4. Enterprise response to the Financial Crisis
4.4 Diversification strategy
diversification and reinsurance an insurer can lower the volatility of underwriting results and the cost of capital, and raise enterprise value assuming that the cost of diversification and reinsurance are not so great that they offset the gains generated from lower volatility of underwriting results.
Cost and Benefit
A company can be exposed to a range of financial and operating risks. These risks can impact enterprise value by affecting expected Net cash flow through size, timing and
variability. Fundamentally, a firm must consider the cost of risk the implicit or explicit price paid to manage risk exposures when it is creating a risk management strategy, since the cost of risk directly affects enterprise value. The cost of risk comprises various theoretical
components. The ultimate goal of any value-maximizing firm must be minimization of the cost of risk. This, as we shall see, is not necessarily the same as minimizing risk.
Therefore, if the expected cost of risk management techniques is greater than the benefit obtained from a reduction in the cost of capital, then hedging, diversifying or otherwise protecting expected net cash flow may not increase enterprise value. vice versa.
(Appendix 3 and Appendix 4)
4.4 Diversification strategy
A company might wish to purchase insurance to reduce Net Cash Flow variability. If the expected cost of the loss-financing protection is less than the estimated future Net Cash flow, then it is sensible to acquire protection and eliminate uncertainty. However if the company believes that the cost of insurance is too high, It may proceed unprotected by retaining the uncertainty. If it has sufficient cash on hand to cover any losses arising from a future event it must then decide whether to use internal funds to cover the loss when it
‧
occurs, or borrow against expected future cash flows and use funds on hand to invest in an alternative project. The cost/ benefit tradeoff decision surfaces once again; if the project has a positive NPV and outweighs securities issuance or bank-borrowing fees, it may be optimal from an enterprise on hand and lacks loss financing protection is in a lightly different
position; it can borrow against future cash flows in order to cover today’s losses, or it can declare bankruptcy. Supposedly, if a company is able to diversify away risk; investors should demand a lower required rate of return. The question is whether a company can do this diversification efficiently. Risk can be divided in to two components: diversifiable risk and non diversifiable risk. Below figure highlights these relationships.
The more a company spends on its cost of risk, the more variability it eliminates from expected NCFs, but the more it reduces its operating income. All other things being equal, a firm with lower expected NCFs reduces its probability of insolvency. However, at some point the marginal cost of loss control, loss financing and risk reduction will be greater than the reduction in expected losses; when this occurs the firm’s risk elimination, diversification and control techniques no longer serve to maximize enterprise value. This brings us back to our earlier point: it is possible to create a completely risk-free company, but the endeavor is unlikely to yield an enterprise with maximized value. Let us consider a simple framework to illustrate several key points of the concept. To begin, we assume that maximizing
enterprise value means maximizing the present value expected probability of earning $70 in one year, the expected NCF one year from now 97. Discounting back at a 5% rate yields a present value of expected NCF of 92.38. This is the enterprise value today, before the firm undertakes any risk management activities.
‧
4.5 Risk management for banking operation
Banking History: Banks were built for people who want to safely store valuable asset like custody or safekeeping. Bankers noticed that they can earn money by receiving the deposit and lending the borrower with higher interest rates (spread). Now a day, banking
regulation is approaching perfection thought the previous experience of financial incident or crisis by having local banking regulation or global banking regulation like the Basel Accord.
Glass-Steagall Act: An act passed by Congress in 1933 and officially named the Banking Act of 1933, introduced the separation of bank types according to their business
(commercial and investment banking); it was found that the Federal Deposit Insurance Corporation was insuring bank deposits. Commercial bank had a strong regulation on risk control that prohibited them from collaborating with full-service brokerage firms or participating in investment banking activities. But at the same time, they were more easily able to get credit support form the Fed. The Glass-Steagall Act was enacted during the Great Depression. It protected bank depositors from the additional risks associated with security transactions. However, the act was dismantled in 1999 <5>. Consequently, the distinction between commercial banks and brokerage firms had been blurred; many banks own brokerage firms and provide investment service to the public.
