Risks loom as financial system goes global

It was the middle of summer, the global economy was going full tilt, and a small German bank along the Rhine saw a bright future. The bank, known as IKB, forecast a $380 million profit this year.

What the bank's directors didn't know was that a subsidiary had borrowed big sums to hitch its future — and that of the bank — to U.S. subprime mortgages. By late July, defaults on those mortgages were rising. No one would renew the subsidiary's short-term loans.

The fallout was swift: The CEO resigned. Shares of IKB Deutsche Industriebank plunged. Its biggest shareholder, a German state-owned bank, had to step in to stop the nose dive.

How an obscure lender to midsized German firms lost big in America's housing bust is a tale of globalized risk-taking run amok. It also hints at a larger challenge: Despite decades of regulatory reforms, the world's financial system is as vulnerable as ever to serious crises, some experts say.

"There may be more risk in the system today than a century ago," says Robert Bruner, dean of the business school at the University of Virginia in Charlottesville. "We have more complexity today because of the sheer size of the capital markets and the presence of new and unpredictable players."

This environment teems with financial opportunities as well as threats. But it's the dangers that loom large now for consumers and businesses in the U.S. and beyond.

Losses from complicated investments in risky U.S. mortgages have rippled outward, affecting other channels of lending, not just mortgages for the weakest borrowers. This tightening of credit, in turn, has increased the risk of a U.S. recession. Already:

• Many U.S. homebuyers, even high-income ones, are having a tougher time getting home loans.

• Because of mortgage-related losses, banks have less money to lend in general, not just for housing. The worry that a credit crunch could pinch U.S. economic growth is one factor behind the recent drop in U.S. stock prices.

• Even some of the safest investments — money-market mutual funds — have recently faced questions of soundness because of mortgage-linked investments.

• The problems extend beyond U.S. shores. The drying up of money flows to mortgage markets, although triggered by events in the U.S., caused depositors to stage the first run on a British bank in a century. A government bailout of the bank, Northern Rock, may now pave the way for a buyout by media mogul Sir Richard Branson.

All these factors put a tangible face on the threat of recession. Some economists now think that tighter credit, coupled with declining home values and high oil prices, is pushing the U.S. into a slump.

Others think that risk can be still averted. The Federal Reserve, for one, has recently begun to lower short-term interest rates to stimulate the economy.

Either way, the current financial challenges have a strong element of déjà vu. During good times, credit comes easily and rising home prices help to minimize loan defaults by consumers.

As the cycle peaks and then cools, banks begin to tighten credit, and some lenders get burned by a surge in delinquencies. That story has been repeated again in this new millennium.

But new forces have played important roles in this year's credit turmoil. Some economists say these forces also mean that at some point — not necessarily now — the financial industry could be hammered by an even bigger crisis, with more firms collapsing altogether.

These new forces include:

• Complex investments. Financial firms wield ever more sophisticated financial tools. The so-called derivative security that IKB held, for example, was of a type that surged to popularity just in the past few years.

• New institutions. Players such as hedge funds and buyout firms — known as private equity — represent a large and rising share of overall investment money.

• Leverage. The growing use of debt, or leverage, by financial players magnifies the first two forces.

• Globalization. Linkage among nations is as important a trend in finance as in mining or manufacturing.

What all this means is that things can go very well for a long time and then, possibly, go very wrong.

The world economy, however, now has some shock absorbers that didn't exist before, economists say. Businesses have grown better at managing inventories.

Central banks, by many accounts, have grown better at handling crises. And although emerging-nation markets remain the most volatile, many now have large currency reserves that they lacked during the so-called Asian contagion, a financial crisis in the late 1990s.