Risky bets may return to haunt financiers

PUBLISHED : Monday, 02 April, 2007, 12:00am
UPDATED : Monday, 02 April, 2007, 12:00am

Plenty of prominent financiers seem to be suffering acute attacks of the wobblies at the moment.

The reasons they give for their nervousness vary. Some, like hedge fund manager Jim Rogers, blame the world's central banks for printing too much money and debasing the value of financial assets. 'Bonds are finished,' he told a Hong Kong audience last week.

Others, like Morgan Stanley chief economist Stephen Roach, have been spooked by the recent failure of several dozen sub-prime mortgage lenders in the US. The sub-prime sector today is the equivalent of the dotcom market seven years ago, he told a hall full of bankers here last month.

Still more are apprehensive at the recent proliferation of financial derivatives. Like the value investor Warren Buffet, who in 2003 warned that derivatives contracts are 'financial weapons of mass destruction', they worry that the derivatives markets are a ticking time bomb that must sooner or later detonate.

At heart, however, all those croaking about risks in the financial markets are worried about the same thing. They are all concerned that the low interest rates of recent years have encouraged financial institutions to seek higher rates of return from ever more complex and risky investments.

Tighter regulation and more sophisticated risk management techniques may have exacerbated the problem. The sub-prime mortgage market is a good example. Under the Basel banking regulations, banks are required to set aside a proportion of their capital against their portfolios of mortgage loans. Under this system, however, holding low-yielding prime mortgages appears an inefficient use of capital. As a result, banks are encouraged to securitise and sell off their best assets, and hold their capital against riskier and higher-yielding loans.

It is not only the asset-backed securities market that has ballooned in recent years. Dealing in over-the-counter credit derivatives has also taken off. These are complex instruments designed to separate credit risk - the danger that a borrower will default - from other risks associated with lending, for example that interest rates could rise.

By isolating credit risk, banks are able to sell their credit exposure to individual borrowers and free capital for more productive uses. Investors, meanwhile, are able to get tailor-made debt exposure to companies that may not issue bonds.

The Bank for International Settlements last year estimated the value of outstanding over-the-counter derivatives at more than US$10 trillion. Whether it would be possible to net out and settle these contracts in a financial crisis is unclear. Enthusiasts point to the failure of Enron in 2002 as evidence it could be done without endangering the world's financial system. Other observers are less sure, and some are getting very nervous indeed.