The Major responsibility of Bank and investment banks
Investment banks, commercial banks, and universal or integrated banks are focused primarily on originating and managing financial risks. Similar to insurers, they have very specific duties and functions, which they perform to varying degree (depending on
regulatory rules, specific expertise, and corporate strategy). These can include originating credit facilities and loans; providing wealth management, risk management, and corporate
‧
finance advice; underwriting capital market securities (e.g. equities, bonds) on a primary basis; trading assets (equities, bonds, loans, derivatives, foreign exchange) on a secondary basis; developing structured products and other synthetic asset (via cash products and derivatives).
Corporate Bank function in detail (banks step in to the insurance company): Most banks have considerable expertise in designing products and pricing and trading multi-year, bundled risks (e.g. credit, market, liquidity). While that remains their core business, the most innovative have expanded into the insurance world and regularly assume
insurance-related risks. As with insurers, financial institutions are searching for
opportunities to expand and diversity revenues in uncorrelated areas, including insurance and risk transfer market. For instance, several large investment and universal banks have been at the forefront of insurance-related capital market issues, and various others have actively sought to transfer capital markets risks to the reinsurance market through their own dedicated reinsurance subsidiaries. Some have also become involved in trading insurance related-derivatives. More generally, some of the world’s largest banks own insurance subsidiaries that permit them to underwrite certain types of life and annuity covers for their clients. In addition to revenue diversification, financial institutions may be active in “risk transfer” for internal risk management purposes.
Expand Risky Business: Many banks are eager to transfer their risks in order to lower capital charges and write new business. In many cases risks that they originate, particularly in the credit markets, are passed to the insurance sector, who may have some comparative advantage in assuming exposure as a result of unique regulations and diversification, pricing, and risk management policies. In fact, banks have actively worked with insurers in
‧
recent years in transferring credit risks. As noted above, insurers provide a variety of covers on pools of corporate credit risk and also act as investors in a range of trances. Banks routinely create customized trading desk CDOs and portfolio default swaps for insurances, who essentially sell them the required protection.
Mergers and acquisitions make it more complicated: Various mergers and acquisitions have occurred within the banking universe in recent years as firms attempt to create greater operating efficiency, financial strength and broader business and distribution networks.
National and cross-border consolidations within the investment banking and commercial banking sectors have occurred regularly since the mid-1990s. It is also worth nothing that in some instances financial institutions and insurance companies have merged their operations, creating very broad-based financial conglomerates that can offer insurance, reinsurance, and banking products. These firms are arguably well positioned to offer integrated insurance/
banking products and solutions. This cost sell channel is actually making control to the financial sector even harder.
Shadow banking system: Auction rate security is a typical example for the Shadow Banking System <6>. The first Auction rate security was invented by Lehman Brothers in 1984 which was referred to a debt instrument with a long-term nominal maturity for which the interest rate is regularly reset through an auction. As bank loans became more expensive, the auction market became increasingly attractive to issuers who were seeking the lowest costs and flexibility of variable rate debt. Therefore, buyers received a slightly higher
interest and an apparent assurance of liquidity through the auction process. It appears to be a good deal, since Auction rate security provides a better interest return than commercial banks. Also Auction rate security is not monitored by FED, since they were launched by
‧ 國
立 政 治 大 學
‧
N a tio na
l C h engchi U ni ve rs it y
an investment bank. Even though, they are actually doing the same as the commercial bank which is lending money by using the deposit from the shareholder. The Auction rate security had its highest transaction volume at 200 billion <7>. Since February 2008, most auctions have failed, and the auction market has been largely frozen. In late 2008,
investment banks that had marketed and distributed auction rate securities agreed to
repurchase most of them at par. Shadow banks are getting more important as the transaction volume is growing so fast from year to year. The five major investment banks (Shadow bank) were growing so fast as they were selling products including structured investment vehicles, tender option bond, and variable rate demand notes tri-party repo. The total asset value for these big five investment banks accounted for US four trillion in the beginning of 2007. At the same time, the total asset value for these top five commercial banks was USD six trillion, which means almost 40% of lending activity, was not properly regulated by FED.
