How the US subprime crisis came to Dublin

Arthur Beesley, Senior Business Correspondent, analyses this week's crisis at an unregulated Irish investment fund

At around 4.30pm last Friday Simon Coyle, an accountant with Dublin firm Mazars, arrived in Fitzwilliam Square from the Four Courts. He went to the office of a little known business called Structured Credit Company and announced his appointment as provisional liquidator of the firm to a top manager. Then he called together SCC's staff, took all keys to the building and sent most of them home.

Coyle's arrival was the culmination of a fraught period for SCC, which had seen its notional liabilities climb to $438 million from $55 million only weeks earlier as turmoil gripped the international credit markets.

Led by managing director Edward Bowers, SCC raised $207.8 million 14 months ago to start a credit risk business. In its first year of operations, the firm underwrote $5 billion in credit.

As SCC's position worsened throughout July and August, its backers made frantic efforts to recapitalise the business. The liquidator's appointment on foot of a court action by Japanese banking giant Nomura brought that to an abrupt halt. In a last- ditch effort to retrieve the situation, SCC spent the weekend with legal advisers from Arthur Cox preparing a High Court petition to put the firm into examinership.

The court obliged on Monday in a manoeuvre that rescinded Coyle's appointment and gave SCC additional time to pull back from the brink. The company must give an update to Mr Justice McCarthy today on its efforts to restructure the business.

Whatever the outlook for SCC, its troubles derive from a massive increase in defaults among US subprime mortgage holders. Tailored to suit people with poor credit records, defaults on these loans have unwound a spiral of bad debt in the institutions that fund such lending in the wholesale financial markets.

Such defaults increased the risk implicit in all asset-backed securities, posing serious trouble for SCC when its counterparties demanded increased collateral in light of the higher level of risk.

As news of SCC's problems spilled into the open in Dublin, it emerged in Germany that the country's financial regulator BaFin and the German Association of Mutual Savings Banks were meeting to discuss a credit crunch in the federal state bank of Saxony, SachsenLB.

Sachsen was in dire difficulty, unable to meet the liabilities of an off-balance investment fund based in Dublin which has an exposure to some $3 billion in subprime debt. A consortium of other state banks stepped up with a €17.3 billion rescue package.

It was the second bail-out of a German lender in less than a month, leading to worries about the health of the German banking sector at large.

(To put it in perspective, remember the seismic impact of the Irish government's €127 million bail-out of AIB in the 1980s after its disastrous acquisition of the Insurance Corporation of Ireland.)

At issue for Sachsen was its use of a complex investment vehicle known as a conduit. Such funds invest in long-term commercial debt but fund their liabilities with short-term debt from third party lenders. Thanks to historically low interest rates, the use of funds has expanded hugely.

No less than $983 billion in paper was outstanding before this summer.

These funds are lucrative and cost-effective in good times, but the business model falters if there are doubts about the value of the underlying securities and investors refuse to lend money to the conduit in question.

With market participants speaking of "armageddon" in the credit world and international banks becoming increasingly wary of lending to each other, funds such as Ormond became all the more vulnerable. Similar concerns, about the quality of asset-backed securities generally, were the cause of SCC's difficulties.

For all their vulnerability and woe, neither SCC nor Ormond Quay is regulated in the Irish market. In theory at least, that's all right if all is going well. But come the evil day, there is virtually no official scrutiny of their affairs here. That Sachsen might have gone to the wall due to an unregulated Irish fund seems extraordinary.

Neither has the Irish Financial Services Regulatory Authority gone out of its way to reassure the public of its efforts to oversee the stability of the Irish market.

Even as SCC went to the wall last week, the regulator declined to say whether it had taken any specific action to monitor the exposure of Irish institutions or funds to the US subprime issue.

It also declined to say whether it knew of any liabilities incurred in the crisis by Irish institutions or funds.

Only on Tuesday of this week did it acknowledge that it was contacting investment funds that it regulates seeking details of their investments and their performance in light of the problems in global financial markets.

Events in Dublin however, were only a side show. Stock market turmoil this summer may have cut the valuation of some of Ireland's chunkiest companies and stripped 7 per cent from the value of pension savings, but in global markets, investment banks as large and venerable as Goldman Sachs, Lehman Brothers and Bear Stearns were not immune to the crunch.

With liquidity drying up on inter-bank lending markets, central banks have intervened to increase the supply of money.

The European Central Bank provided additional liquidity for a fourth time yesterday, with its first emergency injection of funds specifically tailored for smaller banks.

While some economists believe the bank will not go ahead with an expected interest rate increase next month, the bank dampened such speculation this week by saying its monetary stance was unchanged from that set out last month by its president, Jean-Claude Trichet.

His counterpart at the US Federal Reserve, Ben Bernanke, last week cut its discount interest rate, the rate its charges on loans to banks, in a bid to steady nerves on the markets. "The Fed has decided that this won't go from Wall Street to Main Street," said one Dublin-based observer of the international markets.

In addition, there was speculation this week that the Fed might soon cut its benchmark interest rate after Bernanke told the chairman of the US Senate banking committee that he will use "all available tools" to calm the markets.

The argument for a benchmark rate cut says stability might be restored if subprime mortgage-holders are given a chance to start paying off their loans again.

The argument against says the market exists to allocate risk. Those who take on risk do so in the knowledge of that they will benefit if the investment works out, but that they might have to face the severe consequences if it does not. Bernanke sidestepped abstract philosophising last week by making an economic argument in favour of intervention: financial market conditions had deteriorated to the point where "the downside risks to growth have increased appreciably", he said.

According to a senior market participant in the asset-backed securities sector, there is no sign of any certainty returning to that market.

"Over the coming months - and its going to be months as opposed to weeks - there's going to be an exploration process going on to discover where banks are willing to finance these risks," the person says.

"The asset-backed securities world exists because it gives mortgage providers relatively cheap funding, the actual spread that people borrow their money at.

"If banks can't fund themselves this cheaply they're going to have to increase their margin, that's where it starts to hurt the economy."

On one reading, that could mean more expensive mortgages for everyone if there is a general realignment of borrowing costs. On another, it could result in banks imposing tougher lending criteria on mortgage.

Whatever happens, this evolving story is far from the finish.