2007 exposure: Snowy Hydro electricity swaps and swap like instruments

Reference: Snowyhydro Limited renewable energy ABN 17090 574 431, Consolidated Financial Report for the Financial Year, 2 July 2006 to 30 June 2007

State and Fed Govt financial-reporting harmonised; AASB looks at more onerous standards for private companies, non-profits

The accounting standards-setter has agreed to harmonise Federal and State Government financial reporting and progressed talks with New Zealand to ensure the two countries’ standards were “as similar as possible”, wrote Patrick Durkin in The Australian Financial Review (8/10/2007, p.8).

Salteri family appoints investment bank UBS to handle sale of Tenix Group

According to Brett Clegg and James Hall, in The Australian Financial Review, (8/10/2007, p.1) one of Australia’s wealthiest famil­ies was planning the sale of its sprawling defence and technology systems empire in a $1 billion-plus auction of Tenix Group. Tenix Carlo Salteri co-founded Transfield with fellow Italian-born engineer the late Franco Belgiorno­Nettis, employs more than 4000 people and boasts annual revenue of more than $1.2 billion.

Credit markets around the world freeze: UK Bank collapses, street queues: rush of customers desperate to withdraw money from accounts, 9 August

Northern Rock, the provincial also-ran which, in less than a decade, had transformed itself into one of the UK’s biggest lenders, – £100 billion ($238 billion) mortgage portfolio – was in trouble and the court of the Bank of England was required to meet in emergency session to decide its fate.

Wall Street worried as China may prevent foreign investors from taking control of brokerages; central bank predicts economic growth of 11.6pc

The latest initial public offering on the Shanghai exchange was for China Shenhua Energy, one of the country’s biggest coal producers, which raised a record 66.58 billion yuan last week, wrote Colleen Ryan in The Australian Financial Review (4/10/2007, p.13).

Leading bankers warning of the worst crisis in the money markets for 20 years

Leading bankers are warning of the worst crisis in the money markets for 20 years, which would come to a head when $US113 billion ($137 billion) of commercial paper — market IOUs — came up for refinancing, mainly through London, reported The Australian (10/9/2007, p.29).

Resolution of overnight global liquidity squeeze impossible to predict: numbed markets wait for direction

For the past 15 or so years, banks have grown by lending to people and businesses, then bundling those loans and selling them to investors in world capital markets, reported The Australian (8/9/2007, p. 20).

Vict Govt opts for PPP model to design, build and operate new desal plant by 2011

The Victorian Government opted for a public private partnership (PPP) model to design, build and operate the new desalination plant by 2011, reported The Australian (22/9/2007, p.41).

Carbon-exposure survey of Aus companies: BHP, Rio, BlueScope, Qantas account for half top-200 emissions

A survey of the carbon exposures of Australia’s top 200 listed companies conducted for institutional investor VicSuper found three out of four did not disclose comparable emissions data, wrote Peter Hannam in The Age (26/9/2007, p.2).

Rating agencies do double-take: In July Standard and Poor’s, Moody’s and Fitch downgrade hundreds of CDOs from A+ and BB to as low as CCC pushing them into junk status

But there are some curious default probabilities in S&P’s latest CDO model, released in mid-2006, which seem to suggest that historic or “idealised” defaults differ widely for corporate bonds, asset-backed securities and CDOs with the same rating, reported The Australian Financial Review (20/9/2007, p.68).

Thirty-five local councils bought Federation, a Lehman Brothers CDO rated AAA by S&P and marketed by Grange Securities, which tracks the US sub-prime mortgage index

According to Janne Gray in The Australian Financial Review (20/9/2007, p.68), thirty-five local councils (not including Corowa) bought Federation, a Lehman Brothers CDO rated AAA by S&P and marketed by Grange Securities, which tracks the US sub-prime mortgage index.

Conflicts of interest; rating given to a CDO will determine whether it is created – if the CDO is created, the rating agency will be paid for its ratings

Ultimately, rating agencies may have to do more to address the conflicts of interest implicit in their business models, reported The Australian Financial Review (20/9/2007, p.69).

