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Credit has grown rapidly in recent years. This expansion has come in many forms, from home mortgages to newfangled structured products created by clever financial engineers. There are, broadly speaking, two views about these developments. The conventional wisdom -- held by most economists and denizens of Wall Street -- is optimistic. Higher rates of credit growth and increasing levels of leverage, they maintain, are reasonable in light of increasing economic stability.

An opposing view -- held by a miscellaneous bunch, including some notable investors and Wall Street observers -- holds that the massive buildup of debt augurs ill. Drawing on the work of a little-known, deceased economist named Hyman Minsky, the pessimists contend that the recent calm has induced people to take on too much risk. "Stability is unstable," this group says, quoting Minsky. Like the differences of opinion toward the end of the last decade concerning the existence or not of a stock market bubble, the current argument will be settled only by the unfolding of events. Either the prosperity will continue in the years to come, or a financial crisis will occur.

But not everyone can afford to await the passage of time. Professional investors are paid to anticipate. Adherents to the conventional view will construct radically different portfolios from those who accept the instability hypothesis. Many investors, however, are undecided. They believe, or perhaps just hope, that prosperity will endure while at the same time they may feel uneasy about the growth of credit and other risk-taking behavior evident in today's markets. The purpose of this essay is to introduce Minsky's unorthodox ideas and relate them to recent developments in the financial world. Readers should then be better able to judge for themselves where they stand.

THE GREAT MODERATION

Just over a decade ago, a Wall Street equity strategist published a report that helped give birth to the so-called New Paradigm of the 1990s. The monetary authorities, asserted David Shulman of Salomon Brothers, had improved their handling of the economy. Recessions had become less severe and frequent, and inflation was under control. Shulman argued that as a result of these developments, equities should trade at higher multiples than in the past -- the "valuation paradigm" had changed.

The New Paradigm was later used to rationalize the lofty equity valuations at the turn of the century and was much mocked when the bubble eventually burst. But it didn't entirely go away. Rather, the New Paradigm was given a name change. According to central bankers, we currently live in the age of the "Great Moderation" -- a term coined by Ben Bernanke, now Federal Reserve Board chairman, back in 2004. His argument was very familiar, although expressed, in the argot of modern finance, in terms of risk and volatility: The world had become more stable and predictable, economic growth was steadier, and inflation didn't oscillate so violently.

This calm was reflected in the market behavior of various asset classes, including equities and bonds, which had become less changeable and were expected to remain so in the future. Because volatility is equated in theory with risk, it's safe to say the financial markets had become less risky places for investors. As Yogi Berra noted, "The future ain't what it used to be." Today the outlook appears less uncertain and less daunting than in the past.

A recent paper from the Bank for International Settlements, the central bankers' central bank, analyzes the reasons for the decline in financial market volatility. The report's authors argue that alongside more-astute monetary decision making, which has reduced inflation and extended the business cycle, several other factors should be considered. They ascribe lower volatility in part to the benefits of globalization and improvements in information technology. Rising profits and a decline in corporate leverage in recent years have also played a role.

The report draws attention to changes in financial practices. An increasing number of loans are now packaged and sold on through securitizations. The complex world of structured finance, with its alphabet soup of CDOs and CLOs, allows credit risks to be chopped up and parceled out. Credit derivatives enable lenders to insure against defaults. The sophisticated players in this multitrillion-dollar market have been improving the management of credit risk, which is no longer concentrated in banks but has shifted toward hedge funds and other new intermediaries that are more willing and able to hold it. As a result, risk premiums have fallen.

This new financial order has demonstrated its robustness. It has coped well with a variety of shocks, including the bursting of the bubble in technology stocks in 2000, the attacks of 9/11 and the subsequent war on terror, the corporate credit crisis following the failures of Enron Corp. and WorldCom, the run-up in the price of oil and other commodities, and institutional failures such as the bankruptcy of commodities brokerage Refco in 2005 and the recent collapse of Amaranth Advisors, a hedge fund that once boasted $9 billion worth of assets. The recession that appeared in 2001 was mercifully brief and shallow, a small black cloud that scudded across the blue sky and was soon forgotten.

There is no doubt that volatility in the financial markets has declined dramatically. In late November the Chicago Board Options Exchange volatility index, also known as the "fear gauge," which uses options prices to measure the implied volatility of stocks in the Standard & Poor's 500 index, fell to its lowest level in 12 years. The volatility of bonds, which is recorded by the Merrill Lynch MOVE index, also hit an all-time low in 2006.

Various analysts have observed a strong correlation between the decline of U.S. stock market volatility and falling corporate bond spreads. It's no mystery why premiums on bonds, which compensate investors for the risk against default, have narrowed. The number of business failures has fallen dramatically. According to recent figures from the Administrative Office of the U.S. Courts, Chapter 11 bankruptcy filings are at roughly half the level of five years ago. In September defaults on U.S. high-yield bonds reached a record low of 0.89 percent, according to S&P.

The BIS authors conclude that "if the reduction in the volatility of stock returns turns out to be of a permanent nature, sooner or later the equity risk premium will have to adjust downwards." In other words, stock prices would have to rise (as, in fact, they did in the months after the report was published last August).

The Great Moderation, however, isn't generally associated with the case for more-generous equity valuations. Rather, it has been used to rationalize the extraordinary growth of credit in recent years. After all, if economic cycles are longer and less volatile, if interest rates don't jump around as much as in the past, and if the threat of bankruptcy has permanently diminished, it makes sense for everyone -- households, corporations and financial players alike -- to take on more debt.

It's only to be expected that credit should increase with economic activity. But in recent years it has been expanding more rapidly than that. Between the end of 2002 and the third quarter of 2006, total outstanding debt in the U.S. expanded by more than $8 trillion, according to Federal Reserve data. During the same period the gross domestic product increased by $2.8 trillion. That means credit has grown by nearly three times the incremental increase in economic activity.

The exponents of the Great Moderation are unfazed. They argue that as the credit system evolves and becomes more resilient, it can support greater debt levels for a given degree of activity. The rising ratio of debt to GDP is a sign of the "deepening" of the financial system. According to this view, the recent increase in liabilities has been driven by a combination of rising demand (because of greater stability) and plentiful supply (because of improvements to the financial system).

SOME CONCERNED VOICES

Not everyone is so sanguine. In the months before leaving office last January, then­Fed chairman Alan Greenspan made several speeches alluding to the possibility of excessive risk-taking in financial markets. In July 2005 he warned that "vast increases in the market value of assets are in part the result of investors' accepting lower compensation for risk. . . . History has not dealt kindly with the aftermath of protracted periods of low risk premiums."

In a September 2005 speech, Greenspan commented that "extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and the instability they engender." He summed up the irony in words that echoed Minsky's: "Success at stabilization carries its own risks."

Several other central bankers have expressed similar thoughts. In October 2004, Malcolm Knight, general manager of the BIS, cautioned that "lending booms can boost economic activity and asset levels to unsustainable levels, sowing the seeds of subsequent instability." A large appetite for risk, Knight suggested, "can sow the seeds of subsequent problems."

Timothy Geithner, president of the Federal Reserve Bank of New York, has pointed out that "against the background of an apparently healthy financial system, market participants report a substantial rise in transactions leverage, erosion in the use of loan covenants, more favorable financing terms for hedge fund counterparties and especially a pressure to reduce initial margin against OTC derivatives exposure to hedge funds." At the Bank of England, deputy governor Sir John Gieve warned a gathering of hedge fund managers last July of the "danger that risk models are giving too much weight to the low volatility of recent times."

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