In the credit derivatives market, certain
instruments are exposed to what is known as "cliff risk." This
ominous sounding phrase describes a situation where the last in a series of adverse
developments obliterates the value of what was only recently viewed as a
triple-A-rated security. Up until that point, however, rating agencies,
investors, and bankers assume that circumstances will eventually right
themselves and that the principal will be paid in full, in spite of whatever
bad news might have come along beforehand.
This latter way of thinking is not confined to the
nether world of complex securities with tongue-twisting names like CDOs-squared. In many respects, it describes a point-of-view
that permeates many aspects of modern financial life. Increasingly, Americans
have taken it for granted that good times beget more of the same and they
have acted accordingly. If bad news comes along, the damage is absorbed.
Unlike with some toxic derivatives, however, many believe that if
circumstances do manage to take a turn for the worse, something can always be
done about it.
The massive build-up of public and private debts,
unfunded pension promises, and other obligations underscores this
perspective. Rather than coming to terms with untenable liabilities taken on
because of past miscalculations, the mindset has been "don't worry about
it now." If financial problems don't disappear of their own
accord, they can be restructured, rolled over, refinanced, or even renamed.
One way or another, the thinking goes, the situation will be resolved,
because there are any number of options that are readily available.
This mindset probably explains why we haven't seen
the type of response to a growing list of negatives that wizened old-timers
would have expected. In the past, significant trade deficits and other
unstable imbalances, myriad signs of a looming recession, talk of a subprime meltdown-inspired credit crunch, and the
inevitability of down cycles following periods of historically high
profit-margins and overextended uptrends would have
had money managers scrambling to batten down the hatches by now.
Instead, mutual fund cash levels are near record
lows, margin debt and leverage-based speculation are at euphoric extremes,
and risk spreads reflect an extraordinary degree of complacency. Every data
point, whether good or bad, is seen as another reason for heads-I-win,
Nowadays, many would probably argue that it makes
little sense to worry or even plan ahead for disaster, because there are
numerous escape routes available if things do actually come to a head. Liquid
markets, electronic trading and other modern technology, innovative financial
products, hedging and stop-losses, and an unfailingly supportive Federal
Reserve are seemingly permanent fixtures of today's financial landscape that
will no doubt counteract any unwelcome adversity.
At the same time, the belief exists that there is
still big money to be made from taking out-sized risks, and incentives remain
heavily skewed to the upside. Practically speaking, current performance is
all that matters, with nary a thought given to longer-term returns -- or
concerns. What might be lost through aggressively geared-up bets on repeated
rolls of the dice seems to pale in comparison to what can be realized if
everything goes exactly according to plan.
Many Americans have adopted a somewhat similar
perspective in their day-to-day financial lives. Don't make enough to keep up
with the Joneses? Just charge the credit card. Don't have enough to buy a
home? Borrow 100% of what you need -- higher property prices in future will
make the extravagance worthwhile. Interest rates are too high? Sign up for
adjustable-rate financing with ultra-low up-front teaser rates. Can't afford
to make all your monthly payments, or even survive on your paycheck? Refinance what you owe or simply borrow what
In fact, the mantra seems to be: "Why be
defensive at all?" With a support system supposedly in place that can
theoretically postpone the day of reckoning more-or-less indefinitely, the
rational response is to push the envelope to its extremes. Combine that with
the constant bullish squawking and tom-tom thumping by banks and other
financial institutions, retailers, policymakers, politicians, and the media,
and it adds up a siren song of short-sightedness and self-indulgence that is
hard to resist.
Governments at all levels are in the same thrall.
How else can you explain politicians who talk, talk, talk about fiscal
responsibility, but who continue to advocate ever-escalating spending and
borrowing nonetheless? Or who insist on using almost Dickensian pay-as-you-go
accounting systems that ignore mind-boggling financial obligations that our children
-- and our children's children -- will ultimately be responsible for? One
problem, of course, is that many have drunk the Kool-Aid that says we can
grow our way out of each and every mess. In that delusory state, they carry
on as before.
Corporate America is also mired in the here
and now, with little apparent trepidation about any challenges that lie
ahead. Managers seem mainly focused on slashing costs and paring back
investment, instead of longer-term planning, when they are not feathering
their nests, of course. Corporate policies, including executive compensation
plans, are strongly aligned with short-term performance goals. Even in
economically sensitive industries, borrowing levels are going up while
reserves are kept to a minimum. You would have thought the best and the
brightest would know better.
Yet everywhere you look, people are unwilling or
unable to stop what they've been doing, especially in recent years, because it
seems to have worked so far and for so long and everyone else is playing
along, too. Many economic and financial squalls have passed without causing
serious disruptions, at least in the aggregate, and it's hard to refute the
optimists when they argue that the times are as good as they've every been.
And yet, one day, as is likely to happen ever more
frequently with CDOs-Squared and other toxic new
age monstrosities, the "event" that really matters will come along.
A paradigm-killer that sets in motion a chain reaction that completely
undermines the apparently never-ending stability that everyone has gotten
used to. By then, people will realize very quickly that America, once viewed as the
world's foremost economic superpower, is nothing
more than a cliff-risk nation.
Michael J. Panzner
Editor, Financial Armageddon
Michael J. Panzner is a
25-year veteran of the global stock, bond, and currency markets and the
author of Financial
Armageddon: Protecting Your Future from Four Impending Catastrophes, published by Kaplan Publishing.