[Texgreen] The not-so-golden miracle of financial leverage

[Roger Baker]

[Uh oh! The warnings about the lack of transparency, how highly =20
leveraged the whole world financial system is, and how the risk has =20
been increasingly diffused everywhere throughout the system, are =20
coming in fast these days. This associated series starts with a =20
warning just given at Davos by the ECB. If there is a world =20
industrial collapse, oil could get really cheap, BTW. -- Roger]

<http://www.ft.com/cms/s/1a94c8be-af15-11db-a446-0000779e2340.html>


ECB warns on =E2=80=98unstable=E2=80=99 financial markets

By Gillian Tett in Davos

Published: January 28 2007 21:35 | Last updated: January 28 2007 22:55

Conditions in global financial markets look potentially =20
=E2=80=9Cunstable=E2=80=9D, suggesting investors need to prepare for a =20=

=E2=80=9Crepricing=E2=80=9D of some assets, Jean-Claude Trichet, =
president of the =20
European Central Bank, said over the weekend in Davos.

The recent explosion of structured financial products and derivatives =20=

had made it more difficult for regulators and investors to judge =20
current risks in the financial system, Mr Trichet said. =E2=80=9CWe are =20=

currently seeing elements in global financial markets which are not =20
necessarily stable,=E2=80=9D Mr Trichet said, pointing to the =E2=80=9Clow=
 level =20
of rates, spreads and risk premiums=E2=80=9D as factors that could =
trigger a =20
repricing.

=E2=80=9CThere is now such creativity of new and very sophisticated =20
financial instruments ...=E2=80=89that we don=E2=80=99t know fully where =
the risks =20
are located.=E2=80=9D He added: =E2=80=9CWe are trying to understand =
what is going =20
on but it is a big, big challenge.=E2=80=9D

Mr Trichet=E2=80=99s comments reflect a debate in policymaking circles =
about =20
the implications of the growth in derivatives.

Many investment bankers and some regulators and economists argued at =20
last week=E2=80=99s World Economic Forum in Davos that the growth of the =
=20
$450,000bn (=E2=82=AC350,000bn, =C2=A3230,000bn) derivatives sector had =
helped =20
reduce market volatility and made the system more resilient to shocks =20=

by spreading credit risk. But other officials fear these instruments =20
may be raising leverage and risk-taking to dangerous levels and =20
keeping the cost of borrowing artificially low, potentially =20
increasing the chance of financial crises.

Senior policymakers admitted it had become hard to track the risks =20
because the sector is opaque, much activity occurs in unregulated =20
hedge funds, and products shift rapidly across markets and between =20
the boundaries of national central banks.

Andrew Crockett, president of JP Morgan international, said: =E2=80=9CThes=
e =20
new instruments ought to make markets more complete. But there is a =20
lack of transparency ... we don=E2=80=99t know how much leverage there =
is in =20
hedge funds, for example.=E2=80=9D

Copyright The Financial Times Limited 2007

                         =20
**********************************************************************

<http://commentisfree.guardian.co.uk/ann_pettifor/2007/01/=20
braving_the_remote_regions_of.html>

Tottering on the brink

The inherent instability of the giant Ponzi schemes underwriting the =20
world economy means financial meltdown is a huge threat.

Ann Pettifor

All last week doughty reporters from the UK broadcaster ITV braved =20
the icy remoteness of the South Pole to bring home to us the truth =20
about the role of fossil fuel emissions in melting that continent. =20
Few journalists have shown similar bravery by venturing into the =20
equally remote and secretive world of High Finance. But Gillian Tett, =20=

a Financial Times journalist systematically tracking the activities =20
of hedge funds and the credit derivatives industry, last week related =20=

a scary story.

It's the story of everyday life in the world of Haute Finance. Giant =20
Ponzi schemes are being built on a narrow base of real money, and =20
huge sums of borrowed money. The inherent instability of these =20
schemes means that the threat of financial meltdown is comparable to =20
the threat posed by the melting Arctic.

In the case related by Ms Tett, =E2=82=AC20,000 worth of real money was =20=

invested in a "fund of funds". This money was used to leverage three =20
times the amount in borrowed money. This new sum was then invested in =20=

a hedge fund, which invested the capital and the borrowed money into =20
another highly leveraged financial instrument with a leverage ratio =20
of nine. So the final investment of =E2=82=AC1m has behind it =E2=82=AC20,=
000 of =20
real money, and =E2=82=AC980,000 of debt. As the distinguished New York =20=

economist, Nouriel Roubini has noted, "this is a credit house of =20
cards where $1 dollar of capital is turned into $49 of additional =20
debt to finance an investment of $50."

