New Order Ushers in A World of Instability

By Steven Pearlstein
Friday, August 10, 2007

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.

In the space of several weeks, we've moved from an environment in which 25 percent of corporate takeovers could be financed with the junkiest of C-rate bonds, to a world in which the market for C-bonds has completely evaporated.

In just the past few days, problems in the U.S. housing and mortgage markets have come to pose serious challenges for Australian hedge funds, French insurers and mid-market German banks.

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

As it all unfolds, we are learning several painful truths about the new global financial system, which until recently was widely lauded for its ability to price and spread financial risk to investors willing to accept it.

One lesson is that the sophisticated strategies employed by bank and investment funds to "hedge" risk may not be as reliable as had been thought.

In recent years, for example, banks and hedge funds created elaborate investment strategies built around the presumption that Bond A would always go up when the price of Bond B went down, effectively limiting potential losses. But in recent weeks, many such strategies began to go awry as markets for mortgage securities dried up and fund managers began selling whatever they could to raise cash to pay lenders. As a result, Bond A and Bond B began moving in the same direction, creating losses on both.

Another popular way for sophisticated investors to hedge their bets is to buy insurance against the possibility that a particular company or set of mortgage holders will default on their loans. But in some cases, this insurance policy, known as a credit swap, has been issued by hedge funds that themselves had taken on similar risks. If things go bad, a hedge fund may not have the money to uphold its side of the insurance bargain.

It is in the nature of the new financial order that it's hard to figure out exactly what everyone's role is. All the borrowers are lenders and all the lenders turn out to be borrowers, so nobody -- including regulators -- can quite figure out where the ultimate risks really lie.

Yesterday's turmoil, for example, started when BNP Paribas, France's largest bank, announced that it was halting withdrawals from three of its hedge funds. So is BNP Paribas a bank or a hedge fund? Well, it's both.

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