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Rise and Fall of Securitised Structured Finance

This article traces the development of the credit "storm" currently faced by western financial markets and suggests reforms that will help strengthen systems.

PERSPECTIVEapril 19, 2008 EPW Economic & Political Weekly44Rise and Fall of Securitised Structured FinanceAlok Sheel, Meeta GangulyThe current credit storm in western financial markets threatens to bring down the entire edifice of structured finance that has, in recent times, become the high priest of the Anglo-Saxon financial system. Arising in the resi-dential mortgage segment, the storm has rapidly spread to the wider financial sys-tem, blowing away many flourishing financial instruments such as collateral-ised debt obligations (CDOs), collateralised bond obligations (CBOs), leveraged buy-outs (LBOs), structured investment vehicles (SIVs), asset-backed commercial papers (ABCPs) and junk bonds. It has brought disrepute to established financial institu-tions (FIs) such as commercial banks, credit rating agencies, central banks and threatens to be the biggest financial crisis since the Great Crash of 1929. It is fuelling fears of a deep and sustained global recession; pressuring the US Fed into seri-allylowering benchmark short-term rates even as inflationary expectations abound; having a knockdown effect on all forms of consumer debt such as prime mortgages, credit card, auto, as well as commercial property, municipal and corporate loans; spelling the nemesis of high profile FIs and chief executive officers (CEOs); and inducing governments to throw fiscal prudence and moral hazards to the winds to bail out FIs that could well lead to increasing the public stake in the financial sector in the very heartland of global capitalism. In response, the US treasury has already released an optimal model/blueprint for stronger regulatory reform of the US financialsystemcomprising separate market stability, prudential and business conduct regulators to replace the current system of functional regulation, which maintains separate regulatory agencies acrosssegregated functional lines of banking,insurance, securities and futures, that is largely incompatible with today’s integrated financial markets.Driven by complex mathematical engi-neering, securitised structured finance is a modern financial marvel that has deepened capital markets through greaterdispersal of risk, contributed to higher growth by intermediating access to large amounts of low cost funds gener-ated by global imbalances, and made development more inclusive by giving previously excluded groups access to assets like residential property. Ithas also spawned a new breed of highly paid smart graduates well versed in mathemat-ics and calculus but alas, quite divorced from the real world of old-fashioned finance with its putative sixth sense of sniffing out risk through a deep apprecia-tion of human psychology, market sentiment and moral hazards. The gravity of the financial crisis can be gauged from the plummeting values of key financial indices in end-March 2008 that are a measure of the current re-pricing of risk and credit freeze in western markets. The “Ted” spread between yields in three months’US treasuries and London Interbank Offered Rate stood at about 200 basis points (bp), almost eight to 10 times higher than normal. The five-year credit default swap (CDX) index for investment grade corporate bonds, a good measure of corporate borrowing cost, stood at 265 bp above US treasuries, making it cheaper by 125 bp to insure emerging market debt, which is quite unprecedented. The cost of insuring bank debt is even higher.USABCP has fallen off sharply by 33 per cent from its peak of $ 1.2 trillion in mid-2007. New structured finance deals declined by 89 per cent, leveraged loans for buy-outs by 84 per cent, global debt issuance by 48 per cent, and global merger and acquisition volumes by 40 per cent, compared to the first quarter of 2007.Sub-Prime CrisisThe sub-prime financial crisis has its roots in old-fashioned housing mortgage loans extended to borrowers with doubtful income and credit histories at a time when interest rates were low and housing prices were in the midst of an unprecedented This article traces the development of the credit “storm” currently faced by western financial markets and suggests reforms that will help strengthen systems.This article sources information from various international financial dailies and government publications. A short version of the last section ‘Concluding Remarks’ appeared inThe Economic Times, New Delhi, dated Monday, January 18, 2008. The authors wish to thank Joshua Feldman, IMF, New Delhi, for critical inputs. Alok Sheel (aloksheel@gmail.com) is a civil servant. Meeta Ganguly (meetaganguly@ yahoo.co.in) is a banking analyst.
