New Order Ushers in A World of Instability

The bank part has surely made lots of loans to hedge funds, including its own. And the BNP hedge funds surely used those loans to buy other loans and bonds, perhaps even those originated by BNP's bank or underwritten by BNP's investment bank.

These complex and synergic relationships have created a system that is more stable in the face of a mild economic downturn, a string of bankruptcies, or the failure of a hedge fund or two. But as Tim Geithner, the president of the New York Fed has warned, when the financial system comes under extreme stress, those same complex relationships could have just the opposite effect, creating a "domino effect" that increases the risk of a system-wide failure. That fear was very much present in the markets yesterday.

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.

Steven Pearlstein can be reached atpearlsteins@washpost.com.