Sub-Prime – where are the risk managers?

Quantitative risk markets are reeling from the onslaught of the sub-prime credit crunch. The cost of borrowing has rocketed and, following failures in the US, Germany and the Australia, the first UK victim has been claimed.

Earlier this week the three-month rate London Interbank Offered Rate (LIBOR) soared. Libor is the measure of how much money costs on the open market, and is used by lenders who fund themselves from the interbank markets. The spread between the base rates and LIBOR has now hit its highest level for 20 years. Many institutions are blaming the central banks for failing in their prime duty – that of keeping liquidity sufficient by injecting the system with temporary cheap borrowing lines.

Are there major financial institutions in danger of coming off the tracks, or is this a simple lack of confidence in the markets with all banks protecting their loan portfolio - just in case? The next few weeks may tell but it now looks like a consequence could be a recession and earlier this week former US Treasury Secretary, Larry Summers, warned of such a risk. Last week US Fed data also showed that the outstanding stock of US commercial paper fell by $255 billion, a sign that borrowers can no longer roll over major debt. The impact is a further drain on market liquidity and is comparable to events preceding the dot-com crash.

The lack of liquidity and the consequent increase in wholesale borrowing costs comes at a difficult time for the UK banks as £70 billion of short-term money market loans mature this week. If banks have to finance these debts with their own capital this will put strain on their balance sheets and their regulatory capital requirements. A number of US sub-prime focused funds have now collapsed and Sachen Bank in Germany accumulated $80 billion in risky debt and had to be bailed out and be taken over by a competitor. This week Victoria Mortgage Funding, a small UK sub-prime lender was placed in administration after its funding lines dried up.

Why were risk managers caught unaware by this crisis – or were they overridden by the client facing sales teams? Charlie McCreevy has attacked the credit rating agencies for failing in their role of accurately forecasting the ability of sub-prime funds to service their debts. How many risk managers have simply looked at credit ratings as an indicator of the health of loan portfolios?