The mood in the global financial community is shifting rapidly
toward gloom. Warnings of trouble ahead are multiplying.
Many fear that a large number of important financial institutions
in the United States, Europe, and elsewhere have taken inordinate
risks that could damage the pension funds and insurance annuities
that so many people rely on for a comfortable retirement - and maybe
even hurt the broader economy.
"There is plenty of room for shocks ahead," says Harald Malmgren,
a veteran economic consultant in Washington. "Volatility is coming
back to the [financial] market. We could see crackups of some
household names," that is, well-known financial firms.
Already, Wall Street has been troubled by recent events. In late
June, a prominent investment bank, Bear Stearns, came under pressure
to rescue one of its failing hedge funds. (Hedge funds are loosely
regulated private investment pools that cater to wealthy people and
institutions.) The fund had made bad bets on collateralized debt
obligations (CDOs). In this case, these complex financial
instruments were invested in mortgage securities.
As interest rates have risen and home prices have slipped, some
homeowners (especially those with subprime mortgages) have fallen
behind on loan payments. Foreclosures have surged.
Bear Stearns had to offer $3.2 billion in loans to prevent the
fund's creditors, such as Merrill Lynch & Co., from dumping the CDOs
in what could have amounted to a fire sale, a disruptive A-
liquidation of the fund's assets. It was the biggest Wall Street
rescue since that of Long-Term Capital Management in 1998, a hedge
fund that lost $4.6 billion in less than four months.
Last week, two major debt-rating companies, Standard & Poor's and
Moody's, revealed plans to downgrade many mortgage-backed bonds.
Prices for stocks and low-quality bonds plunged for a day.
The action was particularly disturbing to some on Wall Street
because S&P, Moody's, and a third rating agency, Fitch, have been
charging large fees to help banks and other financial institutions
put together collections of debt obligations of varying scale and
risk. They include CDOs and Collateralized Loan Obligations (CLOs),
packages of commercial bank loans. Both are sold to institutions
such as pension funds seeking higher returns.
Mr. Malmgren sees a conflict of interest. "It is really hard to
assign a 'poor' rating when the rating agency has helped put it
together," he notes.
The safety of CDOs has become "a major concern," says David Hale,
of Hale Advisers Inc., a Chicago economic consulting firm. The
"perception of risk" in the financial community has risen.
Last year, $470 billion in CDOs were sold, according to the Bank
for InterA-national Settlements, a central bankers' institution in
Basel, Switzerland. …