Of the three major risks addressed by the new Basel Committee Capital Adequacy Framework (Basel II), credit risk is associated to the counterparty’s ability or willingness to face up to its contractual obligations; market riskis due to volatility in interest rates, exchange rates, equity prices, and other variables;
operational riskis involved in financial transactions and/or the management of assets, including fraud, execution risk, legal risk, and technology risk.
Exposure is also a function of the type of lossthat is covered; for instance life, fire, and accident insurance. And there are also other risks to account for, some of which fall at the junction of the above mentioned classes. An example is pric- ing risk, a hybrid of market risk and operational risk. What all these risks have in common is that:
● A certain event is probable, but not certain
● Risk is the cost of this uncertainty, and return is the reward provided to whomsoever faces it in an able manner.
Risk and returnare related because there is no significant gain without the ability to overcome adversity. In the general case, the doors of risk and of return are adja- cent and identical. Therefore, the first step in overcoming adversity is identifying fundamental risk factors, and establishing metrics and determining linkages. This is precisely what IAS 39 requires that companies do for their financial reporting.
But which companies? The answer is companies quoted in public exchanges where their equities are traded: tapping the capital market for funds (equity or debt); being regulated, and being under steady supervision. Regulatory authori- ties have the mission to keep publicly quoted companies under close watch, and modern risk-sensitive accounting standards are the cornerstone in this edifice.
But there are also financial companies that are not regulated. Some of them are small, and their failure would not do much damage to the global financial sys- tem, though it would hurt their clients. Others are big, indeed very big, because they balloon their capital through inordinate leveraging. The name all of them share in common is hedge funds– and they are not regulated (more on hedge funds and the regulatory loophole in section 7).
Leaving aside the fact that many banks, particularly investment banks, have become giant hedge funds, what interests us in this section is that the applica- tion of IAS 39 should be a ‘must’ not only by publicly quoted entities but by all
companies – a statement that can be extended all the way to private investors.
A case study helps in explaining the reason for this statement.
Wealthy investors with no expertise in risk management account for a good deal of the money that runs, and gets lost, into hedge funds coffers. The rest comes from banks, insurance companies, and even pension funds – who gamble with the savers’ and pensioners’ nest egg. In early June 2005, the Merrill Lynch/Cap Gemini World Wealth Report stated that 8.3 million people around the globe have more than $1 million each and try to find a home for it.
Again according to Merrill Lynch, the average wealthy person has 34% of his or her assets in equities, 27% in fixed income, 12% in cash, 13% in property and 14% in ‘alternative investments’,6like hedge funds and private equity. This gives a measure of the cash flow hedge funds get from private individuals – which they can superleverage through borrowing and trading games.
Since year 2000 private bankers have tried to sell their clients the idea that 20%
of the wealth should be in alternative investments. How does that money fare?
Table 5.1 presents a real-life case study on how investors are cheated by their bankers through alternative investments. The bait on the hook is ‘capital pro- tected’. These two words mean that the investor will get his money back at matu- rity of the issue, which typically is in 5, 6 or 7 years. During that period:
● The investor gets no interest whatsoever, and even at the low 3% one can do with investment-grade corporate bonds in the early 21st century, over 6 years this represents a compound loss of about 20% in earnings, and
● The investor also carries a good deal of credit risk, because if in these 6 years the bank providing capital protection goes bust, which can happen, there is no more capital protection to talk about and the invested capital goes up in smoke.
As in the case of permanent paradise after death, the investor is of course told to wait till the end of the 6-year period for the ‘profits’. And like in the case of an after-life garden of Eden, this is silly. The best test is marking to market at the end of the first year to find out if the alternative investments are indeed a ‘good deal’
or a cheat.
This is precisely what IAS 39 means when it stipulates that companies should mark to market their assets, for financial reporting purposes. And that is what I did with three alternative investments, as a test. As Table 5.1 shows, I bought from a very well-known global bank three of the many structured financial products
IFRS, Fair Value and Corporate Governance
Market Values Alternative Investments
‘Alternative Start value at Current value Difference Difference When On Investor Final difference Investment’ beginning of (12.7.05) in points in % bought 12.7.05 gain/loss to investor
term disfavour
‘CPU SMI’ Zurich 5693 6323 Up 630 ⫹11.1% 100 101–102 1% ⫺10.1%
Stock Exchange
‘Certificate Plus 11 488 11 623 Up 135 ⫹1.0% 100 96–97 ⫺4% ⫺5%
Nikkei’ Tokyo Stock Exchange
The 10% Bonus Coupon Note has no index for direct comparison. The bank who sold the ‘alternative investment’ says that over the elapsed year its overall performance was 6.80%. What investors got was 1.37% – a difference of 5.43% to their disfavour.
they tried to sell me over the years. This credit institution, like practically all of its competitors, has hundreds of different structured derivatives in its inventory for sale to investors. Of those I chose:
● One bet on the Zurich stock exchange
● Another bet on the Tokyo stock exchange, and
● A third one on a basket of 20 American, European and Japanese stocks.
