Taking a New View of Risk
Murky investments are suddenly out of fashion
Spooked by the sudden realization that they might lose money on securities backed by subprime mortgages, big investors started taking harder looks at their portfolios this summer. They quickly started dumping all kinds of other investments—derivatives, commercial paper, municipal bonds, and stakes in hedge funds—because of what they saw.
Or, rather, what they didn't see. There's been a fire sale on just about any investment that doesn't provide what Wall Streeters call "transparency"—detailed information about the finances and business behind the security.
Investors today are enacting a classic "flight to quality," trading complicated, risky investments for ones that are safer and easier to understand. Congress and market regulators have responded to the credit crunch with baby steps so far—scheduling hearings and calling for rules that would require brokers to provide more information about at least some of the mysterious investments. But they are afraid of overreacting, since many argue that too much transparency can hurt investors as much as too little. So in the meantime, whole swaths of the investment markets are being pummeled, as investors attempt to figure out exactly where the hidden risks lie.
"The rule used to be that stocks were riskier. ... If you wanted to invest cash pretty conservatively, that meant debt," says Kevin Callahan, managing director of JonesTrading, which helps big investors buy and sell large blocks of stock. "But now you have a lot of credit products that are significantly riskier and less transparent than stocks."
And the amount of troubled opaque investments dwarfs the $1 trillion or so in bonds backed by subprime mortgages:
— Hedge funds, unregulated investment pools so secretive they typically don't even tell their investors what they are doing, had collected about $1.6 trillion from clients by the end of last year.
— Commercial paper—big, lightly regulated short-term IOUs issued by banks and other businesses—now totals about $2 trillion, up from $1.6 trillion in 2005.
— Municipal bonds—which despite their homey-sounding name can get away with telling investors little about their financial prospects—are now worth more than $2.4 trillion.
— Derivative contracts, which are complex and unregulated bets on the performance of everything from interest rates to subprime mortgages, rose in value by more than a quarter to $7.6 trillion by the end of last year.
Those leveraged bets are now causing some of today's most spectacular investment troubles. As recently as April, hedge fund manager John Devaney boasted about his bets on subprime-backed securities. But when the securities plummeted, United Capital Asset Management bled red ink. His investors began demanding their money back. Devaney's financial troubles are such that he's had to put up for sale his 142-foot, four-jacuzzi yacht, the Positive Carry. Ironically, "positive carry" is a financial term describing an investment strategy of profiting by borrowing at a low rate and investing at a better rate.
Investors are also dumping bank stocks, refusing to buy commercial paper, and reducing the size of loans for leveraged buyouts because they don't know who else has lent or borrowed money to make similarly risky bets, says Satyajit Das, author of several books on derivatives.