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Amid recession jitters, world's financial system vulnerable

Despite regulations, global markets are at risk.

(Page 2 of 2)

What all this means is that things can go very well for a long time and then, possibly, go very wrong.

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"People can borrow greater amounts at cheaper rates than ever before, invest … and share risks with strangers from across the globe," Raghuram Rajan, a University of Chicago economist, wrote in a 2005 research paper titled "Has Financial Development Made the World Riskier?"

He agreed that financial innovation has bequeathed enormous benefits, but he explored the negative side effects. His conclusion: More participants in the economy are able to absorb risks today, yet "the financial risks that are being created by the system are indeed greater."

The risk of a catastrophic meltdown – involving the collapse of many Wall Street firms – remains very small, he concludes.

In fact, the world economy now has some shock absorbers that didn't exist before, economists say. Businesses have grown better at managing inventories. Central banks, by many accounts, have grown better at handling crises. And although emerging-nation markets remain the most volatile, many now have large currency reserves that they lacked during the so-called Asian contagion, a financial crisis in the late 1990s.

In any crisis, and in the current tough times for Wall Street firms, a central issue is what bankers call liquidity.

That's a fancy term for whether people or companies can get cash – by selling an asset or drawing on a line of credit – when they need it. And often people want liquidity at the precise moment when there's not much to go around.

Consider the case of IKB.

It helped set up two investment entities called Rhineland and Rhinebridge. Their formula was just about the oldest one in banking: Borrow money at a low short-term rate and use that money to finance longer-term lending that earns a higher interest rate (in this case by buying securities that represented US mortgage loans).

But when subprime mortgages – loans to people with less-than-perfect credit – started going bad, lenders no longer wanted to extend short-term credit. IKB itself was on the hook but was unprepared to provide the needed liquidity.

Financial firms in America are bearing the bulk of losses from subprime borrowers. But IKB fits a common pattern. It was stretching into new lines of activity that appeared lucrative during the boom. It used leverage, exposing itself to profit but also risk.

And it exposed itself heavily to derivative securities – investments whose value is based on other financial assets (in this case loans) in often-complicated ways.

Derivatives are often successfully used to reduce risks. An export firm might buy a currency-based derivative to protect itself from a sudden swing in currency values. But the flavor that IKB focused on, called a collateralized debt obligation (CDO), proved toxic as the US housing market soured.

"IKB relied predominantly on the good ratings" by outside credit analysts, said Günther Braunig, IKB's new chief executive, at a recent briefing.

CDOs packaged loans of varying quality. Critics say that credit-rating firms such as Standard & Poor's, Fitch, and Moody's too often ranked the packages as much safer than the sum of their parts. And investors could choose to buy various segments, known as tranches, of the CDO. Tranches that garnered a high AA now have lost much of their value, as mortgage defaults increase.

As the problems came to the fore in August, S&P tried to allay concerns that derivative securities had grown too complicated for the financial system to handle.

"Although certain kinds of CDOs are undoubtedly extremely complex, complexity in the capital markets very rarely emerges all of a sudden," the agency wrote. "Investment banks can only sell the latest incremental twist after investors have become comfortable with the earlier iteration."

The CDO investments are similar in many ways to bonds, but they rarely change hands in market trading. That adds another challenge: Many firms used computer models to estimate the value of their investments. Those models didn't anticipate the current fire-sale conditions.

Even for sophisticated investors, today's financial risks might be described in terms made famous by Donald Rumsfeld, when he was the US Defense secretary: There are "known unknowns" and "unknown unknowns."

"The world is better in some respects because of the advances in the design of new securities and the design of new institutions," says Mr. Bruner, who recently co-wrote a book on the financial panic of 1907.

But credit booms and busts remain as much a feature of the economy as ever – as the current challenges attest. "We may be yet in the early stage of the crisis," he says.