US Fed Fund Rates
PERSPECTIVEEconomic & Political Weekly EPW april 19, 200847investors borrowed short-term in low interest currencies like the Japanese yen to invest in higher yielding products in other currencies provided additional bal-last to theCDO, CBO/CLO andLBO bubbles.Junk bonds were also one of the main instruments used to fund the LBO boom way back in the 1980s. In 1989, the pro-posed buyout ofUAL Corporation (parent of United Airlines) for $ 6.75 billion fell through as the buyout firm could not secure the required funds. This marked the end of the LBO boom along with the collapse of the junk-bond market before its re-emergence in early 2000. The tremor of the failedUALLBO reverberated on the Dow Jones industrial average that fell by more than 6 per cent in response. The fail-ure of several LBO deals in the late 1990s underscored the growing investor repul-sion for sub-standard investment products like junk and speculative bonds. A parallel scenario seems to be playing out currently, beginning with the turbulence in the sub-prime mortgage markets. Even though the LBO and sub-prime residential loan markets are apparently unrelated, sys-temic risk plays out more strongly in the banking and financial sectors than in any other industry. The collapse of hedge funds with significant exposure to hous-ing mortgage-based CDOs, massive hits to bottom lines of leading banking giants, rising defaults on home loans, severe liquidity squeeze across financial markets, and events like the run on Northern Rock (the fifth largest lender in theUK) and the collapse of Bear Stearns underscored their exposure to high-end financially engi-neered products, which bank managers frequently admitted to not understanding themselves. FIs were taking risks and passing on little understoodhybrid instruments to entities that could not understand them. The one element that tied the sub-prime residential and LBO markets was the suspect credit quality of the main underly-ing product: a home loan in the case of the former and corporate loan/junk bond investment in the case of the latter. While an LBO is theoretically aimed at trans-forming an undervalued company through infusion of debt/capital, in retrospect it is clear that there was under pricing of risk as a result of which and PEFs ended up purchasing companies at inflated prices. A commercial bank with strong risk manage-ment systems would normally have shunned both these category of borrow-ers. This was overlooked in a booming market, as the strategy yielded good dividends during an era of high liquidity and cheap money that prevailed till early 2007, especially since the loan originator could pass on the credit risk.Onset of CrisisTwo events that were assumed to have a low probability of simultaneous occur-rence in a booming market subsequently occurred: first, interest rates increased and second, home prices began falling, wiping out home equity. After declining from a high of 6.5 per cent in May 2000 to 1 per cent in June 2003, the US Fed Funds rate rose steadily to peak at 5.25 per cent in June 2006. This led to sub-prime mort-gages resetting at shockingly high rates, with homeowners missing payments and foreclosing accounts contributing to fall-ing real estate prices. As a result, banks, other FIs, hedge funds and private equities holding the mortgage-backed securities incurred valuation losses and there was pressure to sell assets at a time when there were few buyers in the market to meet margin – “haircut” – calls. Hedge funds like Carlyle Capital and Peloton Partners collapsed because of their inability to meet margin calls, leaving the funds’ lenders, mostly investment banks and brokers, eventually taking the problematic securi-ties on their balance books. What caused the tables to turn in the LBO domain was the correction in credit spreads and repricing of risk. Risk premiums (credit spreads) have considerably widened over the past six months from the lows already discussed. Potential investors have started demanding much higher yields or returns as the risk price for investing in bonds and commercial paper of over-leveraged com-panies. This has resulted in a substantial increase in interest-burden which, in the event of a recession, could well pre-empt much of the free cash flows of the compa-nies bought out. Such companies will have to display a really strong operating perfor-mance to emerge out of the debt burden that would be very challenging in a recessionary environment. As things stand, corporate profits, though declining, are still healthy and default rates remain relatively low.LBO debt defaults however, as in the case of CDOs with sub-prime housing mortgage exposure, are expected to rise. Since buy-ing bond repayment insurance was com-monly used to enhance credit rating of securitised debt, this is already having a knockdown effect on another thriving and unregulated multi-trillion business, namely the highly under-capitalised credit default swap (CDS) market for insuring corporate bonds.CDS are the most widely traded derivatives with outstandingCDS trades estimated at $ 45 trillion, which exceeds theUS government bond, stock and housing markets combined, and almost