Most commentators, regulators and politicians are sanguine about this =20=

state of affairs. Cassandras and doom-mongers like myself are =20
challenged to offer real-time predictions for the fall of this house =20
of cards; and to predict key "tipping points". This we cannot do. And =20=

yes, we were wrong in believing that the financial bubble had "maxed =20
out" in 2003 and should have burst if not then, at least since then. =20
But then this is a truly extraordinary financial bubble. Total debt =20
in the US now stands at nearly 3.6 times GDP. In 1929 it was 2.8 times.

John Succo, who runs a $1.5bn hedge fund, recently asserted that it =20
is the "guardians of the nation's finances" - central bankers - that =20
have fuelled this debt, and explained how its done.

"If the Fed wants to inject liquidity (credit) into the system they =20
simply call up large broker dealers and buy some of their bonds with =20
credit they create out of thin air ... The dealer then passes this =20
credit on to 'the market' by making loans to mortgage companies ... =20
or whatever ... Because each layer of lender is only required to keep =20=

marginal capital on hand, a $1bn repo done by the Fed eventually =20
creates as much as $100bn in new credit to the consumer ... This =20
situation is very unstable in the long run. The Federal Reserve's =20
balance sheet this year alone has expanded by $30bn in this way, and =20
created $3.5trillion of new credit" (for which read debt) "in the US."

How much more credit/debt will central banks pump into the system =20
before the strain of repaying 980,000 euros of debt from a tiny pot =20
of =E2=82=AC20,000 becomes too great? And how will this year's $3.5 =
trillion =20
of US debt be repaid? By extracting more assets and depleting the =20
earth's resources further? By exploiting even more intensively the =20
millions of people creating real wealth? Or will it simply not be =20
repaid? Will there be a grand jubilee? Will both the innocent =20
investors that provide small pots of 20,000 euros and the financial =20
system that sustains this house of cards just be bankrupted?

On 11 January, the Bank of England began to exhibit some nervousness =20
about the growth of debt - and bemoaned its own creation - "credit =20
and broad money growth". Then as guardians of the nation's finances =20
they decided to rein in lending, by once again raising interest rates.

In other words, having encouraged the spread of easy, but costly =20
credit the Bank, supported directly or indirectly by the Treasury, =20
has now decided hurt those hedge funds maxing out on borrowing; and =20
to punish the victims - millions of consumers that have propelled the =20=

economy forward and enriched financial institutions by borrowing. It =20
is doing so by gradually turning the handle of the interest rate rack =20=

on which these borrowers find themselves stretched.

Where were these stern guardians of the nation's finances when hedge =20
funds were created? Are these reckless borrowers regulated by the =20
government and the Bank? Is the Bank aware of the extent of their =20
liabilities? Are they speculating with our pension funds?

Where were our guardians when, as Creditaction reveals, banks and =20
other financial institutions made mortgages available at five times =20
income; or 125% of the value of the house; or with a repayment term =20
of over 50 years? What did the government or the Bank of England do =20
when, between September and November last year, banks and other =20
lenders sent out at least 100m unsolicited, but pre-approved credit =20
card application forms? Where were the wise men and women of the Bank =20=

of England, when according to uSwitch, almost eight out of 10 =20
borrowers were issued loans without the lender carrying out any =20
checks to verify that they could afford to repay the debt? Over the =20
last 12 months, 763,000 loans were issued, according to Creditaction =20
- a church-based advice centre - for debt consolidation purposes. Yet =20=

91% of these borrowers were not asked to prove that other forms of =20
credit had been closed with the proceeds of the consolidation loan. =20
Where were the guardians of the nation's finances then?

The answer of course is that both the Bank and the government decline =20=

to intervene in such unseemly affairs. The reason? The conduct of =20
hedge funds, banks and mortgage companies is regulated by an =20
"invisible hand". And so effective is this invisible hand at =20
promoting competition amongst banks, for example, that the average =20
interest rate on the virtually costless business of credit card =20
lending is about 12% above base rate - 17.02%. According to the =20
British Bankers Association, fully 75% of credit card balances were =20
bearing this average rate of 17% interest in October, 2006.

Debts of =E2=82=AC980,000 leveraged on =E2=82=AC20,000; and usurious =
interest =20
rates of 17%. It hardly bears thinking about. Which is why most do =20
not. All hail the few who do.

