The dark side of debt

Financial markets

The dark side of debt

Sep 21st 2006
From The Economist print edition
Source

Public markets for raising and investing capital are plunging into the shadows


LENDING is a sober business punctuated by odd moments of lunacy. Genoese lenders' indulgence of Philip II of Spain's expensive taste for warfare caused not only the world's first sovereign bankruptcy in 1557, but the second, third and fourth as well. Lenders recycled petrodollars to third-world countries in the 1970s in the wilfully naive belief that countries, because they cannot go bust, will not default.

The world is once again in the grip of a spree of lending, but this time to companies rather than countries. What is striking is that much of this lending is happening not through public share and bond markets, nor exclusively through banks (see article). The issuance of syndicated loans vaulted to $3.5 trillion last year, from $2.3 trillion in 2000. Thanks to the low cost of debt, private lenders, such as hedge funds, are extending vast amounts of credit to leveraged buy-out firms and other private borrowers. Forsaking the sunlit uplands of global finance, the market for capital is plunging into the shadows.

For the financiers, that is an irresistibly lucrative place to be. In thinly traded, lightly regulated and untransparent markets, the bold can make an awful lot of money—and they can lose it on an even more extravagant scale. A bunch of investors is $6 billion or so poorer this week, after it emerged that Amaranth Advisors, a hedge fund that had some $9 billion under management, suffered catastrophic losses in a few weeks on the back of falling natural-gas prices (see article).

There is every chance that the markets can cope with a wilting Amaranth, or worse. Moreover, business people have perfectly good reasons for wanting to operate out of the public gaze. The trouble is that the vulnerabilities of debt's dark side have not yet been fully tested by the next act of collective lunacy. The shadows are scary because nobody quite knows what secrets they hold. That has got regulators worried—and rightly so.

Dark matter

Back in the days of claret-filled city lunches, life was so simple. Company pension funds and mutual funds put money into the securities of states and listed firms and hoped that they did well. Things are a great deal more complicated now. Even as the private world has eclipsed public markets, finance has been convulsed by a computer-enhanced frenzy of creativity. In today's caffeine-fuelled dealing rooms, a barely regulated private-equity group could very well borrow money from syndicates of private lenders, including hedge funds, to spend on taking public companies private. At each stage, risks can be converted into securities, sliced up, repackaged, sold on and sliced up again. The endless opportunities to write contracts on underlying debt instruments explains why the outstanding value of credit-derivatives contracts has rocketed to $26 trillion—$9 trillion more than six months ago, and seven times as much as in 2003.

In many ways, these complex derivatives are good for economies. Because they allow investors to lay off the risk of borrowers' defaults, they free lenders to lend more. Because risk is dispersed to those who have an appetite for it, the system should be more robust. Because derivatives are traded in liquid markets, they rapidly transmit information about the creditworthiness of borrowers. The benefits of this hyperactive shuffling of money spread well beyond financial markets. If companies are borrowing more cheaply and sensibly to make acquisitions, pay dividends and buy back their own shares, businesses everywhere should run more efficiently.

That is the theory, at least. And so far, it has broadly been borne out. The markets struggled to cope with financial crises in Asia and Russia in the late 1990s and with the implosion of Long-Term Capital Management, a hedge fund, in 1998. By contrast, there were never serious fears that the dotcom bubble burst, September 11th 2001, or, more recently, the collapse of General Motors' bonds and investors' flight from risky investments, would lead the system to collapse.

Regulators understand very well how much the world stands to gain from this revolution in finance, but they are nevertheless nervous. Because of the lack of transparency, they cannot see whether these volatile new debt instruments are in safe hands or how they will behave in a crisis when everyone is heading for the exits. As Donald Rumsfeld might have put it, they have left a world of known unknowns for a twilight landscape of unknown unknowns.

Last week Timothy Geithner, the Federal Reserve's man on Wall Street, gave warning that all this might make financial crises less common, but more severe. Britain's Financial Services Authority complained this week that investment banks and hedge funds were sloppy and prone to conflicts of interest. In a panic, incomplete paperwork could cause the whole system to collapse amid disputes about who owns which liabilities. Worryingly, firms had wildly different estimates for the risks of similar portfolios of investments. Someone somewhere is investing on flawed assumptions.

Sensible things can be done. Mr Geithner and the New York Fed have with some success been demanding that the derivatives markets sort out their bureaucracy. He wants banks to increase the cushion of collateral they require from highly leveraged clients, in case trades go bad. Banks, which routinely play computerised war games simulating the risks in their trading strategies, are being asked to be harder-nosed about assessing which hedge funds they deal with. Because the great fear is ignorance, regulators are commendably seeking unobtrusive ways to keep tabs on the markets.

Regulators also hint that it might eventually be necessary to supervise credit hedge funds, now monitored via their brokers. Here the markets' desire for obscurity contains a lesson as well as a threat. The rush into the shadows is also partly a flight from regulation, to be free of the costs and the burdens of compliance and to preserve the “cover” that helps an outfit keep a profitable trade to itself. When the next recession reveals the next act of lunacy and the urge to re-regulate finance takes hold, remember that today's successes were founded partly on those freedoms.



Post Edited (10-03-06 17:15)