Is This the New World of Finance?

The excerpts below from the WSJ discuss how the risks and problems are beginning to show up in a world where the risk was spread “a mile wide and an inch thick”.

As tremors from the U.S. subprime-mortgage meltdown shake markets around the globe, investors are getting a lesson in how unexpected stresses could emerge in a global financial system that has changed significantly in the past few years.

Markets have taken on an increasingly important role since the financial crises of the 1980s and '90s. When banks make loans, they are now often bundled into securities that are sold in pieces to investors around the world, changing hands many times. It spreads risk, which policy makers believe keeps the overall financial system sound and stable.

But the downsides to this system could be serious. A financial architecture that dispersed risk also helped to create it. And when troubles emerge -- as they have in the U.S. housing market -- they can show up just about any place in the world and in ways nobody predicted.

In the past few weeks, shaky mortgage loans to Americans have emerged in the portfolios of hedge funds, banks and investment vehicles in Australia, Germany, France, Singapore, Korea, China and elsewhere. Investors are also discovering that subprime loans were used as collateral for some short-term commercial loans that are part of a $2 trillion market that banks and investors turn to regularly for quick doses of cash when they need it.

The European Central Bank and Federal Reserve pumped liquidity into the system yesterday to hold down their target short-term interest rates, which had been disrupted by turmoil in the commercial-paper market.

Problem #1 – Spreading Risks Means It Can Effect All Sorts of Markets

"The downside of spreading the risk is that when the problems get big enough, it affects all markets regardless of the fundamentals," says Christopher Mayer, a real-estate expert and professor at Columbia University.

Back in the 1980s and '90s, when financial stress turned up in places like Mexico, Thailand or the U.S., the problems often resided close to home in banks. Now banks often sell their loans after making them. They end up in investments such as collateralized debt obligations or residential mortgage-backed securities and sold to investors around the world. In the process, it might have made investors and lenders complacent about monitoring borrowers to make sure they could pay off their loans or were using borrowed money wisely.

Problem #2 – Spreading Risk Internationally Spreads Uncertainty Internationally

Another problem: The same framework that disperses risk to different corners of the globe can also spread fear in times of uncertainty.

"Credit went belly up, so people got nervous," says Tim Krochuk, managing director of GRT Capital Partners, a Boston investment manager. As a result, investors began looking to pull money out of hedge funds with exposure to the sector. They pulled their money out of other places, too. "Because some of the exotic securities aren't really tradable now, people are getting liquidity by going to other markets" to sell assets and raise cash, he says.

One casualty is U.S. stocks. His firm's research shows that companies with deteriorating financial fundamentals have done significantly better than those with improving fundamentals during the past three weeks because hedge funds are unwinding their best bets. "Why would you buy a crummy stock and sell a good stock?" he asks. "Because you have to."

The value of debt derivatives and credit-default swaps world-wide is approaching $400 trillion, or seven times global gross domestic product, according to Andy Xie, a private consultant and the former Morgan Stanley chief economist in Hong Kong. These instruments can be used to hedge against other risky investments. Mr. Xie says in a recent report it might also have encouraged some traders to take even bigger risks.

Problem #3 – Too Many New Instruments That No One Understands

Other investors say the notion of diffusing risk will ultimately make the global economy stronger, but financial markets will experience severe growing pains. One of the biggest problems, suggests Mohamed El-Erian, head of Harvard Management Co., which invests the university's $29 billion endowment, is that Wall Street is cranking out new products faster than analysts or investors can understand or value them.

Credit-rating services have been struggling to determine the risk level of these new securities. Often they have erred by understating the risk and assigning what now looks like ratings that were too generous.