Amid recession jitters, world's financial system vulnerable

It was the middle of summer, the global economy was going full tilt, and a small German bank along the Rhine saw a bright future. The bank, known as IKB, forecast a $380 million profit this year.

What the bank's directors didn't know was that a subsidiary had borrowed big sums to hitch its future – and that of the bank – to US subprime mortgages. By late July, defaults on those mortgages were rising. No one would renew the subsidiary's short-term loans.

The fallout was swift: The CEO resigned. Shares of IKB Deutsche Industriebank plunged. Its biggest shareholder, a German state-owned bank, had to step in to stop the nose dive.

How an obscure lender to mid-sized German firms lost big in America's housing bust is a tale of globalized risk-taking run amok. It also hints at a larger challenge: Despite decades of regulatory reforms, the world's financial system is as vulnerable as ever to serious crises, some experts say.

"There may be more risk in the system today than a century ago," says Robert Bruner, dean of the business school at the University of Virginia in Charlottesville. "We have more complexity today because of the sheer size of the capital markets [and] the presence of new and unpredictable players."

This environment teems with financial opportunities as well as threats. But it's the dangers that loom large now for consumers and businesses in the United States and beyond. Losses from complicated investments in risky US mortgages have rippled outward, affecting other channels of lending, not just mortgages for the weakest borrowers. This tightening of credit, in turn, has increased the risk of a US recession. Already:

•Many American home buyers, even high-income ones, are having a tougher time getting home loans. On Tuesday, that helped push a widely watched index of US home prices – Standard & Poor's Case-Shiller index – to its deepest-ever year-over-year decline.

•Because of mortgage-related losses, banks have less money to lend in general, not just for housing. The worry that a credit crunch could pinch US economic growth is one factor behind a sharp drop in US stock prices Monday.

•Even some of the safest investments – money-market mutual funds – have recently faced questions of soundness because of mortgage-linked investments. Several providers have set up backup funding to reassure investors that the expected $1 share price won't change.

•The problems extend beyond American shores. The drying up of money flows to mortgage markets, although triggered by events in the US, caused depositors to stage the first run on a British bank in a century. A government bailout of the bank, Northern Rock, may now pave the way for a buyout by media mogul Sir Richard Branson.

All these factors put a tangible face on the threat of recession. Some economists now believe that tighter credit, coupled with declining home values and high oil prices, is pushing the US into a slump.

Others believe that risk can be still averted. The Federal Reserve, for one, has recently begun to lower short-term interest rates to stimulate the economy.

Either way, the current financial challenges have a strong element of déjà vu. During good times, credit comes easily and rising home prices help to minimize loan defaults by consumers. As the cycle peaks and then cools, banks begin to tighten credit, and some lenders get burned by a surge in delinquencies. That story has been repeated again in this new millennium.

But new forces have played important roles in this year's credit turmoil. Some economists say these forces also mean that at some point – not necessarily now – the financial industry could be hammered by an even bigger crisis, with more firms collapsing altogether.

These new forces include:

Complex investments. Financial firms wield ever more sophisticated financial tools. The so-called derivative security that IKB held, for example, was of a type that surged to popularity just in the past few years.

New institutions. Players such as hedge funds and buyout firms – known as private equity – represent a large and rising share of overall investment money. Hedge funds have done fairly well this year, but some were big buyers of investments tied to mortgage loans. Significantly, they are less regulated than traditional public companies – and less transparent, which means they're not monitored closely by regulators or central bankers.

Leverage. The growing use of debt, or leverage, by financial players magnifies the first two forces. An era of easy money has enabled more risk-taking built on borrowed funds. That can accentuate both the ups and downs of a cycle, raising the prospect of "fire sales" to cover losses during downturns.

Globalization. Linkage among nations is as important a trend in finance as in mining or manufacturing. Often, this means that "best practices" are spreading to more nations, and that large banks have spread their risks across a wider range of nations. But it also raises the possibility of worldwide ripple effects from financial shocks.

What all this means is that things can go very well for a long time and then, possibly, go very wrong.

"People can borrow greater amounts at cheaper rates than ever before, invest … and share risks with strangers from across the globe," Raghuram Rajan, a University of Chicago economist, wrote in a 2005 research paper titled "Has Financial Development Made the World Riskier?"

He agreed that financial innovation has bequeathed enormous benefits, but he explored the negative side effects. His conclusion: More participants in the economy are able to absorb risks today, yet "the financial risks that are being created by the system are indeed greater."

The risk of a catastrophic meltdown – involving the collapse of many Wall Street firms – remains very small, he concludes.

In fact, the world economy now has some shock absorbers that didn't exist before, economists say. Businesses have grown better at managing inventories. Central banks, by many accounts, have grown better at handling crises. And although emerging-nation markets remain the most volatile, many now have large currency reserves that they lacked during the so-called Asian contagion, a financial crisis in the late 1990s.

In any crisis, and in the current tough times for Wall Street firms, a central issue is what bankers call liquidity.

That's a fancy term for whether people or companies can get cash – by selling an asset or drawing on a line of credit – when they need it. And often people want liquidity at the precise moment when there's not much to go around.

Consider the case of IKB.

It helped set up two investment entities called Rhineland and Rhinebridge. Their formula was just about the oldest one in banking: Borrow money at a low short-term rate and use that money to finance longer-term lending that earns a higher interest rate (in this case by buying securities that represented US mortgage loans).

But when subprime mortgages – loans to people with less-than-perfect credit – started going bad, lenders no longer wanted to extend short-term credit. IKB itself was on the hook but was unprepared to provide the needed liquidity.

Financial firms in America are bearing the bulk of losses from subprime borrowers. But IKB fits a common pattern. It was stretching into new lines of activity that appeared lucrative during the boom. It used leverage, exposing itself to profit but also risk.

And it exposed itself heavily to derivative securities – investments whose value is based on other financial assets (in this case loans) in often-complicated ways.

Derivatives are often successfully used to reduce risks. An export firm might buy a currency-based derivative to protect itself from a sudden swing in currency values. But the flavor that IKB focused on, called a collateralized debt obligation (CDO), proved toxic as the US housing market soured.

"IKB relied predominantly on the good ratings" by outside credit analysts, said Günther Braunig, IKB's new chief executive, at a recent briefing.

CDOs packaged loans of varying quality. Critics say that credit-rating firms such as Standard & Poor's, Fitch, and Moody's too often ranked the packages as much safer than the sum of their parts. And investors could choose to buy various segments, known as tranches, of the CDO. Tranches that garnered a high AA now have lost much of their value, as mortgage defaults increase.

As the problems came to the fore in August, S&P tried to allay concerns that derivative securities had grown too complicated for the financial system to handle.

"Although certain kinds of CDOs are undoubtedly extremely complex, complexity in the capital markets very rarely emerges all of a sudden," the agency wrote. "Investment banks can only sell the latest incremental twist after investors have become comfortable with the earlier iteration."

The CDO investments are similar in many ways to bonds, but they rarely change hands in market trading. That adds another challenge: Many firms used computer models to estimate the value of their investments. Those models didn't anticipate the current fire-sale conditions.

Even for sophisticated investors, today's financial risks might be described in terms made famous by Donald Rumsfeld, when he was the US Defense secretary: There are "known unknowns" and "unknown unknowns."

"The world is better in some respects because of the advances in the design of new securities and the design of new institutions," says Mr. Bruner, who recently co-wrote a book on the financial panic of 1907.

But credit booms and busts remain as much a feature of the economy as ever – as the current challenges attest. "We may be yet in the early stage of the crisis," he says.