Humankind has worried about risk since our prehistoric ancestors commenced bartering shells. But only in the last couple of decades has risk, by design, become a globally tradable product. As former U.S. Federal Reserve Chairman Alan Greenspan put it back in 2002, “dispersion of risk to those willing, and presumably able, to bear it” acts as a shock absorber to prevent “cascading failures,” like the Great Depression in 1929. Or so goes the theory as presented by the architects of today’s global financial system. Yet plenty of high-profile moneymen, including Warren Buffett and George Soros, don’t buy it. They’ve come to view complex securitization (like the deals that bundled U.S. mortgages into bonds that were sold and resold worldwide on the thinnest of margins) with foreboding. Their concern: opaque risk dispersion, heavily leveraged and spread across global markets, can actually magnify financial turbulence by creating what Soros once called “daisy chains” of interlinked debt.
For the moment, the dispersion skeptics look prescient. Sure, money markets turned round a bit last week as central bankers pumped liquidity into the system, and the Fed raised hopes of a rate hike. But since late July, when America’s subprime mess first rattled global stock markets, financial news has been mainly bad. Panic selling has raged fitfully from Stockholm to Seoul in a reaction that seemingly outweighs the magnitude of the problem. Investors wary of market volatility are shedding not just bonds linked to U.S. mortgages, but anything with the potential to fall. And everyone is looking hard to see what other shaky paper could be lurking inside their portfolios.
It’s fear of those unknown daisy chains that has caused the shift. Optimists cast the three-week slide in global stocks as a needed market correction. Others aren’t so sanguine. In an Aug. 15 report out of London, Credit Suisse warned that the global financial order could be on the cusp of “a system changing crash.” The next day Morgan Stanley’s top China strategist warned of a “fourth generation financial crisis” in emerging markets (following the Latin American debt crisis of the 1970s, the Mexican peso crisis of the 1990s and Asia’s 1997-98 financial crisis) in which the U.S. economy could be “knocked into a serious recession” with global implications.
The dangers of a crisis beyond today’s “bad debt” problem are obvious. If the current sell-off jumps the fire-line from stocks into a wider array of other assets—pushing down, say, real estate in Europe or commodity markets currently energized by the China boom—it will become much harder to contain. And ultimately, the biggest pending issue is how plunging stock prices will affect large economies, in particular the United States, Europe and Japan (the main engines of global economic growth since World War II) as well as newcomers like China and India.
Central bankers are clearly worried. In recent weeks they’ve pumped a staggering $325 billion into the global financial system to brake panic selling and forestall a credit crunch spreading from home loans to other consumer debt, like credit cards. “There’s a difference between subpar growth and recession,” says Mark Matthews, chief Asian strategist for Merrill Lynch, which last week lowered its growth forecast for the U.S. economy from 2.3 to 1.6 percent—deceleration he believes the world’s fastest growing region can endure. “But if it goes below 1 percent, all bets are off.”
Already, the United States is in a severe housing slump—the worst in generations in some cities. The latest industry reports estimate that some 2 million families will lose their homes in 2007. And that’s begun to crimp consumption.
Europeans are feeling the effects of subprime, too. Their exposure is second only to America’s; so far, the crisis has taken down two middling, ex-state-owned German banks that were ill equipped to hold the very complex securities that (under the Greenspan theory) should have migrated to more robust institutions. This underscores the point that many parts of the global financial system are still evolving to cope with such complex products. “There are two worlds colliding right now,” notes Morgan Stanley’s chief European economist Eric Chaney, “the old world of banking, and a new and much more complicated and sophisticated modern system, involving more complex products and deals.” In this paradigm shift, notes Chaney, “everyone can’t win all the time.”
In Asia, the subprime crisis has raised questions about the region’s ability to stand on its own should its traditional export markets in the United States and Europe flounder.
As ever, prospects hinge on the fate of a single country: China. Some argue that growing domestic consumption, a surge in interregional trade and “solid growth fundamentals” in Asia are sufficient to withstand all but the worst export shock, as UBS outlined in a report to clients last week. Others challenge the assertion, casting China not as a font of new consumer-led growth but rather the inheritor of Asia’s boom/bust export legacy. Indeed, trade statistics suggest that today’s intraregional commerce is mainly in parts and raw materials for Chinese factories producing goods for the West. If the U.S. slips into recession, says Anthony Nafte, a senior economist at CLSA in Hong Kong, “we see the potential for quite a significant slowdown in China.”
That would cost millions their jobs, tumble the local stock market, force painful consolidation in a range of industries and likely expose yet another link in the risk daisy chain—the mountain of nonperforming loans hidden inside state banks (the official Chinese NPL rate is 7.5 percent; healthy banks have 2 percent). Manu Bhaskaran, managing partner in Asia for Centennial Group, calls China’s hidden bad debt “a time bomb waiting to explode,” adding that “poor credit culture combined with easy liquidity, hubris and speculative behavior are always ingredients for a bad loan problem.”
The American subprime implosion makes that case all too well. But does it also indict the use of complex securities as a buffer against global turbulence? “There is a question of whether a good thing [financial innovation] creates some vulnerabilities that you wouldn’t otherwise have,” says Tyler Cowen, a professor at George Mason University and creator of the popular blog Marginal Revolution. Still, he adds, “You could go back to the 1950s where you have small banks that lend money to homeowners and just sit on the loan, but credit would be a lot more expensive, and I don’t think anyone would want to do that.”
True enough. It’s also worth remembering that a boom in innovation like the one we’re witnessing in finance will always equal some failures—after all, economic hubs from Silicon Valley to Singapore are littered with entrepreneurial refuse. But right now, all most investors can think about is the fact that “We don’t actually know who has a lot of toxic garbage,” as Mark Cutis, chief investment officer at Japan’s Shinsei Bank, puts it bluntly. As the daisy chain of risk continues to unravel, both Soros and the Sage of Omaha seem, for the moment, wiser than ever.
