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Still the Early Stages of Financial Reckoning

By David Ignatius

"If something is 'unsustainable,' that means it won't be sustained." This bit of financial wisdom is attributed to the late Herbert Stein, a former chairman of the Council of Economic Advisers. And it comes to mind now, as a warning about the underlying problems of the financial markets.

Wall Street has been breathing a sigh of relief since the Federal Reserve cut interest rates last week by a half a percentage point. The Dow Jones average has regained much of the ground it lost in July and August -- including a 336-point jump the day the Fed announced its sharp rate cut, which was the market's collective shout of "whoopie!"

But among seasoned traders, I find a much gloomier mood. They warn that the Fed's actions will have only a limited effect on the imbalances in the financial markets. An analyst for last week asked Satyajit Das, an expert on exotic credit derivatives, whether we were in the third inning of the credit crunch. Das laughed and responded that we're still in the middle of the national anthem.

The best summary I've seen of the current financial picture is the September quarterly report by the Bank for International Settlements in Basel, Switzerland, which acts as a kind of executive committee for central bankers. It warned of the "dark shadow over global financial markets" caused by the collapse of the U.S. market for "subprime" mortgage loans, which was the industry's polite term for mortgages that didn't meet normal credit standards.

The credit market is still locked, months after the subprime problems became clear. Investors can't value their portfolios because they can't sell the underlying assets. Debt that was rated triple-A turns out to be triple-C. In the complex market of credit derivatives, traders tell me it can take weeks to figure out what positions are worth. "That's why the market has frozen up," explains the manager of one leading hedge fund. "We're still in the early stages" of this financial reckoning, he warns.

What's scary is that the financial system has become opaque as assets are bundled and turned into tradable securities. Once upon a time, getting a mortgage was a highly personal transaction: A lender in Des Moines, say, provided money to a local borrower whose income and credit history he knew well. If the borrower got in trouble, the lender could arrange a workout or other repayment terms. The system was transparent, and responsive.

Then the financial engineers took over: The mortgage now is often written by a national lender that has little contact with the borrower; then it is bundled with hundreds of other loans and turned into a tradable security. In theory, the new system spreads credit risk more efficiently, so that each investor can buy the level he wants. But because of deceptive credit ratings (generated by rating agencies eager for fat fees), it turns out investors didn't understand their actual risk positions. And how can they value assets if they can't sell them? That's the meaning of illiquidity.

A deeper problem worrying thoughtful investors is the fragility of the U.S. economy. We have become a nation that borrows abroad to maintain a level of domestic consumption we can't afford. If we were a developing economy, this shaky structure would have collapsed long ago, the way it did with Mexico and Thailand in the 1990s. But as the world's financial superpower, we have had the luxury of borrowing in our own currency. As long as China and other Asian nations are willing to hold our paper, the perpetual-motion machine seems to keep operating. But remember Stein's Law of Unsustainability.

A hot idea in international markets these days is "decoupling" from the U.S. economy. Investors look at the fundamentals and they see a crunch coming. So to the extent possible, they are selling assets that could be infected by future U.S. financial contagion. It's no accident, investors tell me, that the index of emerging-market securities hit an all-time high this week. That's the perverse new definition of a flight to safety -- Indian and Chinese investments.

Wall Street optimists count on the wisdom of the Fed's now battle-tested chairman, Ben Bernanke. With Treasury Secretary Henry Paulson and New York Fed President Tim Geithner, Bernanke has reconvened what under Alan Greenspan was dubbed "The Committee to Save the World." You want to believe that Bernanke & Co. will keep the whole loopy system going. But then you read that there are now half a quadrillion dollars in outstanding derivatives contracts, some of them instruments so complex that most CEOs don't understand them. Try to get your mind around that number -- $500 trillion -- and then tell me you're not a wee bit nervous.

(c) 2007, Washington Post Writers Group

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