The ‘Bet on SMI’, a structured derivative product,7was sold by the bank as an
‘interesting defensivealternative’ to direct investment in the Swiss equity mar- ket. The ‘how it works’ documentation said that the investor participates at maturity 100% in the overall performance, which corresponds to the develop- ment of the Swiss Market Index (SMI), with a cap at 4.00% per year. This means that the 100% participation is a lie, because if the SMI rises 11% in a year, the investor in the derivative instrument will only get 4%.
The bet on Nikkei 225, also a structured derivative, was advertised and sold as an
‘interesting alternative’ to a direct investment in the underlying Japanese index. The catch was the knock-out. This meant that ifthe Nikkei at least once reaches a spec- ified knock-out level during the instrument’s entire lifespan, thenthe investor will not get a minimum repayment as his or her asset would then be fully exposed to any decline in the index. So much for capital protection, even excluding credit risk.
In fact, as the reader can see in Figure 5.3, in the 1999–2004 timeframe the Nikkei 225 nearly hit the knock-out level, which would have meant that the house (in this case the bank issuing the alternative investment) would have col- lected a good part of the investors’ money laid on the table. It should also be noticed that an investor in these supposedly ‘PLUS’ derivative instruments has no claims to any dividends distributed by the companies represented in the Swiss Market Index (SMI) or in the Japanese Nikkei 225.
This evidently makes a mockery of the claim about an ‘interesting defensive alternative’. Moreover, the daily price of these instruments was fixed by the same bank selling them, without access to an open market and in the absence of super- visory control – leaving the way open to all sorts of conflicts of interest. Under these conditions the ‘opportunity’ offered to the investor was between:
● Losing small, and
● Losing out the big way.
The third alternative investment has been a 10% Bonus Coupon Note. All con- sidered, this was a better deal. Apart from the fact that the capital protection of
100% at maturity was not constrained by a knock-out clause, it did offer partic- ipation in each single stock, up to a performance of 10% (quite superior to 4%).
It also paid a minimal bonus coupon every year. In this case too, however, the interim price of the derivative security:
● Was not established by the open market
● It was set by the bank which had sold the security, and which was evi- dently interested in bringing water to its own mill.
As it can be attested from Table 5.1, a little over a year down the line all three bets did well, though Tokyo only slightly so. The SMI index rose an impressive 11.1%, but investors were cheated of their profits. Instead of gaining at leastthe advertised cap of 4%, all they got was 1% in the buyback price – established by the vendor bank itself. Figure 5.4 shows how much of investors’ capital gains went up in smoke.
The Nikkei 225 did not perform so well, with the index gaining just 1%. But this was not true for the investor. As the reader can see in Table 5.1, investors lost 5%, namely the 1% they should have gained and 4% on drawing down the price of the instrument. From an investor’s viewpoint, the case of the 10% bonds coupon was only slightly better (see Table 5.1). How can that happen? There are two reasons for it:
● 1. Since the design stage, the structured derivative instrument sold to the investor is loaded in the bank’s favour.
APR 1999
JUN 2000
DEC 2002 15 500
500 10 500 5500
SEPT 2001
MAR 2004 25 500
20 500
START LEVEL
KNOCK-OUT LEVEL
Figure 5.3 Nikkei 225 index performance in the 1999–2004 timeframe
This means that the investor does not really stand a chance. The prospectus is so murky in its writing that even an expert cannot decipher what it says. Prior to buying, I asked for information, asking for word of honour that the SMI and Nikkei derivative instrument emulated the corresponding index – and got it.
When the end-of-year test showed that this was not at all the case, the bank’s words changed to: ‘We didn’t mean that …’.
● 2. The bank who sold the ‘alternative investments’ made the market, there- fore it could decide whatever it wanted in terms of pricing, since nobody controls it – at least not until now.
12
10
8
6
4
2
0
5
3
1
-1
-3 -4 -5 4
2
0
-2
TIME INVESTOR
MONEY FALLING IN THE
CONFLICT OF INTEREST GAP
WHAT THE INVESTOR WAS OFFERED HOW FAR THE INDEX ROSE WHAT THE INVESTOR WAS OFFERED HOW FAR THE INDEX ROSE
INVESTOR MONEY FALLING IN THE
CONFLICT OF INTEREST GAP SMI INDEX
NIKKEI INDEX
TIME
PERCENT INCREASEPERCENT INCREASE OR DECREASE
Figure 5.4 How investors in ‘interesting defensive alternatives’ have lost their reward
Yet, the home country of this bank has adopted IFRS and IAS 39. Therefore, all instruments in its portfolio, and posted prices, should have been marked to market. Here is another important reason why marking-to-market is vital, and IAS 39 should be welcome as a rule. The problem is not that entities cannot price to market, but that in their pricing they have got one short leg and one long leg.