In February 2008, the auction market failed, and most auction rate securities have been frozen since then, with holders unable to dispose of their securities. Investment banks that participated in the distribution and marketing have agreed to repurchase approximately $50 billion in securities from investors<8>, under duress of investigations by the U.S. state attorney general and auction rate security has become history.
‧
5.1 Repairing the Financial system: Most Economists agree that restoring the basis functions of the financial system intermediating deposits as loans to businesses and households as efficiently as possible is one of the highest priorities. There is much less agreement on the best way to accomplish this goal. Broadly speaking, three types of policies are being considered and implemented to various degrees.5.2 Purchases of “Toxic” assets: one factor limiting lending by banks is that they have significant quantities of troubled assets on their balance sheets. These are securities whose values are greatly reduced but also uncertain because the usual markets in which they trade have dried up. Mortgage-backed securities are a typical example from this financial crisis.
The idea in the original Troubled Asset Relief Program (TARP) was that the government would purchase many of these assets from financial institutions. The difficulty is that what price the purchase should be made.
5.3 Capital Injections into financial institutions. If the main problem with lending is that banks are undercapitalized, then injecting capital directly into the banks may be useful.
This is what the original Troubled Asset Relief Program (TARP) actually ended up doing.
The government invested $25 million in each of many large financial institutions and took equity stakes in these firms. By some estimates, however, losses in the financial sector may be measured in the trillions of dollars, much larger than the equity injections that have taken place so far. Because of leverage, each dollar of equity can in principle be turned into $10 of loans, which is part of the appeal of this option.
On February 17, 2009, US President Obama signed into law the American Recovery and Reinvestment Act of 2009, a $787 billion package designed to stimulate aggregate demand in
‧
the economy<9>. The final plan includes more than $250 billion in tax cuts and more than
$500 billion in new government spending on unemployment benefits, infrastructure, education, health care, and aid to state and local governments.
According to the Congressional Budget Office, about $185 billion of the stimulus will
occur in 2009, with another $400 billion coming in 2010. Given the macroeconomic situation, many economists support some kind of fiscal stimulus. With the fed funds rate at zero,
short-run output turning sharply negative, and deflation a possibility, a large fiscal stimulus seems prudent. The main areas of disagreement among economists concern the types of spending and the relative weight on tax cuts versus new spending.
The Congressional Budget Office (CBO) provides estimates of the impact of the fiscal stimulus package on the macroeconomic. These estimates come in the form of forecasts for short-run output and the unemployment rate. In the absence of a stimulus package, the Congressional Budget Office forecasts are troubling, with short run output reaching -7.4% in 2009 and the unemployment rate peaking at 9.0%. <10> The Congressional Budget Office then provides two forecasts including the impact of the stimulus, a “low estimate” based on pessimistic assumptions about the effects of the package and a “high estimate” based on optimistic assumptions. Notice that even in the best case scenario, the recession is long and deep, with output staying below potential until around 2013. The fiscal stimulus effect had been adopted by Japanese government following its financial crisis and deflation in the 1990s.
The ratio of government debt to GDP rose from about 13% in 1991 to 90% in 2006, as government spending exploded sharply to stimulate the economy. On the surface, Japan’s slow growth in the 1990s might be taken as evidence of little payoff from its fiscal stimulus.
On the other hand, Japan did not experience a depression in the 1990s despite enormous collapses in the stock market and the housing market. This could be caused by timely applying the fiscal stimulus and thus preventing the situation from becoming even worse.
