Debt-market bomb could hurt us all

By Jim Jubak

File this under strange but true: Insurance encourages risk-taking behavior, and ultimately, it increases the size of a disaster when it finally strikes.

That is bad news, really bad news, for the debt markets. So bad, in fact, that if you're worried about a financial-market meltdown, you should be watching the debt markets and not the stock market.

The problem is what I call the insurance effect. Make it possible for homeowners to get flood insurance, and more people will build in flood-prone areas. Sell hurricane insurance, and more people build in areas at risk of getting hit by a hurricane.

The result is logical, if perverse. The insurance policies haven't reduced the risk of floods or hurricanes, but they have shifted part of the risk from the homeowner to the insurance company. The homeowner with insurance, as a result, has less financial motivation to avoid the risk of floods or hurricanes.

Increasingly risky business

Investors aren't any different. For example, look at the buyers of mortgages, securities based on pools of mortgages, corporate loans, and corporate and government bonds. If you offer them insurance against the risk that a borrower will default on paying what's owed, those investors will be more comfortable buying riskier debt from borrowers more likely to default. Why not? Part of the risk has been passed along to those who sell the insurance. In the debt market that insurance goes by names such as "credit default swaps" and "collateralized debt obligation."

When the inevitable flood or storm or debt-market meltdown does finally take place, of course, since there are more homes in the flood plain, more buildings in the hurricane zone, more shaky credits in portfolios, the size and cost of the disaster is much larger. In fact, if the flood, hurricane or market meltdown is big enough, the costs of the disaster can overwhelm the ability of insurance providers to pay. The availability of insurance has created a feeling of safety that has encouraged so much risk-taking behavior that the insurance safety net itself can fail, leaving homeowners or investors fully exposed to the risks of their behavior.

I think that's where we are in the debt markets right now. The financial engineers of Wall Street have promised that the sophisticated financial instruments they've invented make it safe to buy riskier types of debt. The result has been a predictably large increase in risk-taking behavior.

Certainty and vulnerability

All this has left the debt markets vulnerable to a storm -- an economic slowdown -- big enough to test Wall Street's promise. I think it's almost certain that these insurance instruments will fail the test. The biggest risk in the financial markets today isn't that a deflating housing market will trigger a stock-market bust but that the huge expansion of risk-taking -- of which the problems in the market for the riskiest of home mortgages is just one part -- will overwhelm the debt markets, creating a quick reduction in the amount of money available to borrow and forcing the global economy into a credit squeeze and recession.

You can better grasp how the financial markets have gotten themselves -- and us -- into this fix by understanding exactly why investors in the various shapes and sizes of debt were so eager to believe Wall Street's promises. Interest rates around the globe are low, extremely low, in historical terms. That's great for borrowers and has fueled economic booms that stretch from Beijing to New York City to Bangalore to Ho Chi Minh City. But it's not so great for investors in debt. When 10-year U.S. Treasury bonds are yielding just 4.7% -- that's about 2% to 2.5% after inflation -- investors are constantly scouring the globe for better returns.

Piling on the risk

Traditional wisdom says that there's no free lunch, however. To get higher yields, you have to take on more risk. For example:

• Buying bundles of mortgages held by homeowners with shaky credit ratings will net you an extra 2 to 3 percentage points over the yield of mortgages for the most creditworthy homebuyers.

• Buying the newly issued bonds of financially challenged telecom Level 3 Communications (LVLT, news, msgs) yield 8.75% versus the yield of 5.57% you'll get by buying the AAA-rated bonds of the GE Capital, the financial arm of General Electric (GE, news, msgs).

• Buying 10-year Peruvian government bonds, yielding 5.88%, will give you a small edge over 10-year German bonds yielding 4.07%.

Each of these attempts to get a higher yield or to leverage the return on your investment carries enough risk to make a debt investor hesitate before pulling the trigger. About 10% of subprime mortgages are now delinquent by 90 days, according to investment bank Friedman, Billings, Ramsey (FBR, news, msgs).

That's above the peak in the 2000-01 economic downturn. Level 3 has narrowly skirted bankruptcy in the past. And Peru, well, it's not exactly a model of economic stability.

Packaging to appeal to investors

This is where Wall Street steps in to whisper, "Have I got a deal for you." By bundling risky credits together, Wall Street can create a pool of debt that is more diversified and therefore less likely to go into default than the debt of any single issuer. Then, by slicing that bundle into different pieces, called tranches, Wall Street can spread the risk around, so that investors less inclined to take on risk can get still receive a higher yield but without taking on the full risk of the total bundle of debt.

 1 | 2 | 3 | next >