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Editor’s letter: Where to begin?

The events of the past three weeks have provided a
fascinating and illuminating insight into how things can go wrong in the world’s
financial markets ­ markets which are based on instruments of such mind-numbing
complexity that it’s unlikely anyone understands the whole picture anymore.

While the full impact of the US sub-prime mortgage crisis is not yet known;
at the very least, banks have had to be bailed out, investment funds have had to
be frozen, and seriously-spooked investors are still cowering in the shadows
with their cash firmly under lock and key.

With hindsight, it’s perhaps not surprising that we have found ourselves in
this mess ­ it doesn’t take a genius to work out that lending hundreds of
thousands of dollars to individuals with poor credit histories ­ sometimes no
permanent address and often no proof of income ­ was, at best, foolish. But no
one likes a wise man with hindsight.

For US lenders to then chop up this debt into smaller portions and sell on
the risk to investors around the world, and to Europe in particular, is
perfectly normal. Some might see it as a little disingenuous of US lenders to
pass on such high-risk investments. But those same people would be unlikely to
cut it in the fiercely competitive world of capital markets. Derivatives traders
are, after all, not stupid. They know the risks they are taking and, as a
result, the rewards of taking on those investments are high. But, unfortunately,
that’s where the comprehension stops.

Some of the casualties of the sub-prime mess got into trouble because they
bought into consolidated debt obligations. Essentially, they were gambling on
the chances of several different high-risk loans defaulting. A world of
questionable transparency was beginning to appear very murky indeed. Those same
consolidated debt obligations, or CDOs, can be bundled into other CDOs to create
the ridiculously-named instruments known as CDO squared.

In 2003, Warren Buffett famously described derivatives as “financial weapons
of mass destruction” saying that, after reading the footnotes to the derivatives
activities of major banks, all he knew for certain was that he didn’t know
anything about the level of risk the bank was taking on. It’s this lack of
understanding which now threatens to de-stabilise financial markets. Confidence
has been rocked and nobody really knows what institution or which investor is
exposed to what risk.
The fall out from the debacle is difficult to predict. Corporates probably
shouldn’t worry too much in the short term, as Steve Webster, finance director
of Wolseley, says on page 15. Some investors will take quite substantial hits,
but that’s what the markets are all about.

The longer term impact could well be with the markets themselves. For while
derivatives certainly provide the lubrication for modern finance, they are
becoming increasingly complex and difficult to rate ­ maybe the Sage of Omaha
was right all along.

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