Friday, August 10, 2007

Bush Shows Off His MBA

Hint to White House economic team: You might not want to have had the president repeat that numbskull prediction about a "soft landing" for housing at precisely the moment central banks were pumping $150 billion into the financial system to prevent a market meltdown over anxieties about mortgage-backed securities. Brings back memories of "Mission Accomplished."

Seriously, folks, we all need to get used to days like yesterday because there are going to be a lot more of them. In a world in which trillions of dollars have been bet on the premise that low interest rates and record-low default rates would continue forever, "repricing of risk," as the administration likes to call it, is not some minor technical event. It's more like a tectonic shift going on beneath the surface of the economy.

Think about it. In the space of just several months, we've moved from an environment in which fly-by-night brokers were peddling low-interest mortgages to bad credit risks with no documentation and no money down, to one in which the largest banks are raising rates and tightening terms for their best borrowers. ...

And in the course of several hours, a financial system that was seemingly awash in liquidity suddenly didn't have enough. ...

One concern is that rather than spreading risk among millions of investors, the current system has reconcentrated risk on the books of a dozen global broker-dealers who lend most of the money to fund managers so they can buy all those credit instruments. And it is many of the same firms -- Goldman Sachs, Bear Stearns, Deutsche Bank, Citicorp -- that have also underwritten hundreds of billions of dollars in corporate takeover loans that, suddenly, they cannot sell as they had planned. It's no coincidence that the shares of such firms have taken a beating in the past few months as rumors swirl around Wall Street that one or another is facing major losses.

We may be discovering, in fact, that the new financial order is not all it is cracked up to be.

Although it has provided ingenious new mechanisms to finance the legitimate needs of businesses and householders and new ways for investors to hedge risks, it has also created opportunities for potentially destabilizing speculation. It is now common for the aggregate value of "derivative" instruments to be many times the volume of the stocks, bonds or commodities on which they are supposedly based. And often it is the trading on derivatives markets that now drives the trading on "real" markets, rather than the other way around.

Australian analyst Satyajit Das makes the point that the main achievement of the new financial architecture has not been to spread risk so much as it has been to expand risk by vastly increasing the amount of borrowed money. Making loans to buy bonds secured by packages of other loans makes for big fees and exciting work for bankers. But as Das predicted last year in his book, "Traders, Guns & Money" -- and as we all discovered yesterday -- if the supply of credit suddenly dries up anywhere in the system, the elaborate new structure they've created can come crashing down on itself.

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