Jeremy Warner's Outlook: Forest fires still raging in credit markets

We are now a month into the crisis which has enveloped credit markets and there is as yet no sign of the dust settling. To the contrary, the situation seems to become more confused by the day. Most of the big banks have attempted to reassure investors by insisting through unattributable and off-the-record comments to journalists that their direct exposure to the the losses being sustained in credit markets is limited to non-existent.

However, perhaps significantly, few of them have yet had the confidence to repeat these reassurances formally in a stock exchange announcement. Understandably, observers are sceptical. How can the banks know, at this stage, what their exposure might be? It scarcely needs saying that they can't. The resignation last week of Edward Cahill, known in the City as "Mr SIV-lite" for his trailblazing work at Barclays Capital in structured finance, has only served to highlight these doubts.

The lack of a comprehensible explanation even of what he did for Barclays let alone to what extent his work might have left the bank exposed has allowed speculation to run riot, leading one national newspaper to suggest that perhaps he is the next Nick Leeson, the futures trader whose uncontrolled financial speculations famously brought down Barings bank. Since resigning, Mr Cahill has gone to ground, further reinforcing the idea of potentially catastrophic losses.

This may be a quite unlikely eventuality, but in a panic all threats become exaggerated. Even if the press has been unable to track Mr Cahill down, Barclays itself claims to be in regular contact with its former employee and refutes suggestions of big losses. If there was a material loss, it points out, then it would certainly have made a statement by now. Barclays cannot afford to be bamboozled into detailing every minor bad debt experience.

Mr Cahill was not trading with the bank's money, but advised others on how to set up structured investment vehicles so as to take advantage of cheaper forms of credit. The turmoil in credit markets has caused some of these vehicles to go badly wrong, but Barclays is technically only exposed to the extent that it provided start-up loan facilities. These are said to have been largely hedged.

Would anyone have taken any notice of all this had it not been for Barclays' bid for ABN Amro, where rival bidders have a vested interest in spreading black propaganda?

Absolutely. Even in circumstances where banks believe they have made themselves fully immune to the risk of default, the losses have a nasty habit of finding their way back on to the books. The front door is not the only means of entry; there's also the unlocked kitchen window or the open bedroom skylight. As we learned with Enron, disadvantaged investors are prone to sue, claiming negligent advice or a false prospectus.

The bigger worry is that, in a credit system riddled with default, it becomes progressively more difficult to establish where liability lies. This has been a source of concern to the Financial Services Authority for some years now. The growth in credit derivatives has far outstripped the ability of back-office systems to cope.

The FSA thought it had cracked the problem. The evidence of the present credit crunch is that it has not. There is said to be a mind-boggling backlog of transactions which needs to be unpicked before we know for sure where the losses might lie. The more the uncertainty grows, the harder it becomes to obtain credit on reasonable terms.

The need to ensure adequate back-office systems is just one of the lessons financial regulators are being forced to relearn. Also now up for review are the conduits and structured investment vehicles which lie at the heart of the present mischief, as well as the key role played by credit rating agencies in mispricing debt.

The agencies have occupied a similar position in virtually every financial crisis since the sovereign debt fiasco of the early 1980s. You would have thought everyone would have learned their lesson by now. For whatever reason, credit rating agencies are poor at pricing financial innovation. We need to know why. Investors also need to be better tutored into not relying on the agencies to do the job of risk assessment for them.

A common theme of many financial crises is the growth of arbitrage, or borrowing cheap and short in one market to lend more expensively long in another. Everything goes swimmingly until the loans are called in, which is when the problems begin if it proves difficult to liquidate the assets rapidly at decent prices. I'm not sure that regulators can or should be doing anything about the tendency of markets to exploit these pricing differentials. Yet what they can do is to ensure greater transparency and accountability. This is perhaps where the focus of public policy reform should lie.

Carlyle: lessons in debt leverage

For a case study in the detail of what's gone wrong, look no further than Carlyle Capital Corporation, a hedge fund where the management group Carlyle has been forced to double the size of a rescue loan to $200m as well as agree to buy some of the assets the fund has been forced to liquidate to meet margin calls from lenders.

Hedge funds of this type work in much the same way as a mortgage on a house. With a house, the purchaser typically puts down a deposit – the equity – and then relies on the mortgage provider to pay the difference. If the equity is 10 per cent of the purchase price and the value of the property doubles, the equity will have risen eleven-fold in value and the purchaser will feel enriched. That's the effect of debt leverage. However, it can equally work the other way around, though there has been no recent experience of it in the UK housing market. If the price of housing falls, the purchaser will quickly find himself in negative equity.

That's essentially what has happened to Carlyle Capital. The fund has equity capital of just $900m, but, by borrowing, it has been able to purchase assets to the value of $22.7bn. These assets were mainly triple A rated US mortgage-backed securities, and as a consequence were meant to be bombproof. Yet it took only a quite small downward shift in their value for lenders to start calling in their debts. As a consequence, the fund has been forced to dump assets and seek an emergency loan from its sponsoring company.

John Stomber, the chief executive, insists the fund was set up to withstand a liquidity crisis equivalent to the one in October 1998, when Long Term Capital Management had to be rescued. Unfortunately, this one is rather worse. He simply hadn't anticipated that triple A rated paper would fall so much in value.

This begs an obvious question. Why not? The answer lies in a potent mix of greed, vanity, and bravado, for it is of course the case that, had he allowed for greater volatility in the value of the assets, he couldn't have made the numbers stack up and the fund would never have got off the ground in the first place.

The fund's finances, allowing lenders to call in their loans on quite small falls in the value of the underlying assets, also seem to have been built on quicksand. It is the presentation of what is in truth the relatively high-risk as a copper-bottomed, surefire, one-way bet which lies at the root of the present crisis. The snakeoil salesman preys on the naive and the ignorant. Some of these funds are not a whole lot different.

This is again a theme common to most financial crises. As the good times roll, investors and lenders become ever more oblivious to risk, and in a process which Wall Street investment bankers sometimes call "reaching for yield" are drawn into ever more high-risk investments in their search for a decent rate of return. The difference between the low and high risk becomes compressed. Then someone defaults and the whole thing unravels.

Of one thing we can be sure. There will be a lot more of these rescues and bankruptcies before it is over. And it won't be the snakeoil salesmen of Wall Street and the City who pay the price. They will already have made their piles and run for the hills. Rather, it will be the common man, through his pension, savings and mortgage, and, if things get really bad, perhaps his job too.

j.warner@independent.co.uk