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.
Fault. There is plenty of blame to go around for these troubles, says Thomas McCraw, a retired Harvard Business School professor and author of a Pulitzer Prize-winning history of securities regulation. Big investors failed to investigate the risks associated with the promised high returns. Investment banks and brokers "always fight transparency because they think they make more money when they know more than their customers." Credit rating agencies gave top grades to risky ventures. And politicians and bureaucrats were too slow and fearful to rein in the party. "A confluence of forces has resulted in the evasion of the strategy of transparency on which the entire system rests," McCraw says. "That's what makes it so alarming."
While there are still plenty of cracks through which hedge funds, derivatives, and other newfangled investments continue to fall, there are signs that the markets and regulators may try to clear up at least some of the mysteries. The House has scheduled a September 5 hearing on the credit markets. And Securities and Exchange Commission Chairman Christopher Cox has asked Congress for the power to better regulate municipal bond issuers. The SEC ought to be able "to insist on the disclosure of material information to investors at the time that the securities are being sold," he told Congress in July.
Caution. But many in Washington say they are wary of doing much more since it may be better for investors over the long term if the market works things out on its own. Reforms sparked by the 1929 stock crash and the 2001 Enron collapse protect retail investors by requiring companies issuing old-fashioned stocks and bonds to detail everything from corporate tax payments to the CEO's life insurance policy, notes SEC commissioner Paul Atkins. And although hedge funds are not regulated, their managers still cannot legally lie, cheat, or steal. Most of the unregulated securities can be sold only to those with millions of dollars—who presumably know how to fend for themselves, he says. "We have to go very cautiously and look out for the long term," says Atkins, noting that too much transparency can hurt investors who think they have a good investment idea and don't want others to ruin it for them.
In fact, the market shows signs of adjusting to the new information demands. Jason Tyler, director of research for Chicago-based Ariel Capital Management, says he has noticed that brokers and investment bankers are "offering a lot more detail, unsolicitedly, to try and assure people."
Investors are also doing more research and singling out riskier investments that should have lower prices from those that have been unfairly tarnished. Christopher Ryon, who runs some Vanguard municipal bond funds, says his research team has been taking a second look at bonds they had rejected when first offered because the deals weren't either well-explained or profitable enough.
Brokers offering more information and investors doing more research and withdrawing from risky securities are all signs of a healthy correction. But history shows markets don't always cure themselves. After the 1929 stock crash and bank failures, many Americans literally stored their savings in their mattresses, hoarding money that could have been used to invest and expand the economy. If today's investors also lose faith, they may well follow suit.
This story appears in the September 10, 2007 print edition of U.S. News & World Report.