                                     =20
*****************************************************

http://www.ft.com/cms/s/92f7ee6a-a765-11db-83e4-0000779e2340.html

The unease bubbling in today's brave new financial world

By Gillian Tett

Published: January 19 2007 02:00 | Last updated: January 19 2007 02:00

Last week I received an e-mail that made chilling reading. The author =20=

claimed to be a senior banker with strong feelings about a column I =20
wrote last week, suggesting that the explosion in structured finance =20
could be exacerbating the current exuberance of the credit markets, =20
by creating additional leverage.

"Hi Gillian," the message went. "I have been working in the leveraged =20=

credit and distressed debt sector for 20 years . . . and I have never =20=

seen anything quite like what is currently going on. Market =20
participants have lost all memory of what risk is and are behaving as =20=

if the so-called wall of liquidity will last indefinitely and that =20
volatility is a thing of the past.

"I don't think there has ever been a time in history when such a =20
large proportion of the riskiest credit assets have been owned by =20
such financially weak institutions . . . with very limited capacity =20
to withstand adverse credit events and market downturns.

"I am not sure what is worse, talking to market players who generally =20=

believe that 'this time it's different', or to more seasoned players =20
who . . . privately acknowledge that there is a bubble waiting to =20
burst but . . . hope problems will not arise until after the next =20
bonus round."

He then relates the case of a typical hedge fund, two times levered. =20
That looks modest until you realise it is partly backed by fund of =20
funds' money (which is three times levered) and investing in deeply =20
subordinated tranches of collateralised debt obligations, which are =20
nine times levered. "Thus every =E2=82=AC1m of CDO bonds [acquired] is =20=

effectively supported by less than =E2=82=AC20,000 of end investors' =
capital =20
- a 2% price decline in the CDO paper wipes out the capital =20
supporting it.

"The degree of leverage at work . . . is quite frankly frightening," =20
he concludes. "Very few hedge funds I talk to have got a prayer in =20
the next downturn. Even more worryingly, most of them don't even =20
expect one."

Since this message arrived via an anonymous e-mail account, it might =20
be a prank. But I doubt it. For, while I would not normally write an =20
article about responses to an article (it is the journalist's =20
equivalent of creating derivatives of derivatives) I am breaking this =20=

rule, since I have recently had numerous e-mails echoing the above =20
points. And most of these come from named individuals, albeit ones =20
who need to stay anonymous, since they work for institutions reaping =20
profits from modern finance.

There is, for example, a credit analyst at a bulge-bracket bank who =20
worries that rating agencies are stoking up the structured credit =20
boom, with dangerously little oversight. "[If you] take away the =20
three anointed interpreters of 'investment grade', that market folds =20
up shop. I wonder if your readers understand that . . . and the non-=20
trivial conflict of interest that these agencies sit on top of as =20
publicly listed, for-profit companies?"

Then there is the (senior) asset manager who thinks leverage is =20
proliferating because investors believe risk has been dispersed so =20
well there will never be a crisis, though this proposition remains =20
far from proven. "I have been involved in [these] markets since the =20
early days," he writes. "[But] I wonder if those who are newer to the =20=

game truly understand the impact of a down cycle?"

Another Wall Street banker fears that leverage is proliferating so =20
fast, via new instruments, that it leaves policy officials powerless. =20=

"I hope that rational investors and asset prices cool off instead of =20
collapse, like they did in Japan in the 1990s," he writes. "But if =20
they do, monetary policy will be useless."

To be fair, amid this wave of anxiety I also received a couple of =20
"soothing" comments. An analyst at JPMorgan, for example, kindly =20
explained at length the benefits of the CDO boom: namely that these =20
instruments help investors diversify portfolios; provide long-term =20
financing for asset managers and reallocate risk.

"Longer term, there may well be a re-pricing of assets as the economy =20=

slows and credit risk increases," he concludes. "But. there is a very =20=

strong case to be made that the CDO market has played a major role in =20=

driving down economic and market volatility over the past 10 years." =20
Let us hope so. And certainly investors are behaving as if volatility =20=

is disappearing: just look at yesterday's remarkable movements in =20
credit default swaps. But if there is any moral from my inbox, it is =20
how much unease - and leverage - is bubbling, largely unseen, in =20
today's Brave New financial world. That is definitely worth shouting =20
about, even amid the records now being set in the derivatives sector.

Copyright The Financial Times Limited 2007