Merchant banks' problem: Conflict of interest

Share Shah

Investment Corporation of Pakistan (ICP) had barred its employees from taking part in both primary and secondary markets. This was based on the principle of access to inside information, which ICP had as the most important merchandiser, portfolio manager and underwriter of shares and securities. This practice was not followed by the precursor- ICB that permitted its employees to deal in the stock market.
   While the role of ICB's staff is not clear but it is generally alleged that many are involved in active trading through fake accounts and omnibus accounts in the names of relatives and surrogates. In this context the role of the present merchant bankers is also of significance as no firewalls exists in the many functions that have been permitted. While SEC has attempted to curtail conflict of interest by controlling the numbers of market roles, it is still possible to have surrogates sitting on the boards as is the case with the employees of ICB.
   Today the conflict of interest in the state investment house has reached new proportions when the endeavour of the Asian Development Bank to spin off the various functions were by subterfuge transformed into three heads of the hydra. Now the private sector has to contend not with one but four organisations which in fact have internecine links.  Among the many public grievances- one of monopoly practices indeed stands out. ICB gets all the business from the public sector without any competition. It reminds one of President Ershad's monopolies given to the Thai Aluminium company. Through staff linkages ICB is able to have a dominant role in the market essentially based on insider connections. Moreover it is in a position to influence the market overtly and covertly through interactions with the mutual funds.
   
   The Indian scene
   In India the concept of conflict of interest is defined structurally and is more precise in respect of both real and artificial persons. In simple terms the economic laws define family in a larger extent which includes wife, sons, daughters and the in-laws even if they are separate tax centres from income tax point of view. The scope of influence is further extended to included controlling interest by way of shareholdings or stake in a firm. For instance, in our market, directors of listed companies are not permitted to hold memberships in the stock exchanges. But once their firms are incorporated and a surrogate professional management is in place all facts are overlooked by the regulator. But everyone knows who may and can pull strings. It will only be fair if the regulator starts looking into the make up of the shareholding pattern of such firms both brokerage houses and merchant banks.
   The SEC Ordinance 1969 requires trade dealings of persons holding five per cent or more to be reported to the authority. This control should be applicable to all shareholders and directors and their spouses etc. of merchant banks or incorporated brokerage firms in the matters of their dealings. This will enable the regulator to monitor or cap panic trades by such entities whenever required. It was surprising to note that the reporting by the spouses of Directors was withdrawn last year by a regulatory order.
   
   Weak regulations
   The insider regulations in our market is still very weak and as such there are number of ways to circumnavigate around it requirements. Albeit the gap is becoming smaller and with due exposure may be filled up. But there is still no way for the regulators to determine the minds of those that may control and direct board decisions. The regulation requires that the information must be passed on to the exchanges within a certain period does not help because markets reacts to the speedy information that may seep in through other quarters. The reality is that those who make the decisions know what it is going to be well in advance of its finality. While there is a six-month bar on certain classes of shareholders this has not been activated to take into account others who may be close to the decision-makers or are surrogates of the decision-makers.
   Our regulator, unlike in U.S. and other developed markets, believes that the stockbrokers are the key ingredients in market manipulation. But in reality the brokers are the ones who are able to bring to surface the tip of the iceberg and therefore able to alert the market about a change in the market equilibrium. A stable market would require the regulators to trust to work with stockbrokers in order to maintain a stable market as far as possible. Distrust by the regulator of the main players will only result in getting the wrong vibes and further strengthened his continued mistrust of the main players.
   The other matter is for the regulator to re-think is about firewalls. Everyone knows that these are never sufficient and then again our ethos will never let firewalls work. Therefore the regulatory insight is necessary to further segment roles and functions in totality as far as possible. Should all functions be given to a single entity in terms of their corporate connections and ownership? Or should functions be divided? That is, merchant banks should have no connection with the brokerage business etc. One should not forget the other side of functional risk. Least we forget the demise of a four hundred year old British merchant bank which lost every thing in a single day because of an errant broker. Such risks are to be carefully monitored as they are bound to be repeated in any market because of the follies and greed of men.

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US on brink of financial 'tsunami'

Martin Khor

In recent days, the United States' financial system has been going through tumultuous times, with one major problem or crisis following another.
   Because US finance is so large, with tentacles throughout the world, a tsunami-type situation may be building up in the global financial system as well.
   Last Monday the stock markets in Asia and Europe took a big tumble. Tokyo closed 3.7 per cent down, Hong Kong 5.2 per cent and Mumbai 6.5 per cent. The indices were also down for Frankfurt (4.1 per cent), London (3.9 per cent) and Paris (3.5 per cent).
   The immediate trigger was the collapse of America's fifth biggest bank, Bear Stearns. It had to be temporarily rescued 0n 14 March by US Federal Reserve emergency funds channeled through another bank, JP Morgan.
   Then two days later, it was announced that JP Morgan would purchase Bear Stearns for the basement price of $2 a share (or $230 million in total), as a part of a package deal also involving the Federal Reserve.
   The Federal Reserve moved into intervention mode, with three emergency measures announced on that Sunday. First, it will provide up to $30 billion in loans to bolster Bear Stearns's balance sheet by funding illiquid assets (including $13 billion of net exposure to toxic mortgage-related securities), thus reducing the risk to JP Morgan, a condition for JP Morgan's take-over. To minimise its own risk, the Fed will take direct control over Bear Stearns's huge portfolio of financial assets.
   Second, the Fed also announced a new lending programme, making funds available to the 20 large investment banks that serve as "primary dealers" and trade Treasury securities directly with the Fed. The Fed will reportedly hold as collateral a wide variety of securities that include hard-to-sell securities backed by mortgages, according to media reports. There will be no limit to the amount that can be borrowed, which is a major departure from previous Fed fund injections.
   Third, the Fed also lowered the rate for borrowing from its so-called discount window by one-quarter percentage point, to 3.25 per cent.
   "The moves amounted to a sweeping and apparently unprecedented attempt by the Federal Reserve to rescue the nation's financial markets from what officials feared could be a chain reaction of defaults," according to an International Herald Tribune article.
   The speed of Bear Stearns's collapse and takeover was astonishing. The bank faced two problems-it had to write off $2 billions of losses in mortgage-related investments, and then investors withdrew their funds-forcing it to seek the bail out.
   On 11 March, the Chairman of Bear's executive committee Ace Greenberg dismissed speculation that the bank had liquidity problems as "totally ridiculous." Just a few days later (14 March), it was revealed that the bank had become insolvent and had to be bailed out. And on Sunday (16 March), the buy-out to JP Morgan was announced.
   Dramatic as it was, the sudden demise of Bear Stearns was only one of many major developments in recent days indicating that the crisis is spiraling in many areas.
   First, data was released on 7 March showing that the US lost 63,000 jobs in February, following a fall of 22,000 in January. A few days later came data showing a decline in retail sales. This has prompted many economists to conclude that the US is in a recession.
   