four timesUSGDP. CDS spreads are rising and were they to increase above a certain threshold (generally around 200 bp above applicable treasuries for highly rated bonds) there are often covenants mandating unwinding of the underlying complex-structured vehicles which could really trigger financial Armageddon. This “shadow banking” poses a relatively unh-eralded systemic risk as even relatively modest defaults could pressure this mar-ket since it is typically highly leveraged, withCDS (protection) sellers insuring up to 150 times their capital base. Monoline insurance companies like AMBAC andMBIA, important links in the CDS chain, offered bond repayment insurance. These companies traditionally churned huge profits by insuring safe municipal bonds, wherein the bonds that they insured took on the rating of the in-surer. Monolines foresaw huge business potential in insuring bonds and securities issued by investment banks. Soon they were insuring the default risk of mortgage-backed security andCDOs only to realise, in the wake of sub-prime write-downs, that they had insured risk where the actual payouts would be much greater than their reserves and capital. The total debt in-sured by monolines is estimated at $ 2.4 trillion. AMBAC andMBIA have reported record losses during 2007 and are facing rating downgrades from the currentAAA ratings. The consequence of a rating downgrade would be a requirement of ad-ditional capital by the banking system as the risk weighted capital requirement is in
PERSPECTIVEapril 19, 2008 EPW Economic & Political Weekly48proportion to the external ratings as-signed by credit rating agencies – better the credit rating, lower is the correspond-ing risk weights allocated for capital ade-quacy. The market for speculative bonds, which had re-emerged as a preferred vehicle for financing LBOs is now facing investor repugnance as they reassess and reprice risk. The spread between high yield bonds in the US and 10-year treasury yields captured in theCDX North America high yield index stood at above 700 bp on March 20, 2008. The ITRAAX European crossover index rose from under 200 bp in May 2007 to over 600 bp in March 2008. The leverage that once generated huge gains for PEFs has become a millstone around their necks threatening gravita-tional collapse. The market for LBO debt seems to have fallen through again. Banks and brokers in the US are currently sitting on a huge pipeline “hung”LBO loans worth about $ 200 billion with no potential takers in sight. Citigroup has the biggest exposure of $ 43 billion, followed by J P Morgan Chase, Goldman Sachs ($ 26 billion each), Lehman Brothers, Morgan Stanley (about $ 23 billion each), Merrill Lynch ($ 19 billion) and Bank of America ($ 12 billion). These are the same FIs that have the largest housing mortgage and sub-prime exposures. Structured Investment VehiclesSIVs were critical links in both the sub-prime housing mortgage and LBO funding chains. These were the vehicles through which commercial banks took loans extended by them for mortgages and LBOs, as the case may be, and bundled and repackaged them off their balance sheets through instruments such asCDOs and CBOs. SIVs were typically funded through low cost short-term senior debt instru-ments such asABCP and asset backed medium-term notes (ABMTN). Like home finance companies, they usually run huge asset-liability mismatches. The lifeline of an SIV lies in its ability to successfully refinance continuously maturing short-term obligations through the issue of fresh ABCP and/orABMTN. The market for ABCP and ABMTN has vanished due to the downturn in the credit cycle with the result thatSIV assets are being liquidated at a discount to pay for maturing debt. Under extant regulatory norms asset values need to be “marked to market” at regular intervals. Since the market values of these assets have fallen steeply, even as defaults have been relatively modest, it is entirely possible that the sub-prime crisis crash may well be the first major financial crisis where there are few actual defaults. MostSIVs are sponsored by commercial banks who also manage them in return for a fee and are held as “off-balance sheet” conduits of the latter. The parents are now pumping in funds to revive the almost sinking SIV industry, which currently carries a baggage of assets worth around $ 300 billion. If the parent bank does not step in – they are not always legally obligated to – then it risks a fire sale of assets and collapse of theSIV, conse-quently damaging its reputation. Once the “toxic assets” are taken on their balance sheets, banks are required to mark them to market. Since the market for these derivatives has evaporated, this presents a practical difficulty. Banks have, therefore, been constrained to use the very thinly traded ABX, which shows steep falls in valuations, as a result of which they have had to take huge hits on their balance sheets. Launched in January 2007, the ABX serves as a market benchmark for securi-ties backed by home loans issued to borrowers with weak credit.Fear of ContagionAccording to Standard and Poor’s, sub-prime losses are currently estimated at around $ 285 billion, mostly in the form of asset