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Sunday, 21 September 2008

Global financial crisis: 'Keep a significant portion of your portfolio in cash'

I AM A financial advisor and money manager, and many of my clients have asked me about the stability of banks in general and some of them have joked about keeping cold, hard cash under their beds.

While I want Singaporeans to be fully aware of the current circumstances and take precautions if necessary, I do not want to instil fear in their hearts.

Is there a chance of a global financial meltdown?

First, we need to define systemic risk.

Systemic risk is the risk which is common to an entire market and not to any individual entity or component thereof. It can be defined as 'financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries'. It refers to the movements of the whole economy and has wide-ranging effects.

Next, we need to understand the credit derivatives market. The credit derivatives market is a US$63 trillion (S$90 trillion) market. To put that into perspective, this market is about 50 times the size of the subprime market. The subprime market has wreaked havoc in the financial markets, imagine what will happen if the credit derivatives market turns sour.

A credit default swap is a credit derivative that transfers an investor's risk to someone else in exchange for a fee.

For example, if you are a bank and you have granted a loan to Company ABC for 10 per cent per annum for five years, you may pass on part of this risk to another party by going into a credit default swap. The bank pays the counterparty five per cent per annum on the amount and, in return, the counterparty takes on part of the default risk of Company ABC. This all looks very good on the surface.

1. Company ABC gets its loan.

2. The bank earns an X per cent on the loan after deducting the cost of funds and paying the counterparty.

3. The counterparty earns five per cent in fees and takes on the risk of company ABC which it thinks has a low chance of default. On the financial books, the profits of the counterparty will be the fees they earn minus the provision for the credit default. This provision works out on the chance that company ABC will default multiplied by the nominal amount of the credit default swap.

It will not take a genius to tell you that it will be in the interest of the counterparty to put the risk of default lower as this will result in higher profits for the company and thus higher bonuses for everyone.

This system may not take systemic risk fully into account. When there is a global recession and more companies go belly-up, the writer of the credit default swaps may not have enough resources to provide for these defaults. If they collapse, the banks are in trouble as well. They may have thought that they have hedged their exposure to these loans, but their hedge is useless now and they must bear the losses as they are not able to claim on the writer of the credit default swap, leading to a domino and snowball effect.

What does this mean to the man on the street?

Banks will start scrutinising their risk exposure.

1. Small banks that are in trouble will not be rescued as they will not contribute so much to the snowball. The big banks will be either bought over or will merge to form a stronger bank. If they are really in trouble, the authorities will have to step in to bail them out. Once again, in choosing a bank to bank with, every bank is subjected to some form of risk. Some banks are more exposed to this risk than others. Because of the strict capital requirements of the Monetary Authority of Singapore (MAS), I think that the risk of a bank failure in Singapore is low.

2. However, the general public needs to realise that the real risk is for the borrowers. Strange idea? Let me explain. If you are borrowing from a bank, I believe the bank will be cutting liquidity and be very selective in its loans. I would not rule out banks increasing their collateral requirements. In the last few years, many Singaporeans were exposed to the property market and property loans. It is unlikely that the banks will decrease the collateral value of your property in terms of percentage. If you had borrowed an amount to the tune of 80 per cent of the value of your property, the bank is unlikely to tell you suddenly that you can borrow only 60 per cent next year. That will be unfair.

However, one thing the bank can and will control will be to follow up religiously on the re-valuation of your property. This is especially so when property prices are coming down.

If the prices of the property market continue to fall, property investors who are highly geared may be faced with a situation whereby the collateral value of their property after re-valuation is lower than the loan amount. In such situations, the investors will have to reduce their loan amount by coming up with cash.

If the borrower cannot come up with the cash, it will be a case of foreclosure. As such, I would urge investors to have enough liquidity to cater for such situations.

So what does a borrower need to do?

Firstly, re-evaluate your loans and property. If the price of your property drops by 30 per cent, how does that affect your standing with the bank? Do you have enough liquid assets to cover yourself?

To sum it all up, keep a significant portion of your portfolio in cash just in case you need it in situations like these.

Risk management is not rocket science and neither is it only for financial institutions. I hope I have highlighted the risk that Singaporeans are exposed to in their personal finances and take necessary precautions if needed.

Patrick Chan

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