Credit Market's Weight Puts Economy on Shaky Ground

What concerns people like Buffett is how much leverage there is in credit markets -- how much debt is being used to buy other debt.

In the simple model of yesteryear, a bank would essentially borrow money from its depositors and lend it to households or businesses that needed loans. For every dollar it lent out, however, the bank was required to set aside some of its own money in reserve to cover losses it might suffer if some loans were not repaid.

But all that went out with deregulation and the rise of financial engineering. Big banks now borrow most of the money they lend by selling bonds to investors. And most of the loans they make do not remain on their books, but are immediately packaged with other loans and sold to buyers such as hedge funds.

Unlike banks, hedge funds are under no obligation to maintain minimal levels of equity, so they can buy these instruments (that is, make loans) with as much borrowed money as anyone is willing to lend them. And because they don't have to disclose their investments, no regulator knows how much debt is in the system or where it is concentrated.

By one estimate, for example, more than half the loans used to finance corporate takeovers are now packaged with other loans and sold as "collateralized debt obligations." And among the big buyers of CDOs are investment banks that package them with other CDOs and sell them again. Those are called CDOs-squared.

One advantage of this packaging and repackaging of loans is that it spreads risk so widely among investors that any default by a borrower will have negligible impact on any one lender or investors. Over the past five years, this has added a good deal of stability to the financial system. And with stability has come lower interest rates.

But at the same time, this financial engineering has encouraged debt to be piled on debt, making the system more susceptible to a meltdown if credit suddenly becomes more expensive or unavailable. And that's precisely what's been developing over the past several weeks.

The official name for this problem is contagion, which has two basic components.

The first is psychological: When investors and lenders, for example, realized the true risks with the subprime mortgages underlying the bets they've made, they began to wonder whether the same shoddy lending and underwriting practices would soon be discovered in corporate buyouts.

The second component of contagion has to do with forced selling. As it turns out, the hedge funds that have been big buyers of mortgage-backed securities are also big buyers of many other forms of credit, including leveraged loans and junk bonds to finance corporate buyouts. Once the hedge funds began to get in trouble with mortgages, investors started demanding some of their money back while lenders began calling in loans. To raise the necessary cash, they had to sell something. And with nobody wanting to buy mortgages or mortgage-backed securities, they were forced to sell their leveraged loans and junk bonds, creating a selling panic in those markets as well.

You might ask at this point why clever and well-paid investment bankers and hedge fund managers would jeopardize their jobs, their fortunes and their reputations by taking on excessive risks. The short answer is that they were encouraged to by the incentives imbedded in their compensation.

Investment bankers, for example, get their big bonuses shortly after the corporate takeovers are completed, the bonds issued and the loans syndicated, no matter how things turn out in the long run.

And each year, hedge fund managers get a fee of 2 percent of all the money they are managing, plus 20 to 40 percent of the increase in the paper value of the fund's holdings at year-end. Add that up over four or five years of 30 percent returns (not uncommon for the better-performing funds) and managers of a $5 billion hedge fund can easily earn $2 billion before the market turns and the consequences of their risk-taking are apparent.

As this credit-market drama unfolds, the big banks and Wall Street investment houses will move to center stage. According to the asset managers at Barings, these institutions have committed themselves to $500 billion in "bridge" loans to finance corporate buyouts, with the expectation that they could quickly resell these loans at a profit. But several recent offerings have had to be pulled because of a lack of buyers, and there is a good chance that the banks will either be forced to sell many of these loans at a discount or hold them on their own books and write down their value.

The extent of such writedowns won't become apparent until the third week in October, when the banks and brokerages report their third-quarter earnings. But if the market for takeover debt doesn't rebound by then, these blue-chip institutions could be looking at losses in the tens of billions of dollars.

That's real money, even by Wall Street standards.