financial house in trouble

by Hugh

From the Pessimism file:

I’ve always been skeptical of hedge funds and sophisticated derivative products. In theory these financial instruments protect against risk, by playing potential movement of the market in one direction, off of movement in another. It’s high-powered math stuff, and it’s made many many people truckloads, billions of dollars. But I don’t really understand it – though I was tangentially involved in the derivative business for a while. And it’s always seemed to me that hedge funds, at their base, are about getting money for nothing. That is, getting money without accomplishing anything. Still the house that Enron helped build has gotten bigger and bigger, and has become to some extent the underpinning of the entire global economy. Basically, it’s flooded the world with lots of cheap money. That sort of thing, eventually causes problems, because the laws of physics will always beat out the laws of the market.

And, according to Steven Pearlstein in the WaPo, the whole thing might come tumbling down.

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.


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.

And chances are you and I will get caught under that crashing system, one way or antother.

Scary stuff.