from Follow the Money

Gerd Hausler is a brave man.

November 3, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Hausler heads the IMF's capital market division - so he is paid to worry. 

And he is not all that worried: "I don't see a systemic crisis"

That is a bold thing to say - even if he is right to note that some widening of risk premiums now is something to welcome, in part because a modest widening now reduces the risk of a sharp widening later.  No central banker (or quasi-central banker) wants to be accused to complacency in the face of rising risks.

Look at the Wall Street Journal graph (p. A6) showing high-yield and emerging market spreads now - and how far they have come down since 2002.

Hausler's thesis is that real money - namely pension funds - now owns most risky assets.  And since pension funds have long time horizons (assuming that they have not subcontracted out management of their funds to an asset management company that is evaluated quarterly or yearly) they "might not dump assets as readily as other investors would." (Quotes are from today's Wall Street Journal )

And even if they do, there are now no shortage of hedge funds willing to step in and buy risky assets.  

I worry though about the opposite possibility.  Leveraged hedge funds already own a significant chunk of the world's risky assets.  And if they get hit by an anticipated shock (or if the  models they use to hedge their risk prove to be a bit less robust than they think, so some "hedges" prove to be less of a "hedge" than expected), they might be forced to dump their risky assets.  And real money might sit on the sidelines, afraid to buy an asset that is falling in price and might fall further.

The Greg Ip/ Mark Whitehouse story (subscription required) certainly provides anecdotal evidence for concern.

  • Jon Schotz of Saybrook Capital admits that he has upped his leverage to keep up his carry trade returns as the spread between his cost of funds and muni bonds has fallen.  That means he is more exposed to any market move.  No wonder he "pray[s] a lot."
  • The least risky tranche of a synthetic CDOs is now only pays "0.25 percentage point more than the benchmark rate at which banks lend to another.  Two years ago, comparable synthetic CDOs paid about 1.45% percentage points more than the benchmark rate."  That sure sounds like Kate Moss-thin credit spreads.  Anyone buying those synthetic collateralized debt obligations better hope that they are not buying a package of Delphi, Visteon, Ford and GM  -- or any other set of less obviously correlated credits.
  • Commerzbank seems to love US CDOs because they yield more than German bunds, even if they credit spread on US CDOs is small.  I sure hope they have hedged their exchange rate risk; indeed, I assume they have, and still found the trade attractive.  If the dollar starts to fall against the euro (as it did in 03 and 04), hedging demand from Europeans with unhedged dollar exposure could amplify a market move. 

The Journal says this is the first in a series of articles on "Cheap Money, Growing Risk."  I await the next installment eagerly. 

I also suspect Tim Geithner is a bit more worried than Gerd Hausler.  After all, it is pretty clear that "market infrastructure" has not kept up with recent financial innovation.  See the problems with settlement in the credit derivatives market, and the problems with assignment.  And we still don't really know if risk management systems used to hedge various risks (and the mathematical models used to price certain risks) will prove to be as robust as many in the market think in the event of a major shock. 

To quote Mr. Geithner:

These developments [substantial changes in the structure of the US financial system, innovation in credit risk transfer] have contributed to what seems to be a significant improvement in the overall stability and resilience of the U.S. financial system, by reducing the vulnerability of individual institutions to a broader range of potential shocks. They may also, however, add to uncertainty about how well the system might function in the context of a major systemic shock.

Given that the President of the New York Fed has to speak with a degree of understatement, I would put more emphasis on the last sentence of that paragraph than on the first.

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