Wall Street wakes up to more risk

Big investors looking for higher returns may have exposed themselves to more risk than they thought.

The mood in the global financial community is shifting rapidly toward gloom. Warnings of trouble ahead are multiplying.

Many fear that a large number of important financial institutions in the United States, Europe, and elsewhere have taken inordinate risks that could damage the pension funds and insurance annuities that so many people rely on for a comfortable retirement – and maybe even hurt the broader economy.

"There is plenty of room for shocks ahead," says Harald Malmgren, a veteran economic consultant in Washington. "Volatility is coming back to the [financial] market. We could see crackups of some household names," that is, well-known financial firms.

Already, Wall Street has been troubled by recent events. In late June, a prominent investment bank, Bear Stearns, came under pressure to rescue one of its failing hedge funds. (Hedge funds are loosely regulated private investment pools that cater to wealthy people and institutions.) The fund had made bad bets on collateralized debt obligations (CDOs). In this case, these complex financial instruments were invested in mortgage securities.

As interest rates have risen and home prices have slipped, some homeowners (especially those with subprime mortgages) have fallen behind on loan payments. Foreclosures have surged.

Bear Stearns had to offer $3.2 billion in loans to prevent the fund's creditors, such as Merrill Lynch & Co., from dumping the CDOs in what could have amounted to a fire sale, a disruptive ­liquidation of the fund's assets. It was the biggest Wall Street rescue since that of Long-Term Capital Management in 1998, a hedge fund that lost $4.6 billion in less than four months.

Last week, two major debt-rating companies, Standard & Poor's and Moody's, revealed plans to downgrade many mortgage-backed bonds. Prices for stocks and low-quality bonds plunged for a day.

The action was particularly disturbing to some on Wall Street because S&P, Moody's, and a third rating agency, Fitch, have been charging large fees to help banks and other financial institutions put together collections of debt obligations of varying scale and risk. They include CDOs and Collateralized Loan Obligations (CLOs), packages of commercial bank loans. Both are sold to institutions such as pension funds seeking higher returns.

Mr. Malmgren sees a conflict of interest. "It is really hard to assign a 'poor' rating when the rating agency has helped put it together," he notes.

The safety of CDOs has become "a major concern," says David Hale, of Hale Advisers Inc., a Chicago economic consulting firm. The "perception of risk" in the financial community has risen.

Last year, $470 billion in CDOs were sold, according to the Bank for Inter­national Settlements, a central bankers' institution in Basel, Switzerland.

After the financial community weathered quite successfully the brief US recession in 2001, fears of financial risk declined. Financial institutions, such as hedge funds, regarded more and more leverage (using borrowed money to buy assets) as acceptable in the effort to improve investment results. They were more willing to buy risky CDOs, even though the quality of the mortgages behind them was not fully known. They relied on credit-rating agencies to assess the risk in a package of investments, a process that often involves complex mathematical models and historical experience that may or may not be repeated.

The Federal Reserve has been "overly lax" under both Chairman Alan Greenspan and his successor, Ben Bernanke, in its regulation of the US financial markets by allowing them to become "increasingly opaque and private," charges Tom Schlesinger, executive director of Financial Markets Center in Howardsville, Va. He holds that hedge funds and private-equity funds should be obliged to disclose more.

The financial innovations initiated by such funds can shift risk from the bankers (who put together CDOs and other complex financial instruments) to the buyers, such as pension funds, Mr. Schlesinger says. Households become "the shock absorber of last resort."

A few days ago, the Fed issued stricter mortgage-lending guidance to banks, notes Malmgren. The Fed "has proven itself to be too slow and timid in responding to fundamental shifts in financial market behavior, even when the dangers were fully recognized by regulators."

Part of the problem, Malmgren says, is a lack of financial fear among investors. That, combined with greed, "bred fraud, which began to spread … as mortgage originators lied to home borrowers and underwriters, and banks misled investors about the quality of mortgage-backed securities."

If there are more financial casualties on Wall Street, in London, or elsewhere, there could be both a flight to quality (better investments) and a flight to liquidity (investments that can be sold easily), warns Malmgren. The secondary market for outstanding CDOs is very limited, partially because the value of their underlying assets is often mysterious.

The financial damage from future shocks, says Malmgren, could stretch over the next three or four years as the CDOs mature. Many Americans may find it harder to get a mortgage or home equity loan, and interest rates may rise. Home appraisers may find themselves instructed by banks to lowball their valuations. "Everybody is in a state of anxiety in the financial sector," he says.

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