Maybe it's because so many markets around the world continue to defy gravity. Maybe it's the change in the seasons, which is causing some individuals to grow more hot and bothered than usual. Then again, maybe it's just a coincidence, and the nervous nellies will soon fade into the background for a few more months. Whatever the reason, there seems to be a bit of a pick-up in the number of warnings being issued by regulatory overseers, both here and overseas.
On Monday, Reuters reported that "leaders of the G8 powers will call this week for greater vigilance on hedge funds...to prevent accidents like the collapse of LTCM in the late 1990s." There was also word from John Berry of Bloomberg, as I noted in "Another Day, Another Warning," that members of the Federal Reserve were concerned about the sizeable risks that people are taking in exchange for not so ample rewards. Today, according to Reuters, in a story entitled, "ECB's Trichet Warns of Credit Market Vulnerability." it is the Europeans' turn to raise he alarm.
European Central Bank President Jean-Claude Trichet warned on Tuesday that credit markets face "a triangle of vulnerability" that could trigger an upset to robust global growth and soaring financial markets.
In a speech to international bankers, Trichet identified the three factors involved as low risk premia on debt instruments, the explosion of unregulated hedge funds and private equity firms combined with their widespread use of complex new credit derivative instruments.
"A shock at any corner of this triangle could have implications for the other two," Trichet told the International Monetary Conference here.
"For instance, a significant turn in the credit cycle could mean that credit protection-sellers, such as hedge funds, could become unable to make due payments to banks."
"Similarly if widespread problems were to emerge at hedge funds or private equity firms, which are active in the CRT (credit risk transfer) markets, this could even spark a downturn in the credit cycle," he said.
Trichet urged private firms to cooperate with governments and public officials to oversee these risks in order to manage any market adjustment smoothly.
"Ultimately the triggers for any potential adjustment cannot be predicted with any degree of certainty. All that we know is that the present state of global finance - where we are observing a level of risk pricing which is historically low - is not necessarily sustainable in the long run," Trichet said.
"All parties therefore should...contribute to an orderly and smooth adjustment," he said.
In this respect, he backed:
- Close scrutiny of hedge funds by their investors and those financial institutions and investors that do business with them, as recommended by the Financial Stability Forum report in May.
- A voluntary code of conduct prepared by the hedge fund industry on sound practices.
These topics are on the agenda for the Group of Eight summit of the world's wealthiest nations this week in Germany.
Trichet also warned of:
- Possible softening of lending standards by banks and financial institutions extending credit to private equity and hedge funds, as banks pursue market share and fee income.
- Pricing models and risk management techniques by financial market participants that could be based upon "overly benign assumptions"
- Banks making loans with covenants that have been relaxed, which may limit the ability of creditors to recover assets if a borrower runs into trouble over repaying the debt.
These comments were the latest in a series over the past week from European central bankers warning of credit market risks when financial markets are trading around record levels. Central bankers are concerned that extraordinarily high levels of liquidity in markets and a search for higher and higher returns is causing riskier behaviour that could cause problems.
"Riskier behaviour that could cause problems?" Now that's an understatement.
Comments