Following a period of unusually mild weather, Wall Street experienced the sudden onset of winter this week. Along with the icy blasts came warnings about the prospect for similarly abrupt and unwelcome changes in global financial markets.
In "Summers, Trichet Warn Davos Party-Goers They Underestimate Risk," Bloomberg notes some less than sanguine perspectives on the period ahead.
Lawrence Summers has a message for investors heading to the Swiss mountain resort of Davos this week to toast a year of booming returns and record bonuses.
"It's worth remembering that markets were very upbeat in the early summer of 1914," the former U.S. Treasury secretary observes.
While Summers isn't predicting the onset of another world war, he and European Central Bank President Jean-Claude Trichet are among those who are warning the more than 2,200 movers and shakers at the 37th annual meeting of the World Economic Forum that they've become too complacent about risks ranging from trade imbalances to terrorism.
A glut of cheap money and the strongest global economic growth in three decades have encouraged banks, private-equity firms and hedge funds to bet that the good times will keep rolling.
"It's too good to be true," says Vittorio Corbo, head of Chile's central bank, who will speak at a seminar in Davos about the dangers of derivatives. ``Tomorrow the mood could change. We have to be prepared."...
Several measures show perception of risk is near historic lows. The gap between the yield demanded by investors to hold emerging-market and U.S. government bonds narrowed to a record on Jan. 17, according to JPMorgan Chase & Co., while the amount of debt used to finance European buyouts rose to 8.7 times earnings in the third quarter, the most ever.
Hedge funds in the U.S. are the most leveraged since 1998, the year that Long-Term Capital Management collapsed, according to Bridgewater Associates Inc., a Westport, Connecticut-based fund manager. Regulators from the U.S. Securities and Exchange Commission, the Federal Reserve Bank of New York and the U.K.'s Financial Services Authority, concerned that credit standards for hedge funds are too lax, are jointly probing whether lenders set strict enough limits on loans....
"Current risks are ludicrously underpriced,'' says [Willem] Buiter, a former member of the Bank of England's Monetary Policy Committee. ``At some point, someone is going to get an extremely nasty surprise.''...
Summers, 52, in an e-mail drawing his World War I parallel and expanding on a column he wrote in the Financial Times, says that ``financial history demonstrates that the biggest liquidity problems always follow the moments of greatest confidence.'' The six months after the Sarajevo assassination of Archduke Franz Ferdinand, heir to the Austro-Hungarian throne, saw the Dow Jones Industrial Average lose a third of its value -- an object lesson in the perils of failing to adequately price risk.
"Complacency can be a self-denying prophecy," Summers says.
The Financial Times would seem to agree. In "An Accident Waiting to Happen in Walter Mitty Land," John Plender reports that
in retail financial markets the search for yield has long been over. As the recent results of JPMorgan Chase, HSBC, Wells Fargo and others have shown, bad debts are creeping up, especially in the sub-prime lending market, which is where the fattest yields and highest risks are to be found. An inverted yield curve, meaning that short term interest rates are higher than long-term rates, makes it much harder for everyone in retail banking to make money. A reality check is under way, and poor-quality assets are once again recognised for what they are.
In the wholesale markets, by contrast, everyone remains in Walter Mitty land and the flight to junk is still in full cry. In the European junk bond sector the cost of insuring against credit risk in the derivatives markets reached another historic low last week. Meantime, Merrill Lynch confirmed in its fourth-quarter statement that it had been purposefully increasing its exposure to private equity at the frothy point in the cycle. Like other investment banks, it has stepped up proprietary trading while increasing short and long-term debt by no less than 46 per cent over the year.
Even those who are knee-deep in all sorts of risky activities acknowledge the dangers. In "Sachs Appeal," Forbes takes a look at one of Wall Street's biggest financial operators.
No wonder this nebbishy Master of the Universe is smiling: Lloyd Blankfein, 52, has spent seven months now as chief executive of Goldman Sachs (nyse: GS - news - people ) Group, the richest, shrewdest and most powerful investment bank in the world. He just earned $53 million. The firm hit $9.5 billion in net income in 2006--even as it paid out an astonishing $16.5 billion in compensation to the faithful, most of it in year-end bonuses. Blankfein, in charge since predecessor Henry Paulson quit in June to become Secretary of the Treasury, inherited growth that would make an Internet venture squeal with delight.
Goldman's earnings set an alltime high for investment banks in 2005--then grew 76% last year to set a new record. In 2006 revenue rose 50% to $38 billion (net of interest cost). Its dealmakers handled an industry-high $1.1 trillion in mergers and acquisitions; its wealth managers raked in $94 billion in new customer money. Its stock climbed 55% to hover near $200.
Yet Blankfein can't sleep some nights, fretful over what could go wrong "when the unforeseeable happens," he says. "What keeps me up nights is how changes in sentiment because of unforeseen events could unravel years of wealth creation." He adds: "How much wealth would leave how quickly? And what would be the knockoff effects? I worry about scenarios like that."
Some might say it's a case of "when," not "if," circumstances will suddenly take a turn for the worse.
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