Industry expert warned of financial meltdown
For some who toil in the murky world of financial derivatives, Satyajit Das is nothing more than a turncoat.
A former industry whiz, the Australian author and risk consultant could be considered the financial world’s Dr. Frankenstein.
After making a handsome sum engineering exotic credit derivatives during his 25-year career, Das has spent the better part of the past decade preaching on their dangers.
Those convoluted debt instruments, particularly toxic credit default swaps, helped trigger the demise some of America’s most storied financial institutions.
With the financial crisis tightening its chokehold on global banks, Das’ forewarnings – outlined in his 2006 book Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – are looking rather timely. Still, some in the industry initially scoffed at his warnings.
"They thought that I had somehow found religion in my old age," Das said in an interview at a downtown hotel. "There were two views. I was a crackpot now … The second was a deep sense of betrayal. Some people felt deeply betrayed. How could one of their own do this?"
Now the industry is paying for his advice. Toronto’s investment community is no exception. Working as a consultant for Jory Capital Inc., Das is bending the ears of all who will listen. "I haven’t had much sleep in 10 days. I’ve been trying to work out for several people what exactly is their exposure," he said.
Much more work lies ahead. Das estimates there is US$600 trillion of derivatives outstanding in the world. It is a whopping sum that reflects the total amount of leverage in the global financial system.
At its core, derivatives are about taking a bunch of risk, cutting up in smaller chunks and selling it off to investors. The idea is to spread the risks through the system.
The problem is that the theory was never tested – until now. "Financial markets are only sophisticated in upswings. In down swings, we get down to really basic things of human fear and fear of loss," Das said.
Global banks have already absorbed more than $500 billion in losses related to the collapse of America’s subprime residential real-estate market, the original catalyst for last week’s historic shake-up on Wall Street. With the International Monetary Fund predicting the final tally could top $1 trillion, the American government has announced its own $700 billion bailout to shore up confidence in the industry.
Das, however, questions the long-term consequences of that move. The clean-up could take years and have profound consequences for the economy.
"The U.S. government has now put its balance sheet at risk, which now means it is at the mercy of foreign creditors," Das said. "… They have $9.5 trillion in debt quick payday loan. Roughly about a third of that is owned by foreigners."
Average Canadians may feel removed from the crisis, but Das warns they are not immune. As Canadian banks deal with ongoing financial fallout, consumers can expect to pick up at least some of that tab.
Domestic banks have an estimated $823 billion of "notional exposure" to the world’s troubled credit default swap market. The notional amount is the face value of the assets underlying the derivatives. Actual losses would likely be smaller, unless their entire value went toward zero.
At the same time, banks around the world are grappling with higher funding costs as they try to shrink the amount of debt on their balance sheets. Banks have been tightening their lending standards for the past year, making cheap credit a thing of the past.
John Aiken, a financial services analyst with Dundee Capital Markets, reiterated some of those concerns yesterday in a note to clients.
"Although the U.S. government may have avoided the complete failure of the financial system, we believe that we are far from out of the woods," Aiken said. " Liquidity will still be hard to come by – although inter-bank lending spreads eased on the announcement, we believe that distrust will remain amongst various lending institutions, creating higher funding costs and lower levels of credit available to be lent out and ease the pressure on the U.S. economy."
Das’ advice to consumers? Brace for even higher fees in the months ahead: "They are going to put up fees. They are going to make your loans more expensive. Ask anybody who has a line of a credit with the bank to go and try to draw it down. It will be cause for some interesting reactions."
Adrian Mastracci, a portfolio manager at KCM Wealth Management Inc., has suggested that Canadian banks could even begin clamping down on unsecured lines of credit to help deal with those higher funding costs.
Meanwhile, that "curtailment of credit" has yet to make its way into the real economy, Das said. Ontario, already hard hit by a slump in the manufacturing sector, could face more tumult in its financial services sector at a time when the provincial government is banking on that key industry to help prop up the economy. The fortunes of Western Canada, meanwhile, will be pinched by the slowing Asian demand for energy exports.
For his part, Das makes no apologies for his role in helping to create complex credit derivatives, suggesting that hindsight is always twenty-twenty. He also believes he has taken more than his fair share of flack for the current crisis. Said Das: "Somebody actually blames me for all of this. I said, `I didn’t invent everything.’"