Debt Pyramid Threatens to Topple Markets

His answer on Feb. 28 was reassuring to the markets in the short term, but I worry that all it does is extend the complacency about risk piled on risk in the debt markets that got us into this fix in the first place.

Let me first run through the evidence from the market action on Feb. 27 that shows that the problem is in the financial markets and not in the economy.

• Just about every asset sold off. Emerging-market stocks down. Developed market stocks down. Commodities down. Some of those assets are normally good hedges against declines in other asset classes. Gold often goes up when stocks fall, for example, but not this time. The coordinated selloff was evidence, I believe, that speculative buying had driven up the price of just about every asset class. And prices fell across all classes as traders unwound those speculative trades.
• Why did a 9% plunge in a small and unimportant market such as Shanghai, largely off-limits to any but domestic Chinese investors, set off a global selloff? Leverage. If you're using borrowed money -- lots and lots of borrowed money -- to buy assets, you can't wait to see if prices will stabilize. After borrowing 10 or 20 or even 50 times more money than their actual capital, very few investors are willing to bet the future of a company on the hope that a manageable 1% decline won't turn into a disastrous 3% retreat.

  Of course, all the automatic computerized selling programs designed to cut an investor's losses just trigger more selling, which, in turns, sets off more selling. The result is the kind of downside cascade that swept the New York Stock Exchange on Feb. 27.

• While everything else, except for safe U.S. Treasuries, fell, the Japanese yen rallied by about 2%. The most likely explanation is that the traders and speculators who had borrowed in Japan at 0.5% interest rates to invest in everything from New Zealand bonds to U.S. stocks were selling those assets in local currencies and then buying yen to repay their loans. The move on Feb. 27 certainly doesn't mark the end of what's called the yen carry trade, but it does illustrate the role of cheap money in the current rally in all kinds of assets and the increased volatility of a market where "everybody" is making the same bet.

But the evidence isn't limited to the market's plunge on Feb. 27. The use of derivatives to insure against risk actually increases the amount of risk-taking behavior, which means that when something goes wrong, it will go wrong in a big way.

Don't Stop, Just Insure

Investors don't change risky behavior -- they just insure against it. So on Feb. 28, the premiums on derivatives to insure against default in risky corporate junk bonds soared on the European markets.

About $100 billion in derivatives, four times typical volume, traded on Feb. 27 and Feb. 28, and premiums to insure junk bonds against loss for five years climbed by about $80,000 in just those two days. The prices of the actual junk bonds fell much less than the premiums rose: Investors weren't selling the risky asset, just buying more insurance.