Autumnal Lessons in Credit Risk

Halloween was an auspicious date for George Papandreou to play a Greek version of trick or treat on his European neighbours.  By calling a referendum on the country’s second international bailout he spooked the markets and once again raised the spectre of a sovereign default that was supposed to have been safely entombed after last week’s eurozone summit.  The implied threat is that if Nicolas and Angela don’t sweeten the terms of the bailout, then George and his friends could make a mess of Europe’s front garden.

The latest corporate casualty of the crisis is the broker MF Global, whose $6.3bn gamble on eurozone sovereign debt, hidden by an accounting trick, was uncovered by a credit rating agency. The subsequent downgrade quickly impacted on its clients’ willingness to trade, and potential buyers for the unprofitable core business evaporated.  But more shocking than the loss of one of London and New York’s leading intermediaries is the news of $700m in missing client funds, apparently misappropriated to shore up the failing broker’s own liquidity shortage.

This sorry tale reminds us of several valuable lessons in credit risk management. Firstly, financial institutions are always highly geared (with debt/equity ratios above 20 not uncommon) and so tend to fail much quicker than companies with more standard capital structures.  The proposal by CLG to remove restrictions on English local authorities investing in corporate bonds is therefore very welcome and should go some way to dispelling the myth that banks are always the safest place to put your money.

Secondly, we have seen that when an overseas parent company goes bust, UK subsidiaries tend to be placed into administration to protect the claims of local creditors.  This was the case in 2008 with Lehman Brothers and Landsbanki/Heritable, and again this week with MF Global.  It is therefore difficult to argue that any UK subsidiary bank is less likely to default than its foreign parent.

Finally, we have a reminder that credit risk exposures don’t just arise from the ultimate counterparty.
Depending on the arrangements for money transfer and the location of your investments, you can be exposed to failure and fraud at clearing banks, brokers, fund managers, custodians and clearing houses.  I wonder how many owners of supposedly ultra safe US treasury bills considered the risk of MF Global misusing their assets?

As Guy Fawkes Night approaches, the various parliamentary plots underway in Greece are adding to market uncertainty.  Gunpowder and assassinations may be things of the past, but don’t be surprised to see more fireworks next week

David Green is Head of Sterling Consultancy Services, a treasury management adviser for local
authorities and other not for profit organisations.  This is the writer’s personal opinion and does not constitute investment advice. It should not be relied upon when making investment decisions.

Image: Ron Bird / FreeDigitalPhotos.net