Summers, Trichet warn Davos party-goers they underestimate risk


By John Fraher
Bloomberg News Service
Monday, January 22, 2007

BERLIN -- Lawrence Summers has a message for investors heading to the Swiss mountain resort of Davos this week to toast a year of booming returns and record bonuses.

"It's worth remembering that markets were very upbeat in the early summer of 1914," the former U.S. Treasury secretary observes.

While Summers isn't predicting the onset of another world war, he and European Central Bank President Jean-Claude Trichet are among those who are warning the more than 2,200 movers and shakers at the 37th annual meeting of the World Economic Forum that they've become too complacent about risks ranging from trade imbalances to terrorism.

A glut of cheap money and the strongest global economic growth in three decades have encouraged banks, private-equity firms and hedge funds to bet that the good times will keep rolling.

"It's too good to be true," says Vittorio Corbo, head of Chile's central bank, who will speak at a seminar in Davos about the dangers of derivatives. "Tomorrow the mood could change. We have to be prepared."

Davos attendees -- who are likely to include U.K. Prime Minister Tony Blair, U.S. Sen. and possible 2008 presidential candidate John McCain, Citigroup Inc. Chief Executive Officer Charles Prince and Carlyle Group Inc. co-founder David Rubinstein -- have heard the warnings about complacency before.

In fact, they heard them last year at Davos, when Summers, the former president of Harvard University, billionaire George Soros, and Bundesbank President Axel Weber cited the potential consequences of trade imbalances, budget deficits and the then- surging price of oil.

Since then, the rewards have just gotten better for investors. Prices of London's most expensive homes surged 29 percent last year, bonuses at the five largest U.S. investment firms rose 30 percent to $36 billion and the Dow Jones Industrial Average climbed to a record.

"We shouldn't pour cold water on everything," Deutsche Bank AG Chief Executive Officer Josef Ackermann, 58, said in a Jan. 16 interview. "We, the eight or nine players in global investment banking, have a very good future."

Profits are soaring, the value of takeovers last year rose to a record $3.6 trillion, and the Morgan Stanley Capital International World Index of global stocks climbed to a record on Jan. 3. Goldman Sachs Group Inc. Chief Executive Lloyd Blankfein, another Davos attendee, last year earned a bonus of $53.4 million.

With banks tapping what Trichet calls an "ample" pool of liquidity, investor appetite for risk has never been greater.

Several measures show perception of risk is near historic lows. The gap between the yield demanded by investors to hold emerging-market and U.S. government bonds narrowed to a record on Jan. 17, according to JPMorgan Chase & Co., while the amount of debt used to finance European buyouts rose to 8.7 times earnings in the third quarter, the most ever.

Hedge funds in the U.S. are the most leveraged since 1998, the year that Long-Term Capital Management collapsed, according to Bridgewater Associates Inc., a Westport, Connecticut-based fund manager. Regulators from the U.S. Securities and Exchange Commission, the Federal Reserve Bank of New York and the U.K.'s Financial Services Authority, concerned that credit standards for hedge funds are too lax, are jointly probing whether lenders set strict enough limits on loans.

Meanwhile, one gauge of stock-market volatility -- the Chicago Board Options Exchange's VIX index -- shows that concern about a slump in equity prices is at a 13-year low.

Trichet, 64, who's scheduled to speak at a Davos seminar on the topic along with Israel central-bank chief Stanley Fischer, People's Bank of China Deputy Governor Wu Xiaoling and Harvard economist Kenneth Rogoff, said at a Jan. 11 news conference that "we continue to see, overall, a low level of risk appreciation, and a disorderly unwinding of this situation would be a risk that we have to be fully conscious of."

Willem Buiter, professor of European political economy at the London School of Economics, is considerably more blunt.

"Current risks are ludicrously underpriced," says Buiter, a former member of the Bank of England's Monetary Policy Committee. "At some point, someone is going to get an extremely nasty surprise."

Among things that might go wrong: a renewed surge in oil prices. Jim Rogers, chairman of New York-based Beeland Interests Inc. and co-founder with Soros of the Quantum hedge fund, says crude is likely to exceed $100 a barrel, almost double its current level.

"Within the context of the bull market, oil will go over $100," Rogers, who predicted the start of the commodities rally in 1999, said in a Jan. 18 interview in Tokyo. "It will go over $150. Whether that is in 2009 or 2013, I don't have a clue, but I know it's going to happen."

Higher interest rates might also topple exuberant markets. The Bank of England surprised investors this month with a quarter point increase in its benchmark rate. Trichet's ECB is raising borrowing costs to try to rein in soaring asset prices and credit growth.

The ECB, unlike other major central banks, explicitly uses money supply to gauge inflation. Growth of M3, the broadest measure of money supply and the bank's preferred measure, unexpectedly accelerated to the fastest pace in more than 16 years in November, climbing 9.3 percent.

Some investors have already been stung. Venezuela's Caracas Stock Exchange Index has lost more than a quarter of its value in the past three weeks after President Hugo Chavez pledged to nationalize industries. The prices of copper and other commodities have plunged partly on concern a slowing U.S. economy will cool demand.

"We've seen a taste of what's to come in the last few days," says Nouriel Roubini, a professor of economics at New York University who will attend the forum's opening seminar on the state of the global economy with Summers. "You'll see declines in equity prices, further falls in commodity prices."

Summers, 52, in an e-mail drawing his World War I parallel and expanding on a column he wrote in the Financial Times, says that "financial history demonstrates that the biggest liquidity problems always follow the moments of greatest confidence." The six months after the Sarajevo assassination of Archduke Franz Ferdinand, heir to the Austro-Hungarian throne, saw the Dow Jones Industrial Average lose a third of its value -- an object lesson in the perils of failing to adequately price risk.

"Complacency can be a self-denying prophecy," Summers says.

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