value write-downs occasioned by mandatory mark-to-market fairvaluations. Of this, about $ 85 billion is still to be reported. While sub-prime loans were mostly an American phenomenon, London bankers had become particularly adept at repackaging these assets. Consequently, it is widely felt that the losses are likely to be shared equally between theUS and Europe. The contagion, which has seen even top rated financial assets outside the housing sector lose market value has led to major FIs taking huge hits on their bottom lines, mainly through huge mark-to-market losses.UBS has reported the biggest loss by far of over $ 40 billion, with Merrill Lynch and Citigroup follow-ing with more than $ 20 billion each. HSBC, Morgan Stanley, Bank of America, IKB Deutsche, Washington Mutual,AIG, Credit Agricole, Credit Suisse, and Wachovia have reported losses of between $ 5 and $ 10 billion each. CIBC, Societe Generale, J P Morgan Chase, Muzho Fi-nancial, Barclays, Royal Bank of Scotland, Dresdner, Bayerische Landesbank, Freddie Mae and Freddie Mac are amongst other major banks that have reported substan-tial losses. In addition, Northern Rock and Bear Stearns have had to be bailed out. Fresh losses are being reported practically every day and eventual losses are expected to be much higher, with the most pessi-mistic speculations approaching $ 1 tril-lion. While it is unclear where the balance losses lie, it is widely believed that sub-stantial losses have gone unreported in the absence of credible mark-to-market valuations in a highly illiquid market and that the procession of write-downs is likely to continue for some time. It is such notional “mark-to-market” earnings that led Warren Buffet to view derivatives Prime Subprime Subprime Alt-APrimeArm Arm I | I I I Housing Loan²CDOttt###t##t$$$²Subprime MortgagesLiability – Short Term ²#$1 ²Short-Term CP ²#.5/StructuredInvestmentVehiclesInsurance MunicipalitiesCosEquityProfitsCashFees-CashCollateralCashCollateralCashSponsorMortgage orOriginating#BOL/PO)PVTJOH-PBOCashCashEquityProfitsCashAsset-Long-TermPension FundsPrivate EquityHedge Funds Auto Credit Consumer CardLoanInterestRateDifferential}Figure 3: Structured Finance – Cash Flows
PERSPECTIVEEconomic Political Weekly EPW april 19, 200849as potential time bombs way back in theBerkshire Hathaway annual report for 2002. Since these write-downs are not actual credit losses, it is quite possible that they could be written back once the crisis is past and liquidity returns or if these secu-rities are held till maturity since actual defaults are limited. The immediate impact of these write-downs, however, is massive deleveraging in the financial sys-tem through the “financial accelerator”. Jan Hatzius, chief economist at Goldman Sachs, has estimated that a $ 200 billion sub-prime loss could cut banking capital by 12 per cent. Under the fractional system of banking governed by the Basel regula-tory norms, banks are expected to main-tain a minimum capital adequacy ratio. If banks shrank their balance sheets by 12 per cent, the implied reduction in overall lending would total $ 2.3 trillion. This deleveraging is presently limited to the financial sector, which was mostly afflicted by this hyper-leveraging anyway but the epic scale of the deleveraging could well lead to a major spillover into the real economy, which has been relatively little affected by the credit storm so far. Indeed, corporate borrowing costs are now on par with those of crisis-ridden banks. How-ever, since much of the final consumer demand in theUS, which accounts for a quarter of globalGDP, arose out of leverag-ing wealth gains from assets in a booming market, rather than from current incomes as such, it is widely feared that sustained deleveraging could lead to a deep and pro-tracted global recession. Nouriel Roubini of New York University has estimated that a 10 per cent fall in house prices has already knocked the equivalent of 14 per cent ofUS GDP from household wealth andthat a further price drop of 20 per cent could be expected in the near future. TheUS Treasury Secretary has estimated a drop of about 25 per cent over 2007 and 2008. Forced to write down investments and to take exposures back on to their balance sheets, several major international banks now find themselves short of capital, as a result of which there is a virtual credit freeze in Organisation for Economic Cooperation and Development interbank markets, as banks are unwilling to even lend to each other. The US Fed, Bank of England and the European Central Bank have tried to pump in liquidity by lowering benchmark short-term rates and providing unlimited liquidity on demand, which has eased the freeze slightly. PEFs, and espe-cially sovereign wealth funds (SWFs) from developing countries, flush with accumu-lated current account and commodity boom surpluses, have stepped in to inject badly needed capital into troubled banks. This is, indeed, ironic because it was the global savings glut arising from these sur-pluses that fuelled the excess liquidity and low interest rates underlying the sub-prime crisis in the first place.SWFs, floated by oil-rich west Asia nations, Singapore, China, Russia, Norway, Australia