Night of Armageddon follows sunset of Dazzling World of Derivatives: Time to put money in a box under the bed: Banks may fail

It was time to take the money out the bank and put it under the mattress, said Satyajit Das, a risk consultant and author of several key reference works on derivatives. His book Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives was published by FT-Prentice Hall. He said the finance crisis was hidden as the US central bank emergency measure was underwriting the world’s credit risk, according to The Age (8/9/2007).

Banks have no clothes: Banks had also created a plethora of off-balance-sheet structures – arbitrage or conduit vehicles; structured investment vehicles (“SIVs”). The vehicles buy high-quality securities such as AAA or AA-rated CDOs and fund them by borrowing short term.

How it all works: Das said “Traditionally, banks wrote loans and then held them on their balance sheets until maturity. The liquidity factories are based on the new-age idea of “risk transfer”. In the new money game, banks “originate” (sell) loans, “warehouse” (hold) them on their balance sheets for a short time and then use CDO technology to “distribute” (transfer) them to investors (insurance companies, pension funds and hedge funds). Banks must hold the loans until they can be sold. If there is a market disruption and the bank is unable to sell the risk into the market, then the risk remains with the bank.

Market bubble so big you can’t see it: Steven Rattner, managing principal of hedge fund Quadrangle Group, summed it up in The Wall Street Journal: “No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since US financial markets reached full flower.”

Turbocharged by “financial engineering”: “The effects of loose monetary policy, low interest rates, and large capital flows from the savers of Europe and Asia were turbocharged by “financial engineering” (read derivatives). This lies at the heart of the present credit crisis.

Mortgage loan on steroids: Derivatives – highly leveraged commercial bets on movements in prices of financial assets – can be used to manage or create risk. In recent years, investors turned to derivatives to increase risk to earn higher returns. Take, for example, the collateralised debt obligation (CDO) – a mortgage loan securisation on steroids;

• A portfolio of loans, bonds or mortgages is assembled. CDOs, secured over the portfolio, are sold to investors;

• Interest and principal from the portfolio is used to make payments on the CDOs issued;

• Investors receive higher returns than from traditional investments.

When a Bank may close its doors: “Banks provide standby lines of credit to the vehicles to cover funding shortfalls. If short-term money cannot be found then the banks may be forced to send against the assets they have supposedly sold off. In the present crisis, some banks refused to lend, arguing material changes in circumstances.

The new money game: The new money game assumes that the risk moves to stable investors. In fact, credit risk moves

• From a place where it is regulated and observable to a place where it is less regulated and more difficult to identify;

• About 60 per cent of all credit risk is transferred to leveraged hedge funds that may be inadequately capitalised to bear the risk – about $1 of “real” capital supports between $20 and $30 of loans;

• In contrast, banks are required to hold $1 of capital for every $12.50 of loans;

• Hedge fund investors can withdraw funds at relatively short notice, typically one to three months. The hedge fund’s borrowings are also short term. Short-term money finances long-term assets, making the hedge funds vulnerable to a credit crisis. Banks set up hedge funds and invest in them. When a hedge fund gets into trouble, as we have seen, there is pressure – commercial and reputational – to support the fund by bringing the risk back into the bank.

Orphan banks: As of the last month, hundred of billions of dollars of leveraged finance loans made by banks is effectively “orphaned” – the loans cannot be sold off. The temptation to seek a scapegoat (the brokers that sold subprime mortgages and rating agencies loom large) or a quick fix (lower interest rates) is ever present. Note, the US Federal Reserve has cut the discount rate and allowed banks to pledge asset-backed commercial paper as commercial paper as collateral for funding at its discount window. Usually, only government securities are eligible. This means the US central bank is effectively underwriting the world’s credit risk.

Reference: Satyajit Das is a risk consultant and author of several key reference works on derivatives. His book Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives was published by FT-Prentice Hall.

The Age, 8/9/2007