When Risk Outweighs Reward

by: Michael Panzner

As dusk follows dawn, today brings forth further warnings about growing risks in the world of high -- low? -- finance.

In "Davos Economists Say Derivatives Demand Poses Market Risk," Bloomberg reports on a favorite weapon of today's masters of the universe.

Surging demand for derivatives is making financial markets more vulnerable to any slowdown in the global economy, said economists and executives at the World Economic Forum.

"You can easily get liquidity from the market every second for anything," said Bank of China Vice President Zhu Min at a panel discussion on the global economy in Davos, Switzerland. "We really don't know what the risks are."

The use of derivatives grew at the fastest pace in eight years during the first half of 2006 as a glut of cheap money allows investors to bet more borrowed funds in financial markets. That's prompted policy makers including European Central Bank President Jean-Claude Trichet to say investors may not be accurately assessing risk.

Yet even those views may represent something of an understatement, if a new report from Deloitte Research is anything to go by. According to the Financial Times' "Alphaville" blog:

Half of all hedge funds don’t measure the amount of leverage they have embedded in assets such as forwards and derivatives, the report said. Further, 54 per cent of all hedge funds either don’t track liquidity or, of those that do, neglect to do stress-testing and correlation-testing.

And while approximately 80 per cent of the funds polled had written a risk management policy, only about 60 per cent of those actually shared that policy with their investors. Deloitte’s report also criticised the “lack of sufficient breadth and detail” in existing policies, noting that “at a minimum, a written risk management policy should include acceptable levels of risk, how risk exposures will be identified, and how risks will be mitigated.”

Even funds’ directors were in the dark about risk - 20 per cent of funds polled did not share information on their risk management policies with their boards of directors, the report said.

And lest anyone think that the fallout stemming from risks gone wild is likely to be well contained, they should give the Reading, Pennsylvania school board a call. According to Bloomberg:

The third-poorest city in Pennsylvania is a lot poorer because of a 28-year bet on interest rates that already has gone awry.

The Reading school district, which has 18,323 students, this week must pay $230,000 to Deutsche Bank AG, Germany's largest bank, because it's on the losing side of a wager that long-term interest rates will rise faster than short-term rates.

In April, the board rushed approval of the so-called interest rate swap in eight days after its adviser said the transaction may earn the district $16 million by 2034. While Reading's taxpayers are liable for the loss, bankers and advisers already have pocketed $1 million in fees for arranging the swap.

"It was all done in a real hurry," said Keith Stamm, the only member of the board to vote against the deal. ''The whole board is so desperate to try to find a way to raise money, they see this floated in front of them as a big-time amount of money and they want to go forward with it."

Local governments across the country are being lured by similar opportunities to speculate with derivatives created by the world's biggest banks. Most of the $400 billion of private agreements sold to municipalities escape taxpayers' notice and are little understood by the public officials and administrators who approve them.

"It's a recipe for disaster, and it's also a recipe for sharp practices by charlatans," said James Cox, the Brainerd Currie Professor of Law at Duke University and a securities law specialist. "The gains that a community stands to derive from this are at the margins, and the risks they're exposing themselves to, frequently, are greatly in excess of what the expected rewards are."

Hmm, sounds like an apt description for a lot of things going on in today's investment world.