down almost $400 billion dollar from their investment portfolios and in some cases the industry has even witnessed a typical "run" on their institutions. In the center of the crisis are complicated financial instruments, also called derivatives, they allowed banks to take on more risk and increase their "shadow balance sheets" without having to increase the capital base. When the housing market tanked in the U.S. investors withdrew from this kind of business completely and are reluctant to get back in to this day.

I have mentioned write downs of almost $400 billion, most of it centered around financial institutions in the U.S and Europe. This makes sense because this type of business requires experience in financial engineering. Indeed the write downs have been negligent in Asian financial institutions so far. This does not complete the story and there is as always more truth to be found.

Michael Pettis is a professor at Peking University's Guanghua School of Management where he specializes in Chinese financial markets. He also writes an excellent blog, China financial markets, and in his latest entry he submits anecdotal evidence of possible difficulties on some derivative related transactions involving Chinese banks. The derivatives in question are swap contracts that Chinese banks sold to foreign institutions. According to Pettis' sources the outstanding value of these contracts is RMB 170 billion ($25 billion). Due to unfavorable circumstances in the market (inverted euro interest rate curve) the option sellers (Chinese banks) are required to pay out about $300 million to the buyers every month according to Pettis. These losses should be covered by corporate borrowers who initiated the swap contracts with the Chinese banks. Now they refuse to pay off and the whole dispute is supposed to go to the courts. Although this is seemingly a relatively small amount it highlights that derivatives are truly a global problem for financial institutions.

Pettis concludes:
The biggest problem with these transactions, of course, is not whether the banks are going to be paid for these specific losses, but rather that they occurred in the first place. I cannot think of any way in which the euro yield inversion play might have been considered a hedge for Chinese corporations, and so I can only assume that the swap was a purely speculative bet on a completely unrelated market in which the bet was concealed via a lowered interest rate. Anyone who remembers the derivatives-based debacles of the early 1990s, when interest rate markets suddenly did what everyone knew they could not possibly do, and so unleashed an explosion of losses on some truly insane derivative positions, can see where this kind of thing might lead.

I have no idea of how widespread these types of transactions are, but common sense and a little experience suggests that recent conditions have been ripe for an orgy of fairly dodgy derivative transactions sold to greedy customers, who salivate at anything that might lower their financing cost, but who lack the ability and stomach to address the risks. Of course when everything falls apart, their first recourse will be to innocence – how could they possibly have know that all this free money came with strings attached? – and the banks, preferably the foreign banks, will take the blame.

But no matter who gets blamed, the losses will be real. I cannot confirm that this story is true, but I did discuss this transaction with several knowledgeable friends and former students. They all either had heard of these and similar transactions or told me that the story was completely plausible. Unless the regulators are fully aware of the extent of these and similar exposures, there is a real risk that at exactly the wrong time for the banking system and the economy we will discover all sorts of additional and poorly-understood risks hidden away in banks’ balance sheets.

source: Some anecdotal evidence of risks in the banking system
By Michael Pettis, China financial markets

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