‧
5.4 Reorganizations of financial institutions. A standard remedy when liabilities exceed assets in a firm is for the firm to file for bankruptcy. The government steps in and reorganizes the firm if possible so that it can resume its business. The essential way the reorganization works is as follows. Equity (net worth) is already zero or even negative, so the stockholders have lost their entire investment. Debt is then reorganized in to new equity claims. That is, debt is written down to zero and the former debt holders are given equity claims in the newly reorganized firm. Essentially, the value of the debt at the time of bankruptcy becomes the new equity in the new firm. In the context of the financial crisis, this last option has a number of appealing features. First, the stockholders and bondholders in the financial firms that have magnified the crisis bear the brunt of the cost of putting the financial institutions back on their feet; there is no cost to taxpayers. Second, the banks are recapitalized and should emerge with willingness an ability to lend.
5.5 Government Control on the Credit Agencies
Why does the credit rating system exist? It arose in the 1970s when the SEC looked for a way to ensure that the brokers it regulated had enough capital. It was much easier for the commission to accept the opinions of a few agencies than to research every single bond itself, and it also saved money (and regulatory risk) for the brokers the act was known as Nationally Recognized Statistical Rating Organizations, or NRSROs.
At the same time, those rating agencies have earned huge sums in the past ten years offering opinions on the creditworthiness of an alphabet soup of mortgage-related securities created by over-eager banks. As the market blossomed, so did the agencies’ profits. Moody’s net income rose from $289m in 2002 to $754m last year <11>.
‧
“The events of recent months have had a profound effect on our economy and our markets, and they have galvanized regulators and policymakers not only in this country but around the world to re-examine every aspect of the regulatory framework governing credit rating agencies,” said SEC Chairman Christopher Cox.
The agencies feel harmed at the criticism. S&P says it has downgraded just 1% of subprime residential mortgage-backed securities, and that none of those downgrades affected the triple-A bonds. So far, defaults have hit only three of the mortgage tranches it has rated. Of more complex products, collateralized-debt obligations (CDOs) downgrades have affected just 1% of securities by value (*13).
Analyst might retort that the agencies are behind the times; market prices for
subprime-related bonds suggest many are in deep trouble. But the agencies argue that their ratings are designed to measure the probability of default, not to recommend the purchase of individual securities or to predict market prices. And they say their long-term record is good;
the average five-year default rate for investment grade (BBB and above) structured securities is less than 1%. Which implied that their rating will still be accurate only if no crisis will be happen in the future. Which is a question no one can be sure about the answer.
Any set of rules creates incentives for participants to game the system. And that seems to have happened with ratings. After all, CDOs repackage existing securities and charge hefty fees for doing so. There must be a substantial exception in the system to make such
activities worthwhile; the most likely source is the way ratings are treated.
Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors.
On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of
‧
interest between rating agencies and issuers of structured securities. On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found “significant weaknesses in ratings practices,” including conflicts of interest <12>.
The regulatory program established by Congress through the Credit Rating Agency Reform Act allows the SEC to promulgate rules regarding public disclosure, recordkeeping and financial reporting, and substantive requirements designed to ensure their activities with integrity and impartiality. These additional proposed rules supplement initial rules
implemented by the Commission under the Act in June 2007. The detail regulatory program is summarized as below.
Create more agencies: A view that partly inspired the Credit Rating Agency Reform Act passed by Congress at 2008. The negative is, perhaps the existence of more agencies would encourage issuers to shop around for the firm with the weakest standards. Although the agencies’ models make it clear what rating they will give a bond on issue, it is less clear what will cause them to downgrade it later on.
Create more agencies: A view that partly inspired the Credit Rating Agency Reform Act passed by Congress at 2008. The negative is, perhaps the existence of more agencies would encourage issuers to shop around for the firm with the weakest standards. Although the agencies’ models make it clear what rating they will give a bond on issue, it is less clear what will cause them to downgrade it later on.