and South Korea, to name a few, are mostly long-term players with deep financial pockets and usually do not seek quick returns. GIC and Temasek of Singapore, China Investment Corporation and Citic Securities of China, Abu Dhabi Investment Authority of Abu Dhabi and Kuwait Invest-ment Authority have invested almost $ 50 billion to provide liquidity and recapitalise major international banks like UBS, Citigroup, Merrill Lynch, Morgan Stanley and Bear Stearns.The efforts of PEFs and SWFs, which manage resources of about $ 700 billion and upwards of $ 3.3 trillion respectively have had to be topped up by central banks and governments, especially theUS Federal Reserve, in a desperate bid to revive credit markets and limit contagion. The US Fed has lowered short-term interest rates by an unprecedented 300 bp over a six-month period beginning September 2007 to inject liquidity. Gov-ernments and central banks have also rushed directly to the rescue of troubled banks such as Northern Rock, Bear Stearns andIKB because the collapse of major FIs could generate ripple effects amongst counterparties and consequently, a cas-cading effect on security prices. More banks would have struggled to raise short-term finance and possibly collapsed had not the US Fed provided a $ 436 billion liquidity support package to banks to bail out their SIVs, including hedge funds, against illiquid collaterals of doubtful credit quality in the belief that the under-lying instruments are actually sound credit. There are also proposals in the US government to facilitate refinancing of high interest “teaser” loans through loan guarantees of $ 300 billion to forestall foreclosures of mortgages, in a bid to save the gains of the inclusive credit revolution, which enabled previously excluded groups to own houses and also to cut banking losses. Meanwhile, Fannie Mae and Fred-die Mac, the distressed government char-tered mortgage financiers, have been per-mitted by their regulator, the Office of Federal Housing Enterprises Oversight to reduce their surplus regulatory capital requirements from 30 to 20 per cent. This would pump an additional $ 200, billion of liquidity and give them greater flexibil-ity to refinance distressed “jumbo” mort-gages. According to the US Census Bureau, home ownership rose to 69.3 per cent by 2004, an increase of 5.4 per cent over 1991. Foreclosures are currently expected to reach 1.5 to 2 million that, on a total home base of 80 million, could reverse half to one-third of these inclusive gains. The jury is still out on whether these bail-outs, which have been widely criti-cised for their moral hazard in encourag-ing future risky behaviour, would stabilise financial markets and pre-empt major damage to the real economy. However, both theUS Fed and government obviously believe that nothing short of assurances of sovereign guarantees and major regula-tory reform is likely to revive the trust between FIs that forms the basis of the financial system.Concluding Remarks InA Short History of Financial Euphoria, John Kenneth Galbraith advanced the rather depressing theory that finance did not lend itself easily to innovation, since at the end of the day, all credit is secured on some asset no matter how much it is repackaged and sliced horizontally or ver-tically. Is the collapse of the market in complex-structured products merely another manifestation of Galbraith’s dictum, especially since investors are currently eschewing complex-structured financial products in what is termed as a “flight to simplicity”? It is undoubtedly true that excessive liquidity that went beyond what would be expected based upon existing assets was a necessary
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PERSPECTIVEEconomic Political Weekly EPW april 19, 200851Since the state ultimately covers the liquidity risk arising from both conven-tional and investment banking, this gives rise to a moral hazard that encourages risky practices. Some market observers favour setting the clock back to restoring the status quo ante prevailing prior to the repeal of the Glass-Steagall act by separat-ing conventional and investment banking. There is, however, a danger of regulatory overkill that throws the baby out with the bathwater. The case for universal banking that led to the Gramm-Leach-Bliley act supplanting the Glass-Steagall act still rests on solid foundations and some tweaking is all that may be required.Third, there may be a need to take a closer look at the banking emolument structure. The business model of the puta-tively far more exposed private equities and hedge funds seems to have weathered the credit storm far more effectively than banks since traders and managers had a big direct stake to move nimbly to cover their losses. In the case of banks, however, the moral hazard deriving from sovereign guarantees that encouraged risky behav-iour was magnified by the banking emolu-ment structure that rewarded risky prac-tices that yielded high returns during the boom phase of the business cycle. The sum of the bonus contributions in investment banking has frequently exceeded dividend paid to shareholders. The risks taken by these highly paid traders become appar-ent