Please find below an overview of each of the articles published in the June 2007 issue of Financial Market Trends:
Highlights of Recent Trends in Financial Markets
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An Overview of Hedge Funds and Structured Products: Issues in Leverage and Risk
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With their high share of trading turnover, hedge funds play a critical role in providing liquidity for mis-priced assets, particularly when large volumes are traded in thin markets – thereby reducing volatility. This activity is particularly important, given the rapid growth in volume of new-generation structured products issued by investment banks.
Hedge fund leverage estimated via an induction technique suggests a leverage ratio that must be above 3 (versus total AUM of USD 1.4 trillion). Gearing is required to boost returns where low risk and low return styles are implemented. Investment banks are well capitalised against hedge fund exposure.
Structured products” are one of the fastest growing areas in the financial services industry, and may already be over half of the notional size of the hedge fund industry (AUM plus leverage). These products, constructed by investment banks, are extremely complex using synthetic option replication techniques, and offering a variety of guarantees in returns. They are sold to retail, private banking and institutional clients. Hedge funds help reduce volatility risk for investment banks in supplying these products.
Structured products are passive in nature (unlike hedge fund active styles), focusing on providing returns for different risk profiles of clients. These products have not been tested when major anomalies in volatility arise. They are highly exposed to downward price gaps in the ‘risky’ assets used in their construction. Considering the potential for such a crisis scenario, two major policy conclusions emerge: The importance of (1) stress testing of investment banks’ balance sheets; and, (2) given the large retail market segment, consumer education and protection.
The Private Equity Boom: Causes and Policy Issues
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Private equity plays a valuable role, in helping transform under-performing companies. M&A and private equity deals are very strong at present, and use of leverage in deal making is accelerating sharply, as it did in the late 1980’s. The process is being driven by a number of factors, particularly low yields which result from excess global liquidity.
The accommodation of leverage is fungible with innovative global financial markets, and policies to fix the price of money in some parts of the world make it difficult to control supply (as they did in the Louvre Accord period in the late 1980s). The arbitrage opportunity that has been opened up plays a key role in driving asset price inflation, including stock prices through private equity deals. As the LBO process moves into its mature phase, deal multiples are bid up in the industries and companies where the activity is concentrated. Strong investor demand, together with readily available finance, increases the pressure to find new deals, driving down yields.
Excess concentrations of leverage can give rise to financial stability issues. However, policies that contribute to excess global liquidity are difficult to change in the short run, because domestic concerns in some countries are overridingly important. Firms and financial intermediaries therefore should be strongly encouraged to perform stress tests and to maintain strong credit checking processes, particularly with regard to the sustainability of debt at a more normal cost of capital. Credit rating agencies need to apply high standards to credit risk transfer products, and sound principles of corporate governance are required to ensure moral hazard issues do not exacerbate things.
The Role of Private Pools of Capital in Corporate Governance: Summary and Main Findings about the Role of Private Equity Firms and "Activist" Hedge Funds
In November 2006, the OECD Steering Group on Corporate Governance initiated a study of the role of privately organised pools of capital (“alternative investment vehicles”) in corporate governance. With a rapid increase in the size of transactions and investments, and partly due to differences in corporate governance frameworks and company structures, there has been a growing public interest in private equity firms and “activist” hedge funds. The Steering Group agreed that the distinct corporate governance aspects that emerge in these discussions required special attention based on the OECD Principles of Corporate Governance (OECD Principles). This Report summarises the main conclusions reached by the Steering Group in April 2007, including the findings of a factual review that were taken into consideration.
On the basis of available evidence, the Steering Group concluded that “activist” hedge funds and private equity firms could help strengthen corporate governance practices by increasing the number of investors that have the incentive to make active and informed use of their shareholder rights. It was agreed that, from a corporate governance perspective, there was no need to promote a special set of principles for private equity firms and “activist” hedge funds, but that the opportunities and challenges that follow from their ownership strategies should instead be analysed within the general framework of the OECD Principles, also taking into account existing voluntary standards established and promoted by the industry.
Longevity Risk and Private Pensions
This paper examines how uncertainty regarding future mortality and life expectancy outcomes, i.e. longevity risk, affects employer-provided defined benefit (DB) private pension plans liabilities. For this purpose, it examines the different approaches that private pension plans follow in practice when incorporating longevity risk in their actuarial calculations. Unfortunately, most pension funds do not fully account for future improvements in mortality and life expectancy. The paper then presents estimations of the range of increase in the net present value of annuity payments for a theoretical DB pension fund. Finally, the paper discusses several policy issues on how to deal with longevity risk emphasising the need for a common approach. In this regard, it argues, following Antolin (2007), that to assess uncertainty and associated risks adequately, a stochastic approach to model mortality and life expectancy is preferable because it permits to attach probabilities to different forecasts.
