Wall Street wakes up to more risk

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

By David R. Francis | columnist

from the July 16, 2007 edition

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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.

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