Debt Pyramid Threatens to Topple Markets

By Jim Jubak
MSN Money Markets Editor
3/7/2007 6:54 AM EST

After Federal Reserve Chairman Ben Bernanke's Feb. 28 testimony, one member of the House Budget Committee asked him whether the selloff in global stock markets a day earlier -- and in particular the 416-point drop in the Dow Jones Industrial Average -- had changed the Fed's thinking.

"There is really no material change in our expectations for the U.S. economy since I last reported to Congress a couple weeks ago," Bernanke responded. "If the housing sector begins to stabilize, and if some of the inventory corrections that are still going on in manufacturing begin to be completed, there is a reasonable possibility of strengthening of the economy sometime during the middle of the year."

Absolutely true, as far as it goes. But it doesn't go very far. Yes, nothing that happened on Feb. 27 changes the U.S. or global economic picture. But this time it's not the economy, stupid.

What's more important is what Bernanke didn't say: that this time, the biggest potential danger isn't from a slowdown in the U.S. or Chinese economies. It's from the pyramid of leverage in the debt markets created by traders and speculators using cheap money from around the globe, and in particular from Japan.

The selloff of Feb. 27 demonstrated how a panicked unwinding of that pyramid of debt could send financial markets into chaos.

 His answer on Feb. 28 was reassuring to the markets in the short term, but I worry that all it does is extend the complacency about risk piled on risk in the debt markets that got us into this fix in the first place.

Let me first run through the evidence from the market action on Feb. 27 that shows that the problem is in the financial markets and not in the economy.

    * Just about every asset sold off. Emerging-market stocks down. Developed market stocks down. Commodities down. Some of those assets are normally good hedges against declines in other asset classes. Gold often goes up when stocks fall, for example, but not this time. The coordinated selloff was evidence, I believe, that speculative buying had driven up the price of just about every asset class. And prices fell across all classes as traders unwound those speculative trades.

    * Why did a 9% plunge in a small and unimportant market such as Shanghai, largely off-limits to any but domestic Chinese investors, set off a global selloff? Leverage. If you're using borrowed money -- lots and lots of borrowed money -- to buy assets, you can't wait to see if prices will stabilize. After borrowing 10 or 20 or even 50 times more money than their actual capital, very few investors are willing to bet the future of a company on the hope that a manageable 1% decline won't turn into a disastrous 3% retreat.

      Of course, all the automatic computerized selling programs designed to cut an investor's losses just trigger more selling, which, in turns, sets off more selling. The result is the kind of downside cascade that swept the New York Stock Exchange on Feb. 27.

    * While everything else, except for safe U.S. Treasuries, fell, the Japanese yen rallied by about 2%. The most likely explanation is that the traders and speculators who had borrowed in Japan at 0.5% interest rates to invest in everything from New Zealand bonds to U.S. stocks were selling those assets in local currencies and then buying yen to repay their loans. The move on Feb. 27 certainly doesn't mark the end of what's called the yen carry trade, but it does illustrate the role of cheap money in the current rally in all kinds of assets and the increased volatility of a market where "everybody" is making the same bet.

But the evidence isn't limited to the market's plunge on Feb. 27. The use of derivatives to insure against risk actually increases the amount of risk-taking behavior, which means that when something goes wrong, it will go wrong in a big way.
Don't Stop, Just Insure
Investors don't change risky behavior -- they just insure against it. So on Feb. 28, the premiums on derivatives to insure against default in risky corporate junk bonds soared on the European markets.

About $100 billion in derivatives, four times typical volume, traded on Feb. 27 and Feb. 28, and premiums to insure junk bonds against loss for five years climbed by about $80,000 in just those two days. The prices of the actual junk bonds fell much less than the premiums rose: Investors weren't selling the risky asset, just buying more insurance.

This works as long as there are deep pockets willing to take both sides of a bet.

The subprime mortgage market is a good example right now. Banks with exposure to the risk that borrowers will default in larger-than-predicted numbers are buying derivative insurance to protect against losses. Hedge funds, other banks and some insurance companies have been selling that coverage because they think the banks are overestimating the dangers of default.

That works to keep the subprime mortgage market liquid and functioning -- no bad thing -- since some lenders will continue to lend as long as they can get insurance in the derivative market. But it does set up the possibility of a swift collapse of the subprime market if the bet starts to go against the sellers of insurance and either a big seller of insurance can't honor its derivatives or enough sellers of derivative insurance pull out, suddenly persuading subprime lenders to stop all lending.

You don't have to look to the mind-numbingly complex world of derivatives to see evidence that the financial markets are too complacent about risk -- and that it could be starting to catch up with the markets and us. The world is building up a long list of ticking financial bombs that are only kept from exploding by the continued supply of cheap money around the globe:

Latvia: This is my favorite example right now. Its economy has been growing at 12% a year, relying on the current flood of cheap money. Credit growth has been running at 60% -- meaning there are 60% more loans outstanding today than a year ago -- and inflation at 7%. Consumers, like their counterparts in the U.S., have kept cash registers ringing even when the country wasn't producing the wealth to pay the bills. Latvia's trade deficit (current-account deficit) came to about 18% of the country's GDP in 2006. The current account deficit in the notoriously spendthrift U.S. amounted to less than 1% of GDP in 2006.

India: India is on the road to an economic and financial hard landing that would send the Mumbai stock market plunging -- certainly taking other emerging markets with it as hot money flees these stock markets. Tiny Latvia is too small to inflict much global damage if it goes into crisis, but India is big enough. Its Mumbai stock market is much more important in the world financial markets than Shanghai's.

Interest rate increases by the Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan haven't significantly cut the global supply of money or raised its cost. Too much money continues to chase too few good opportunities.

These that I've named -- and the others I haven't -- take us to the same place: an old-fashioned credit crunch that marks the turn in the credit cycle from cheap, easy-to-obtain money to more-expensive, hard-to-get credit.
When and Where?
I can point to this evidence and these big trends and say "danger ahead," but I can't tell you what catalyst will trigger a turn or on what schedule. India seems likely to hit its tough patch later this year. The Japanese yen carry trade could be unwinding now -- thanks to a legion of currency traders who all read the same technical charts and who have all started to get nervous because the charts show the yen at major support against stronger currencies and in an oversold condition.

But despite my inability to call the timing of this shift, I think you ought to be preparing for it now. The risk is high enough, and the reward of staying the current course low enough, that I think that getting cautious now is just prudent. No need to panic. No need to undo all your positions. I think there's still a good chance that the Shanghai selloff will turn into a bounce and then a limited, seasonal rally running into the spring.

I think this advice from my Feb. 21 column still stands: "If I can't find bargains right now, I'd be perfectly comfortable selling into this rally whenever a stock hits my target price. I'd certainly like to have some cash on hand as we head into the second half of the year."

But this is the time to take action, especially if a rally gives you a chance to rearrange a portfolio without taking big losses. Notice I haven't said a word about the economy. Currently it's the least of my worries.

I just wish Fed Chairman Bernanke would take some time off from reassuring investors about the economy and the short run and start flagging some of the growing longer-term risks from cheap money and complacency about risk. The Fed could even do something about the problem before it bites us all.