Saturday, May 10, 2008 Talking out of a crisis (3) By Allan S.B. Batuhan Foreign Exchange
SOME years ago, I was assigned in the beautiful country of Turkey. While over there, one of the things that struck me as being quite unique about the place was the way businessmen conducted their trade.
You see, Turkish businessmen—at least during the time I was there—did not want to issue their own cheques. They simply endorsed cheques they already received from their customers, on to the people they purchased goods or services from. In turn, their supplier did the same thing down the line, until the instrument reaches maturity, i.e. it is ready to be cashed.
Sometimes I would see cheques endorsed by over a dozen parties. I even saw, on occasion, a number of cheques that our company had originally paid to a supplier, which founds its way back to us through the multiple endorsement chain!
The system served the Turks well as they had a fairly well developed trading environment, and their economy was fairly strong and robust, albeit they were experiencing conditions of high monetary inflation.
Clearly, the system I described was partly to blame for fuelling an inflationary spiral, but near-money creation is not the issue I wish to point out here. It is rather the risk associated with an instrument that is originally owned by somebody else—a “derived” risk from somebody else’s primary risk.
In our cheque example, it is easy to see where this comes from.
The first risk comes from the original issuer—if he or she does not make good the obligation to have funds available when the cheque is presented for payment— then the final payee in the chain will not get paid. Of course, this will unwind its way back up the chain again as each party tries to collect from the one before it, what the original issuer could not make good on.
There are also other risks that may manifest themselves down the line as, for instance, when there is a payment for a fraudulent transaction somewhere in the chain. Still, the most significant one is what derives from the original issuer.
This is exactly what happened with the current economic difficulties being associated with the American sub-prime lending market. During the boom years, a lot of banks made huge amounts of money by lending to minorities and low-income individuals who would otherwise not have qualified for mortgages from the high street banks. And like our Turkish businessmen, they “endorsed” their claims on these loans by packaging them as securities and selling them on to interested investors all over the world—investors ranging from other banks, to insurance companies, mutual funds, individuals and even countries and local governments.
Banks across the Atlantic got into the action, too, including some of Europe and the UK’s largest institutions. And for a while they made money from their investments. But, as we said last week, this was a good thing just so long as “times were good.”
But then we know what happened next. There was 9/11, Iraq, spiraling oil prices, escalating business costs, job losses—you can fill in the blanks for what happened next. In the end, like our Turkish cheque example, many of the original mortgage borrowers defaulted en masse, sending chaos throughout the chain of issuers and investors.
Surely, someone has to be at fault here. How is it that no one ever said anything when the going was good? If this was an accident waiting to happen, why didn’t anybody sound the alarm bells that we were headed for a collision course with disaster?
Could the present problem have been avoided altogether?