only during economic downturns that are unrelated to the (generous) annual bonus cycles of banks. There is a struc-tural asymmetry in the banking industry where traders get a good share of the prof-its but the losses are borne entirely by shareholders. Instead of being primarily based on the previous year’s performance, bank bonus schemes need to be more long-term oriented. It has been suggested that only part of the bonus should be paid out in the profitable year, the balance being adjusted against shortfalls, if any, in sub-sequent years. The accrued unpaid bonus of employees who lose money could be used to cover the losses, at least partially. Fourth, lending discipline needs to be restored by mandating that the loan origi-nator retains a portion of the original loan portfolio – especially the equity or the lowest credit quality/rated tranches – so that it is compelled to maintain and monitor credit quality. One of the lessons of the sub-prime crisis is the moral hazard inherent in the “originate and distribute” lending model where there is little incen-tive for the loan originator to adhere to prudential lending and monitoring stand-ards with the risk being “distributed”.Fifth, there may be a need to review the list of financial products that only quali-fied investors can buy. Spreading of risk proved delusive since it was ultimately foisted on borrowers who did not quite understand the complex product they were buying into. Indeed, there has been speculation that whether even directors sitting on the boards of leading invest-ment banks were equipped to fully assess the risks posed byCDOs and SIVs. Sixth, hedge funds, SIVs and CDS may need to be brought within the regulatory framework. It is not entirely coincidental that the most exuberant players in the sub-prime boom were such unregulated entities.Seventh, a financial system that can be embroiled in a major crisis without defaults actually taking place requires some tweaking of the “mark-to-market” mechanism. Real estate and consumer loan delinquencies have no doubt been rising from the second half of 2006 but these are by no means alarming measured by historic trends. Ninety-two per cent of all mortgagees continue to pay mortgages on time each month, and only 2 per cent mortgages are in foreclosure, mostly concentrated in the small sub-prime and ARM segment. The values of several inherently sound financial instruments plummeted simply because trading froze, leading to massive write-downs and fire sales that aggravated the decline in valua-tions. The time has perhaps come to let structured products be traded in regulated exchanges. CDOs,CBOs, etc, are presently traded over the counter, making it impos-sible to mark such products to market because trading in these products virtu-ally ceased. Exchange-based trading would make price discovery in difficult market situations easier. Last, who will regulate the regulators? The sub-prime crisis has in particular brought credit rating agencies and central banks under the lens. Since the former have been arraigned for not maintaining arms length distance from the products they rated, thereby under-pricing risk, they may need to be brought within the ambit of a Sarbanes-Oxley type of act sothat there is no occasion for conflict of interest.New Financial Bubbles?Central banks have been criticised for loose monetary policy narrowly focused on consumer prices even as asset prices were rocketing. Rapid globalisation has a disinflationary impact on the prices of tradable goods, on which the consumer price index is mostly based. Overheating pressures in the economy are therefore more likely to be reflected in asset prices. While rental prices are included in some consumer price indices, it is difficult to see how asset prices could be similarly incor-porated. With growing sophistication and innovation it is difficult to foresee what kind of financial assets would attract excess liquidity. There is already talk of commodities and freight derivatives as new targets of future financial bubbles, for global imbalances and the associated savings glut persists and needs to be parked somewhere. Since asset value appreciation is the major source of funding, consumption and well-being for most people in developed markets, monetary policy response to asset infla-tion is likely to be strongly resisted especially once the crisis is past. As for junk bonds and aggressive lever-aged buy-outs of companies, they appear to resurface during the boom phase of practically every economic cycle and pose little systemic risk since the losses can be limited to high-risk companies and individuals. It is well known that compa-nies can sustain higher debt equity ratios during boom times and that some, especially commodity-based, are more susceptible during the bust phase, and so prudence dictates that they should not be highly leveraged. The same logic applies to high yield bonds, whose seductive yields can be serviced only during an economic boom. There is, however, a trade-off between return and risk, and there will always be high risk takers who will try to push the envelop as far out aspossible.

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