How the World Works adores economic research papers with exciting titles like "Has Financial Development Made the World Riskier?" When such papers are written by the director of research of the International Monetary Fund, Raghuram G. Rajan, and not some one-man Web crank with a cartload of axes to grind, all the better. After pondering the astonishing growth, last week, of credit derivatives -- financial instruments designed to slice and dice risk and spread responsibility for it widely throughout the financial community -- we were more than ready for a 43-page analysis of whether innovations in risk management may have increased the chances of financial instability.
Rajan believes, in sum, that new developments in technology and finance have made the world better off, but "they may also create a greater (albeit still small) probability of a catastrophic meltdown." But he's not too worried, proposes a package of minor, "market friendly" reforms and generally seems to think things are on the right track. Still, he concurs with the observation expressed here last week: The new world of credit derivatives hasn't been tested by a major downturn, so we just don't know what's going to happen.
But could we be about to find out? One example Rajan used to illustrate potential problems was the housing sector. The great thing about credit derivatives, as far as a bank is concerned, is that they allow the banks to buy protection for the possibility that borrowers will default on loans. Protection in hand, the banks can then go out and make more loans, ever riskier in nature. This is precisely what has happened in the housing sector, in which banks have bent over backward to offer interest-only, no-money-down loans to customers whose credit rating is, shall we say, dicey.
Well guess what -- since last September the market for a particular kind of credit derivative, technically described as "credit default swaps on subprime ARM pools," has taken off. ("ARM" stands for "adjustable-rate mortgage," and "subprime" means the borrower has a low credit rating.) According to Mark Whitehouse of the Wall Street Journal, who does the best reporting on credit derivatives of anyone in the financial press, such derivatives doubled in price between mid-September and December of 2005. I haven't been able to find more recent data, but given the steady drumbeat of negative news from the housing sector, it's hard to imagine that the trend line has changed.
So who is doing the buying? According to Whitehouse, the main players are hedge funds that specialize in debt trading: "The new credit-default swap 'allows us to express a bearish opinion' on the housing market, says Steve Persky, managing partner at Dalton Investments, a Los Angeles hedge fund with about $1 billion in assets. 'A lot of people debate whether the housing market is overpriced, but, for sure, the credit quality of home borrowers has deteriorated.'"
The hedge funds are basically betting on the likelihood that there will be a housing sector collapse. They are short-selling the real estate business. The potential for profit is significant. "In mid-September, an investor seeking insurance on $10 million in mortgage securities with the lowest investment-grade rating of triple-B-minus, for example, could have bought a credit-default swap by agreeing to pay an annual premium of about $170,000 a year. Now, with hedge funds and others piling in to buy insurance as the housing market shows weakness, the premium on the same swap has risen to about $320,000, allowing the investor to sell the insurance at the new, higher price and pocket the difference."
So here's the deal: The smartest players on Wall Street see the housing market about to implode. So they're loading up on cutting-edge financial instruments that will theoretically protect the buyer from exposure to millions of homeowners suddenly beginning to default on their loans. And for the moment, they're making money hand over fist as the value of those derivatives rises with every new data point about slumping housing sales, slow housing starts and rising interest rates.
But what happens if the defaults do start rolling in, and the sellers of those derivatives have to make good on their obligations with cold, hard cash? Will there be enough liquidity in the system to handle the shock? Will state-of-the-art capitalism work as advertised? As Whitehouse reports, the market for credit-default swaps that could be applied to pools of home mortgage loans is new -- it's only been around since last June. Again, no one knows how it will play out.
But any prospective homeowner thinking right now about jumping into the market with a no-money-down, adjustable-rate mortgage might want to think twice. Wall Street is betting against you.