When storm clouds gather, know where to find shelter
BRIAN MILNER
Globe and Mail Update
June 23, 2007 at 9:51 AM EDT
Like biblical famines, the financial world can expect to be visited by a major calamity every seven years or so. A look at the calendar, as well as at warnings from banking watchdogs, shows that the next bad thing is just about due.
Yet few people are boarding up the windows to wait out the coming storm.
The reason is a case of collective amnesia of the sort that takes hold after years of robust profits, healthy economic growth, tame inflation and buoyant markets swimming in liquidity.
Fuelled by a dangerous combination of greed and complacency, bankers, traders and other financial players have become more aggressive in their risk-taking. Which is what lies behind the cheap financing for the massive global boom in leveraged buyouts and also explains how the subprime mortgage fiasco in the United States could inflict so much damage.
This week, we saw the latest fallout from the mortgage meltdown, as major Wall Street banks seized collateral from two Bear Stearns hedge funds that took a bath on their subprime bets. Merrill Lynch initially intended to dump all of its $850-million (U.S.) in seized assets on the market, before deciding that the shock of that move would be too severe to the overall market.
But the hedge fund debacle has already shaken investors in other risky areas, such as junk bonds and emerging-market debt. This week, Thomson Learning had to restructure a planned junk bond deal because investors made it plain that they found it much too risky, an indication that the days of easy money to finance costly buyouts may be coming to an end.
And the fallout will soon hit pension funds, banks and other institutional investors, because most of them also have a stake in the risky investments. They all have money tied up in what is known as collateralized debt obligations, or CDOs, and similar structured investment vehicles that look safer than they may actually be. If you don't know what these are, you will.
Plenty of these products carry strong credit ratings. What institutional investor wouldn't be tempted by a fixed-income product with a good credit rating offering, say, 6-per-cent interest, when 10-year government of Canada bonds are paying only 4.7 per cent? But what people don't fully realize is that they are essentially buying a basket of mortgages or other debt and if any part of that basket goes into default it reduces how much money you recover. These aren't like a normal government or corporate bonds at all and people aren't accounting for their risk.
"The big question is whether people are being properly compensated for the risks they're taking," says Arthur Heinmaa, managing partner with Toron Capital Markets in Toronto. He is one of those wily veterans who has lived through the best and worst of times in the markets.
The market could be in for some nasty surprises, particularly if there is a sudden stampede for the exits.
"The last time we really saw a good old-fashioned run to liquidity was in the bond market in 1995," says Mr. Heinmaa, who worries that it's about to happen again because risk has been so badly underestimated.
"What if a small minority decides to liquidate and it starts a potentially dangerous move? All of a sudden, volatility rises and all the participants reduce the size of their positions," because they all rely on the same data. At the end of the day, central banks, a handful of major commercial banks and some traditional money managers with cash will be left to pick up the pieces.
Those who insist that this is a different financial world, because risk is now spread so widely and global pools of capital have grown so large, have short memories.
Long forgotten are earlier bets that went horribly wrong, such as global real estate investments in the 1980s and tech and telecom financings in the 1990s.
"After the event, everybody takes the pledge not to do it again," Mr. Heinmaa says. "And then they take a little sip and find that's it's not that bad. So they say, 'We can trust these guys' and they taste a little more." Soon, there's an enormous concentration of capital in one part of the market.
So what is an ordinary person to do as the dark clouds gather? "When liquidity dries up," Mr. Heinmaa says, "you have to know how you're going to get out."
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