Prepare for Repricing

In "Prepare for Asset Repricing, Warns Trichet," the Financial Times' Gillian Tett describes what seems to be a quickening sense of alarm among some policymakers.

Current conditions in global financial markets look potentially "unstable", suggesting that investors need to prepare themselves for a significant "repricing" of some assets, Jean-Claude Trichet, president of the European Central Bank, warned at the weekend in Davos.

The recent explosion of structured financial products and derivatives had made it more difficult for regulators and investors to judge the current risks in the financial system, Mr Trichet said.

"We are currently seeing elements in global financial markets which are not necessarily stable," he said, pointing to the "low level of rates, spreads and risk premiums" as factors that could trigger a repricing.

"There is now such creativity of new and very sophisticated financial instruments . . . that we don't know fully where the risks are located," he added. "We are trying to understand what is going on - but it is a big, big challenge."...

Malcolm Knight, managing director of the Bank for International Settlements, said: "Financial innovation has produced vehicles for leverage which are very hard to measure . . . liquidity is increasing very rapidly and this is affecting asset prices."

Central banks were scrambling to address the problem by intensifying their joint discussions via forums linked to the BIS, he said, but he warned that international co-operation and data gathering efforts "need to be deepened".

A few have even started voicing once unthinkable concerns about who will clean up the mess if and when policymakers' worst fears are realized.

Stanley Fisher, governor of Israel's central bank, pointed out that it remained unclear "who takes responsibility for the [financial] system" at a time of crisis, particularly given that the "hegemony of the US is diminishing".

Given all the warnings coming out of Davos recently, some might be wondering how things had gotten to this point to begin with. While there have been a number of interconnecting factors involved, today's Wall Street Journal adresses at least one key driver: "The Greed-Fear Imbalance."

The smart money knows today's liquidity-inflated financial markets are full of risk. That was clear from the chatter at last week's World Economic Forum in Davos, Switzerland. Yet private-equity firms, hedge funds and investment banks are acting as if the good times will continue.

Skewed incentives, which pump up greed and damp fear, explain the discrepancy. Fortunes will be made if the good times roll on; but the insiders won't lose much if there is a crash because they are mostly playing with other people's money....

The main way to get seriously rich quickly these days is to play the hedge-fund or private-equity game. The incentive system -- the notorious "2 and 20" under which managers get some 2% of funds under management as an annual fee and 20% of the profits -- favors those who can scoop up the biggest pots of other people's money. The primary aim has become to gather assets rather than to deploy them effectively.

That's not to say the smart money likes to make bad investments. But when things go pear-shaped -- as with Amaranth Advisors -- the managers don't share in the losses or give back past takings. In a well-functioning market, greed and fear are appropriately balanced. The "heads-I-win, tails-you-lose" structures rife today have distorted the balance....

The smart operators are aware the party can't go on forever. But the longer it continues, the more money they will make. What's more, there is no obvious reason why it has to end now. There may be kindling on the forest floor, but where is the spark that is going to ignite it?

The snag, of course, is that as time passes, more brushwood accumulates. When the conflagration comes, it could be dramatic.

An understatement, perhaps?