Asset Allocation Challenges for Pension Funds: Implications for Bond Markets
Pension funds have become the largest class of investors in many markets and, given their size, the allocation of their assets has important implications for the relative prices of financial assets. There may be a trend shift of private (defined benefit) pension fund asset allocation strategies away from equity to bonds, especially to government bonds, given their limited credit risk. The potential demand for such bonds could, in principle, be very substantial, sufficient in fact to result in a scarcity of such bonds in circulation. Many debt managers have taken advantage of current bond market conditions and issued long-term to ultra-long-term bonds. But whether they should follow a strategy of maturity-lengthening with the express aim to facilitate the task for pension fund managers is a different matter. Most policy makers would not recommend that governments undertake to issue long-term debt with the express intent of meeting this demand, not least because they expect the price mechanism to clear apparent imbalances in asset markets.
Governments and the Market for Longevity-indexed Bonds
Uncertainty about length of life, longevity risk, is a growing financial problem for pension funds and annuity providers. Unfortunately, there is a lack of financial instruments to hedge against this longevity risk, thereby complicating risk management by pension funds and hindering the expansion of the annuity market. Consequently, this paper examines the role of government in promoting a private market solution for longevity hedging financial products. Governments could in principle improve the market for annuities by issuing longevity-indexed bonds and by producing a longevity index. The paper argues that the first public policy role is hampered by the fact that governments are themselves already exposed to significant longevity risk. However, governments could take other steps such as producing a reliable longevity index.
Retail Instruments in Public Funding Strategies
Retail borrowing programmes are one component of government debt issuance in both OECD and non-OECD countries. These programmes take a variety of forms and often exist to satisfy a number of objectives. In some jurisdictions, they play a significant funding role. Even in countries where retail borrowing programmes play a small role, they are in many cases politically important because they satisfy primarily social objectives.
In recent years, some OECD countries have begun to reconsider their retail borrowing programmes. Shrinking borrowing requirements in a number of countries have led to priority being put on maintaining liquid wholesale markets. Other countries continue to see benefits from their retail borrowing programmes and use them as a significant and stable source of funding. These governments are often innovative at finding ways to drive down administration costs, such as through the use of new electronic distribution channels and total dematerialisation of securities.
Housing Markets and Household Debt: Short-term and long-term risks
The short-term effects of cooling housing markets on consumption and financial institutions’ profitability and capital have so far not been as bad as had been feared by many observers. There are vulnerabilities of specific groups of households, but the sector as a whole does not seem to be exposed to large risks. As a result, broader financial stability risks arising from the current situation appear to be limited, at least over the short term. Nonetheless, the situation in household balance sheets bears monitoring and the potential for problems to emerge in the longer term should not be overlooked. Households may take on too much debt, as they may not only overestimate their subsequent income growth, but also underestimate the long-term risks that they face, including those related to their retirement income financing.
Government Debt Management and Bond Markets in Africa
This article presents highlights from the forthcoming OECD cross-country study Public Debt Management and Bond Markets in Africa.
Debt managers from an increasing number of emerging market jurisdictions face challenges similar to those of their counterparts from advanced markets due to competitive pressures from global finance and the related need to implement OECD leading practices in this policy area. The article shows that OECD standards in public debt management and related market operations are, therefore, of great importance for public debt management and bond market development in Africa. Several African debt managers have introduced the leading debt management practices of OECD countries, use them for designing new debt strategies (including for managing contingent liabilities), and have made impressive progress in developing their local government securities markets. Many countries in the region are taking advantage of debt reduction initiatives. Avoiding falling back into positions of unsustainable debt is identified as a key challenge for many African governments.
OECD financial policy makers are increasingly interested in developments in emerging markets, including those on the African continent. Moreover, emerging markets (including the latest emerging market region, Africa) are an increasingly important asset class for investors from the OECD area. Thus, the policy conclusions and priorities identified here are of interest to not only African countries but also the OECD area and other emerging market countries. Local bond markets in several African countries have gained in strength in terms of liquidity and maturity structure, making them more attractive for important categories of OECD investors and less vulnerable to exchange rate shocks.