If a quake hits markets, at least shock absorbers have improved since 1987
Saturday, 30 June 2007
David Wessel
Wall Street wizards discover the world is riskier and more complex than they -- and their foolproof computer models -- recognize. Congress ponders tweaking the tax code to squeeze takeover kings. The U.S. trade deficit is widening, and the dollar is sinking. Inflation jitters are in the air.
It's October 1987, just before the stock-market crash.
This isn't a prediction that the crash of 2007 is at hand. (It might be. I just don't believe anyone can predict such events.) It's a reason to ask if events in Washington, on Wall Street and in global financial markets are tremors that signal a shifting of the tectonic plates that underlie the economy.
For the past several years, global markets have been kind to the economy, and the global economy has enjoyed a great run. Interest rates and inflation have been low. Credit has been readily available; even near-deadbeats have been able to borrow cheaply. Wall Street has come up with ever-more-complicated ways to make bets, leverage them and hedge them in ways that diffuse risk far more widely than ever before. It has profited handsomely from doing so.
Today, there are signs that the era of placid markets and cheap money may be coming to an end. Inflation pressures are emerging as the global economy strains to supply growing demand from India and China. Gone is the talk of China exporting deflation. Central banks are pushing up short-term interest rates, and bond markets are pushing up long-term rates. Falling U.S. home prices are ending the frenzy of lending to subprime borrowers.
More broadly, it looks like lenders aren't going to be quite so generous with the terms they offer in making risky loans, whether to home buyers or companies.
Now, Bear Stearns discovered that financial innovation has moved faster than its high-paid employees' ability to understand what's going on -- and someone is going to lose a lot of money as a result.
There is an aura of inevitability to this. Twenty years ago, it was portfolio insurance and index arbitrage. Nine years ago, it was the hubris of Long-Term Capital Management, the big, leveraged fund that thought it was smarter than everyone else. Today's financial instruments are so opaque that almost no one can be certain how risky they are.
"It's not hard to argue that our understanding of economic processes may even be less today than it was in the past," says the Bank for International Settlements -- the central bank for central bankers -- in a thoughtful essay in its just-published annual report.
"On the real side of the economy, a combination of technological progress and globalization has revolutionized production. On the financial side, new players, new instruments and new attitudes have proven equally revolutionary," adds the BIS. "There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking."
"The danger with such...market processes is that they can, indeed must, eventually go into reverse if the fundamentals have been overpriced," the BIS continues, its worries beginning to show.
"Should liquidity dry up and correlations among asset prices rise" (That's central-banker-speak for: too many investors trying to sell all sorts of things at the same time.) "the concern would be that prices might also overshoot on the downside." (That's central-banker-speak for "crash.") "Such cycles have been seen many times in the past," it adds.
Now maybe these are just tremors. Maybe the woes that recently brought two Bear Stearns hedge funds to the brink of a meltdown will shake Wall Street out of its complacency. Maybe the inflation scare fades. Maybe the markets are a little bumpy, but there's no confidence-rattling crash. Maybe Congress tweaks the tax code enough to raise some revenue and let off populist steam without overdoing it.
But what happens if it's more than that, if these tremors turn out to presage an earthquake? Obviously, that will hurt those who lose money. But what about the rest of us?
Part of the answer lies in the strength of the financial system's shock absorbers, which have improved since 1987, the 1997 Asian financial crisis, the 1998 Long-Term Capital mess and Sept. 11 attacks. Hedge fund Amaranth Advisors collapsed without many side effects. It looks like the same may go for the two Bear Stearns funds, whatever their fate.
Recent history is encouraging. The 1987 stock-market crash, as frightening as it was, didn't tank the U.S. economy. Neither did the horror of the Sept. 11 attacks.
The economy gulped and then rebounded. That isn't any guarantee that the next crash or crisis, and there will be one someday, will have similarly passing effects on the impressively resilient U.S. economy. But it is encouraging.
..............
Internet
Wall Street wizards discover the world is riskier and more complex than they -- and their foolproof computer models -- recognize. Congress ponders tweaking the tax code to squeeze takeover kings. The U.S. trade deficit is widening, and the dollar is sinking. Inflation jitters are in the air.
It's October 1987, just before the stock-market crash.
This isn't a prediction that the crash of 2007 is at hand. (It might be. I just don't believe anyone can predict such events.) It's a reason to ask if events in Washington, on Wall Street and in global financial markets are tremors that signal a shifting of the tectonic plates that underlie the economy.
For the past several years, global markets have been kind to the economy, and the global economy has enjoyed a great run. Interest rates and inflation have been low. Credit has been readily available; even near-deadbeats have been able to borrow cheaply. Wall Street has come up with ever-more-complicated ways to make bets, leverage them and hedge them in ways that diffuse risk far more widely than ever before. It has profited handsomely from doing so.
Today, there are signs that the era of placid markets and cheap money may be coming to an end. Inflation pressures are emerging as the global economy strains to supply growing demand from India and China. Gone is the talk of China exporting deflation. Central banks are pushing up short-term interest rates, and bond markets are pushing up long-term rates. Falling U.S. home prices are ending the frenzy of lending to subprime borrowers.
More broadly, it looks like lenders aren't going to be quite so generous with the terms they offer in making risky loans, whether to home buyers or companies.
Now, Bear Stearns discovered that financial innovation has moved faster than its high-paid employees' ability to understand what's going on -- and someone is going to lose a lot of money as a result.
There is an aura of inevitability to this. Twenty years ago, it was portfolio insurance and index arbitrage. Nine years ago, it was the hubris of Long-Term Capital Management, the big, leveraged fund that thought it was smarter than everyone else. Today's financial instruments are so opaque that almost no one can be certain how risky they are.
"It's not hard to argue that our understanding of economic processes may even be less today than it was in the past," says the Bank for International Settlements -- the central bank for central bankers -- in a thoughtful essay in its just-published annual report.
"On the real side of the economy, a combination of technological progress and globalization has revolutionized production. On the financial side, new players, new instruments and new attitudes have proven equally revolutionary," adds the BIS. "There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking."
"The danger with such...market processes is that they can, indeed must, eventually go into reverse if the fundamentals have been overpriced," the BIS continues, its worries beginning to show.
"Should liquidity dry up and correlations among asset prices rise" (That's central-banker-speak for: too many investors trying to sell all sorts of things at the same time.) "the concern would be that prices might also overshoot on the downside." (That's central-banker-speak for "crash.") "Such cycles have been seen many times in the past," it adds.
Now maybe these are just tremors. Maybe the woes that recently brought two Bear Stearns hedge funds to the brink of a meltdown will shake Wall Street out of its complacency. Maybe the inflation scare fades. Maybe the markets are a little bumpy, but there's no confidence-rattling crash. Maybe Congress tweaks the tax code enough to raise some revenue and let off populist steam without overdoing it.
But what happens if it's more than that, if these tremors turn out to presage an earthquake? Obviously, that will hurt those who lose money. But what about the rest of us?
Part of the answer lies in the strength of the financial system's shock absorbers, which have improved since 1987, the 1997 Asian financial crisis, the 1998 Long-Term Capital mess and Sept. 11 attacks. Hedge fund Amaranth Advisors collapsed without many side effects. It looks like the same may go for the two Bear Stearns funds, whatever their fate.
Recent history is encouraging. The 1987 stock-market crash, as frightening as it was, didn't tank the U.S. economy. Neither did the horror of the Sept. 11 attacks.
The economy gulped and then rebounded. That isn't any guarantee that the next crash or crisis, and there will be one someday, will have similarly passing effects on the impressively resilient U.S. economy. But it is encouraging.
..............
Internet