From Volume 6, Issue Number 6 of EIR Online, Published Feb. 6, 2007

World Economic News

New Warnings: Hedge Funds Are Leading to a Global Systemic Crash

U.S., U.K., and European regulators have expressed concern in recent meetings on Wall Street that investment banks may be allowing hedge funds to increase their borrowing capacity, using collateral that could lose its value rapidly in a financial crisis, the Financial Times Asia reported Jan. 29. Regulators have asked banking executives how they use "portfolio netting," a practice that allows hedge funds to use relatively illiquid securities such as credit default and total return swaps as collateral. The fear is, that in a big market collapse, the hedge funds won't be able to sell those securities, increasing the likelihood of widespread defaults.

At the same time, the Hong Kong Monetary Authority (HKMA) called for close monitoring of hedge funds, because their "excessive ... risk-taking" could become a "systemic" problem. The HKMA, which functions as Hong Kong's Central Bank, issued this warning in a paper reportedly posted at the Legislative Council website on Jan. 26. They warned of chain-reaction failures, albeit in bankerese: "Research suggests that the systemic risks associated with hedge funds cannot be diversified away by investing in different types of hedge funds. The systemic implication is that when one type of hedge fund fails during extreme market conditions, other types of hedge funds with different strategies are also be likely to fail or perform poorly."

BIS Director Issues 'Carry Trade Alert'

"Carry Trade Alert" is the Financial Times headline Jan. 30, on a article quoting BIS Director Malcolm Knight at the Davos economics forum. Knight warned that with excessively "leveraged" lending going on in all major financial markets, "Taken together, this increasing leverage and carry trades create the prospect that we could have rapid repricing in financial markets." Bank regulators are worried that the yen carry trade has reached a record level, according to the Commodities Futures Trading Commission, and is itself pushing the yen's value down. In this situation, even a small Japanese interest rate increases in 2007 could cause a markets explosion.

More Carry Trade Warnings

The Wall Street Journal reported Jan. 31 that fears are mounting of a shake-out from the end of the carry trade. Fed by Japan's near-zero interest rates, speculators have gone wild borrowing yen, and then investing this borrowed money in a country with higher interest rates. Known as the carry trade, this has sharply weakened the yen because they sell off their yen to convert it into other currencies. Barclays Capital warned, in a Jan. 26 report, that the volume of yen-funded carry trades "is reaching scary levels" not seen since 1998. If investors were to rapidly unwind these trades, currency markets would be rattled.

The Ultimate 'Failed' Bank: The IMF

A panel of experts is advising the cash-strapped International Monetary Fund (IMF) to sell off 400 tons of gold (worth $6.6 billion), and invest the proceeds in what the Wall Street Journal Feb. 1 called more "lucrative, riskier securities." Hedge funds or derivatives perhaps?

The Fund reportedly has "gaping holes" in its budget, expected to reach an annual shortfall of $400 million by 2010. Revenue derived from interest on loans has declined, because many countries are borrowing less from the Fund, if at all. Brazil and Argentina, once two of the largest borrowers, have paid off what they owed altogether. The brilliant experts advising the Fund on how to become more solvent include European Central Bank president Jean Claude Trichet, and former Fed chief Alan Greenspan. With their track record, and the state of the world economy, there may not be an IMF to kick around for much longer.

Clarion Call to City: Danger of Shock to Financial System

London's Financial Services Authority put out a "clarion call" to the City of London that consumer debt, a flu pandemic, and a change in the way the markets price risk, could trigger a "shock" to the financial system, in its annual Financial Risk Outlook published Jan. 31. The FSA warned that a shock would be worse in 2007, due to use of complex financial instruments and a new correlation between financial markets, such as property and equities.

Of the nine priority risks, worst is the possibility that a "significant minority" of consumers have big debt problems. The FSA reports that average consumer debt levels have now reached the all-time high of 140% of income, twice that of the 1980s. This amounts to 1.3 trillion pounds. Now, some 34% of consumers are having difficulty paying their bills. While most of these consumers are renters, those who are homeowners also face problems: if house prices were to fall, they would no longer be able to use equity in their homes to refinance other debts. Carlson said the FSA had been "rather surprised" by the rise in bankruptcies and individual voluntary arrangements, given low interest rates.

The FSA figures said that now 1 million adults regularly fall behind payments on bills and credit cards, and a further 2 million are "constantly struggling" to make ends meet. "Record debt levels and rising interest rates have heightened concerns that some consumers have unsustainable levels of debt, which could lead to an increase in the number of consumers facing debt-repayment problems. Against the backdrop of economic and financial stability, there is a real concern that many consumers hold an over-confident view about the future and would be ill-prepared if the economic conditions were to deteriorate."

Warning of Bubble in China's Stock Market

"There is a bubble going on" in China's stock market, said a leading Chinese Congressman. "Investors should be concerned about the risks," added Cheng Siwei, vice chairman of the National Peoples Congress, in an interview with the Financial Times, conducted at the FT's China-Mideast summit in Dubai Jan. 30. Cheng said that the market could be overheating after rising 138% last year.

"But in a bull market, people will invest relatively irrationally. Every investor thinks he can win. But many will end up losing. People will have to learn their own lessons."

The Shanghai market collapsed in 2001, after strong warnings from then-Prime Minister Zhu Rongji about a bubble, and has only recently been rising sharply. One cited reason, is that investors have been putting some of the vast 14 trillion yuan, or $1.7 trillion in savings, into the stock market. Also, the Shanghai Securities News estimated today that investors had raised several billion yuan to buy stocks by pawning personal possessions.

On Jan. 31, the Shanghai Composite Index fell 4.92% after Cheng's warnings. There have been some measures by the authorities to control the potential stock bubble, including a tax on land appreciation and a ban on the investment of bank loan money in shares.

The Financial Times proposes that China should just allow foreign investors free rein in their stock market, which is now separated into an internal and foreign division—although this would not solve the "fundamental problem" as London's bankers see it: an undervalued real exchange rate and too much government control.

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