It happened overnight - financial products tagged "AAA" or "AA" by credit agencies become "trash".

Banks have to put aside a big part of their profits to mark the losses.

This is how subprime assets - CDOs and SIVs - ravaged local lenders last year.

Seasoned bankers said they had never experienced such a credit crunch, which has crippled the global financial market.

The turmoil has taught banks lessons what to do to avert similar serious economic and financial downturn.

Know about what you're buying

Market participants should never take it for granted that they have understood what they are buying. The experiences of the troubled financial institutions underscore not only the extent of the US subprime mortgage problem but also the risks that banks have taken on.

Hong Kong banks have a long history of investing in securities. But it is only in recent years that some have begun to invest in more complex instruments such as credit derivatives, primarily for yield enhancement, said Joseph Yam, chief executive of Hong Kong Monetary Authority, in his column Viewpoint.

"Although these banks generally felt that they would be more or less insulated from credit risk in the US subprime mortgage market simply by restricting their investments to investment-grade instruments, this view has now proved to be too sanguine," Yam said.

Lenders should carefully study what the products are constructed from and what aftermath they would possibly bring before making any investment, said Dick Lee, a corporate finance officer at Phillip Securities.

"It was obvious that lenders suffering big losses from the subprime crisis had a shallow understanding of the investment products they were buying," Lee said.

Any product lacking accountability, responsibility and transparency should be shunned, he said.

New products = good products

Some structured financial products are labeled with "brand new" and "innovative".

But being new doesn't necessarily mean good quality.

The newly-invented products usually haven't been tested by the market and hence can also be potential traps.

"Some products are more complicated than others, and one should avoid them if he couldn't discover the complication," said Kenny Tang, an associate director at Tung Tai Securities.

"Many mortgage products in the US are very young with a history of 20 years; and those products require decades of market test," said a banking analyst on condition of anonymity.

Risk awareness, even in good times

It is common that banking supervisors are all enthusiastic in boosting revenue in an environment of lackluster loan demand, low interest rates, and excess liquidity.

However, some senior managements may not possess sufficient expertise in understanding the market risks they are getting into when making sizeable investments in exotic instruments such as collateralized debt obligations (CDOs).

The obligation is a combination of different types of debts, which has a different maturity and risk associated with it. The higher the risk, the more the CDO pays.

Now, you can forget about ratings

Good credit ratings should not be taken as "guarantees," said Yam.

"Although credit ratings do provide some indications of the chance of default, they are merely opinions of the rating agencies based on in-house rating models and according to certain assumptions and historical data," he said.

So banks should always do their homework to ensure they understand the underlying assets.

Castor Pang, a strategist at Sun Hung Kai Financial, said investors seem to have an illusion that all US securities are stable and profitable considering the strong economy, but they should diversify investment portfolio for risk safety.

Nevertheless, a turnaround in financial markets and credit conditions would not take place unless certain preconditions are met. And Hong Kong's banking institutions are advised to have strong risk awareness to detect the possible turmoil.

(HK Edition 04/15/2008 page2)