   Deep, serious recession
   And not just a shallow, short-term dip. It will be "a deep recession that could be the most serious since World War II", according to Martin Feldstein, president of the National Bureau of Economic Research.
   "The situation is bad, it's getting worse, and the risks are that the situation could be very bad," said Feldstein, adding that the chief causes are falling housing prices, job losses, and turmoil in the financial markets.
   Second, the US dollar fell sharply to a record low on 13 March, going below Yen 100 to the dollar (Y99.77) for the first time since 1995, and to a record low of $1.56 to the euro on the same day.
   On 17 March, the dollar fell further in Asian trading, plunging to as low as 95.72 yen, while the euro jumped to a new record high $1.5903. In Japan, officials called for calm in the currency markets.
   More gyrations in currency markets are expected. Such a sharp decline in the US currency affects the competitiveness of exporters in many sectors in other countries, as they will receive less in local currency for the sale of their exports that are denominated in the dollar.
   Third, on 13 March, the spot price of gold for the first time broke through the $1,000 level, indicating a further fall of investor confidence in liquid assets and a shift to safety.
   Fourth, in the midst of the financial crisis has come a jump in oil prices, which will increase costs and inflate the import bill of net oil importers.
   The price of West Texas crude oil reached US$111 a barrel on 13 March. On 17 March, in Asian trading, the oil price hit a new record high of $111.80 (light, sweet crude for April delivery) in electronic trading on the New York Mercantile Exchange.
   
   Bad repercussions
   Fifth, there is mounting evidence that the crisis has spread to hedge funds, which are facing pressures from their creditors and investors expect adverse repercussions as these funds "unwind" their positions in the markets in forced sales to meet these demands.
   The banks that lend to the highly leveraged hedge funds are making margin calls. To meet these demands for more collateral, the funds have to sell their securities. Nervous investors are also redeeming their shares, thus adding to the pressures on the hedge funds to sell, and in a falling market. Their losses are thus climbing.
   A dramatic sign of this was the collapse last week of Carlyle Capital Corporation (CCC), a $22 billion hedge fund that is part of the Carlyle Group, one of the world's largest equity fund groups.
   CCC had unwisely invested in mortgage-backed securities. It revealed that up to 12 March it had defaulted on $16.6 billion of its indebtedness, and the remaining indebtedness is expected soon to go into default. It added that its banks are likely to take possession of its remaining assets and liquidate them, after it ran out of cash to meet margin calls.
   A front-page article in Financial Times (14 March) said the markets are "grappling with mounting signs of forced sales by hedge funds driven to reduce their portfolios by lenders trying to reduce their own risk exposures."
   Chief US economist at Merrill Lynch, David Rosenberg was quoted as saying that "the credit crunch has now reached the hedge fund industry." Co-chief executive of Pimco Mohammed El Erian said there were signs of "a growing number of hedge funds having to go into survival mode."
   
   Mounting credit default
   Sixth, the cost of protection against credit default is also mounting, and this may soon trigger forced sales of structured credit instruments. The cost of protection from credit risk is measured by two indices - in the US, the CDX index for investment grade companies; and in Europe, the iTraxx index of investment grade corporate debt.
   On 10 March, the CDX index jumped 15 basis points (bp) to a record 193 bp (a year ago, the index was only 30-40 bp). The iTraxx index was trading on 10 March at a record 157 bp, up from 146 bp on 7 March.
   According to Financial Times (11 March): "Structured trades based on the value of the CDX and the iTraxx are close to reaching a major inflection point. Many complex structures including so-called constant proportion debt obligations (CPDOs) have triggers that are released when spreads widen to a certain level. This could cause such complex vehicles to begin selling into the market and push credit spreads wider still."
   The CDX and iTraxx are very close to triggering a wave of such forced sales. Further ratings downgrades could also cause the sale of other structured credit instruments and weigh further on CDX and iTraxx, according to traders.
   
   Govt bail-out
   And seventh, is the news that the two big companies, Fannie Mae and Freddie Mac, which hold or guarantee most housing loans in the US, are also facing a crisis and that Fannie may require a government bail-out as well. Credit Suisse has estimated that Fannie and Freddie might have to write down $5 billion on portfolio of sub-prime mortgage bonds.
   They have already reported large losses in the fourth quarter of 2007 - $2.5 billion for Freddie and $3.6 billion for Fannie.
   All the above are signs of a most serious crisis causing the crumbling of significant parts of the US financial structure. The impact on the real economy of production, jobs, and income will be serious, not only for the US but also the rest of the world.
   - Third World Network Features

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