Andreas Whittam Smith: Why I fear a financial crisis is in the offing

Financial gearing works both ways - turning a small gain into a large one or a minor loss into a serious shortfall

A financial storm is heading our way. Just a few hedge funds have capsized so far. If the winds do keep blowing, professional players and institutions in financial markets will take the main impact. But the rest of us would feel the effects.

As with all financial stories, greed and fear explain most of the action. In this case, however, it is also necessary to understand a technical device - financial gearing or leverage.

Most homeowners have seen this technique in action. You purchase a property for, say, £200,000. You put up £50,000 yourself and borrow the balance, £150,000. Then suppose prices rise by 10 per cent. Your home is now worth £220,000, your loan remains at £150,000 and your so-called equity in the property has risen from £50,000 to £70,000, an increase of 40 per cent.

Financial gearing, achieved by borrowing, is the mechanism which has turned a small percentage gain into a large one. It also works in the reverse direction and can turn a minor loss into a serious shortfall, or even wipe you out.

Nonetheless, financial gearing has seemed to be an answer to a difficulty. Benign as a lengthy period of low inflation and steady growth has been, it has also been marked by lower returns on financial assets. Interest rates have come right down. Shares don't yield much above 3 per cent. And these reduced returns are one reason why people at work have been required to pay more into their pension funds or see them closed to new entrants.

Seeking better returns, professional investors have responded by using financial gearing. As in the example above, they have sought to leverage 10 per cent gains into 40 per cent ones. And lenders have answered the same problem by engaging in more risky lending because higher rates can be charged.

The phrase "sub-prime" lending, often mentioned in financial stories these days, refers to this very activity, the provision of home loans to borrowers whose credit rating is poor. The one big collapse that we have seen so far, two hedge funds run by the prestigious American investment bankers, Bear Stearns, neatly combined both these attributes. The funds made highly leveraged investments in loans to sub-prime borrowers.

At this point in the story, we are on the boundary line between decisions driven by rational financial considerations and those where greed has clouded judgement. There is nothing inherently wrong, for instance, in lending to borrowers with poor credit risks, just so long as you can make an accurate appraisal of individual financial circumstances, have reliable statistics for the incidence of defaults by such borrowers and can price the risk fully in the interest rate.

Nevertheless there is an overlay to all this. The sheer size of the incentives and rewards that financial institutions give their best performers is now generating raw greed. Believe it or not, the customers aren't bothered when things are going well.

To show this, let me give you an example. Let us say that a £100m hedge fund increases the value of its assets by 25 per cent in one year to £125m. The investors in the fund - the customers - would be charged 2 per cent of the funds under management - £2m. And they would also be charged 20 per cent of the capital gain - 20 per cent of £25m equals £5m. Thus the fund has gained £25m and the investors have given £7m of this to the managers. Actually everybody is happy. Win win, as they say.

However greed is a form of disability. For with it comes a sort of blindness. This takes various forms. One is an invincible optimism. You can see this in the newspapers now. Whenever financial executives are asked about the current state of credit markets, they almost always say - "well yes, there have been one or two problems, but there is nothing systemic in this". Or, as a leading American banker said the other day: "when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance". And he added: "We're still dancing."

The blindness takes other forms. Some players are loath to admit they are engaging in double leverage. They borrow funds to buy securities which are themselves highly geared. Or they rely on valuations that come from financial modelling. They think that a few keystrokes on a computer will tell them what something is worth rather than the acid test of a transaction between an actual seller and an actual buyer. Without greed the true extent of leverage would be measured. Without greed artificial valuations would be seen for what they are.

After greed comes fear. An idea of what this would mean was illustrated by some minor developments last week - though they were sufficient to make me suddenly sit down and write this article. A small Australian hedge fund said it would restrict investors' rights to withdraw their funds because it had been hit by "indiscriminate" re-pricing of "otherwise fundamentally sound collateral". It reported losses of 14 per cent in one of its funds in June. What "indiscriminate" means here is that actual flesh and blood buyers are putting a much lower price on the firm's assets than its computer model had suggested. And it is restricting withdrawal because it knows that their customers are unforgiving. One lapse and they want out. Fear replaces greed in a trice.

If greed is blind, fear is contagious. I know very well what I would do if refused an exit by one hedge fund in which I was invested. I say this as someone who has trustee responsibilities for substantial endowments and savings but which, as a matter of fact, have no hedge fund involvement. I would begin to pull out of other hedge funds where withdrawals were still unrestricted.

Another development that caught my eye concerned the specialised agencies that give a rating to various classes of debt, all the way from supremely safe government securities such as those issued by the US or UK, to what are rightly known as junk bonds. These agencies downgraded debt that is backed by mortgage loans. Just catching up with reality you might think, particularly in the US where house prices are falling. Except that pension funds and insurance funds are often forbidden to hold lowly rated debt. A down rating can mean that they are legally compelled to sell every security they own in the down-rated class.

I could go on to describe the horrible consequences of financial gearing working in reverse and of risky borrowers proving even less reliable than assumed. I could illustrate how financial fear spreads like the Black Death. I could emphasise the malign impact of rising interest rates on the junk bond world. But I won't do so because little has gone wrong so far. The financial storm I espy is still well out to sea. It could lose momentum or change direction. Or it could hit us full on.