And to gain insights into how to offset the risks facing affluent families, staff writer Elizabeth Harris interviewed dozens of economic, banking and investment industry leaders. Accompanying the roundtable discussion, we present their thoughts on specific perils, and ideas for mitigating them.

Worth: We are ending 2006 with mixed economic signals: Oil prices and housing prices are both declining, inflation remains a worry, but the Fed has stopped raising rates. The stock markets are up. What is in store for 2007? Let’s start with the view of the main risks.

Nouriel Roubini: The answer is simply that we’re going to have a recession in 2007. We are in the midst of the biggest housing slump in the last five decades. In some areas, new home sales have declined more than 30 percent since 2005. Residential investment is likely to fall as much as 15 percent in the second quarter.

People are concerned about inflation, but at this point, inflation might not be a problem; if anything, inflation will fall in a global slowdown. Knowing that, interest rates now may actually be too high.

Consumption will slow down as housing goes bust. Corporations are flush with liquidity and profits, but they are on an investment strike. Instead of investing, they are giving money back to shareholders through the biggest share buyback bonanza in history. This is a signal of pessimism, because no corporation would give its profits back to shareholders if it had strong investment or M&A prospects. With the housing bust causing demand to fall, companies are cutting production and investment instead of coming to the rescue of the economy.

James Glassman: I think the one area Nouriel and I agree on is that inflation is not a problem. Inflation is an oil story, a relative price story, rather than a real threat. I think people have misread this, including the Fed. It started a normalization campaign perhaps sooner than it should have. So the job recovery was a little more muted.

Housing is going through a big adjustment. The problem with housing is that prices got out of line. When housing becomes unaffordable, people don’t keep buying. We all live in neighborhoods where there are houses that have been on the market for a long time. But they are starting to move now because people are willing to accept a lower price—that’s what fixes the problem. This is not a big deal.

I think we are in the fifth inning of an expansion, and I think we are going to go extra innings. We always have sectors that are out of line, and that’s what’s going on in the housing sector and the auto industry. They are going through adjustments.

I don’t think I know of a recession that was caused by the consumer. Recessions are caused by things that happen in the business sector, and because the business sector has to meet shareholders’ expectations, when problems arise, it has to address them quickly. That’s what we are seeing in the construction business. Overall, profits are strong. If we have a recession now, it would be the first one since the 1850s to happen when corporate profits were at record levels.

THE PARTICIPANTS
JAMES GLASSMAN  managing director and senior policy strategist at JPMorgan Chase & Co.	RICHARD BOOKSTABER  portfolio manager for the FrontPoint Quantitative Fund, a quantitatively driven long-short equity hedge fund, and the former head of risk management at both Salomon Brothers and Morgan Stanley.	NOURIEL ROUBINI  professor of economics and international business at New York University’s Stern School of Business, and chairman of Roubini Global Economics, a macroeconomic analysis and consulting firm.	ETHAN BERMAN CEO of the RiskMetrics Group, a leading financial risk analytics firm. (Photograph by Thomas Hart Shelby.)

There is the question of why businesses have been so cautious about spending, which I don’t think is much of a mystery. I think we are in a time of economic renaissance. The world is opening up. There are new alternatives in Asia, and we just don’t know what to do yet. It takes time to get acclimated to the way business is done in China, India and Indonesia. People are trying to figure out how to manage globalization best. If you are an investor, there are risks ahead, because you don’t know how much it takes to make that adjustment. But frankly, the low corporate investment levels in a world that is seeing a second industrial revolution taking place across Asia—which is, by the way, what is driving the U.S. trade deficit—makes this a very interesting time.

Worth: Nouriel has said the large proportion of new job growth attributable to the housing sector in the last few years is out of line with historical levels. If the housing market does turn down, wouldn’t it have an outsized effect on the economy through employment?

Glassman: A lot of this has happened already. Housing job creation has disappeared. It was generating a lot of jobs, and it would have a negative effect if economic conditions were the same as they were in the past. They aren’t. When the frenzy dies out in one place, you get relief somewhere else.

The consumer has benefited from rising balance sheets and rising asset prices in stocks and property. That is why people didn’t feel the need to save, but that is changing. The consumer is no longer benefiting from balance sheet windfalls, and we are going to start to see consumer behavior getting more in line. What that means is that you are going to get sectors like housing becoming more balanced.

In the background, interest rates are adjusting. The market has been on to this for a while. Bond markets are indicating that we have a new natural level of interest rates, which seems likely to be lower. The market is trying to find a new equilibrium. You don’t have housing driving the market, but something else will step in.

Worth: Recent blowups, like the demise of Amaranth Capital, have had very little impact on the financial markets, unlike, say, when the near-collapse of Long Term Capital Management (LTCM) threatened the financial system. Do you think the financial sector is becoming better at managing these sorts of risks?

Richard Bookstaber: The recent hedge fund losses did not affect the money-center banks, which is what caused the wider concerns about LTCM in 1998. The trigger for the LTCM crisis was fairly minor by most measures. It was the default in Russia, where they lost $300 million. Usually when something like this happens, you can say, "OK, I lost this money, I’d better pull some capital out to meet the obligation with the banks," and you sell something. But then the prices of the assets you need to sell go down, so you have to sell more and more to make good on the leverage. But if you are leveraged through, say, futures, rather than bank loans, that sort of cycle is not a problem for the system overall.

Glassman: There’s more liquidity in the market today, in part because of hedge funds. Amaranth was taken out by another hedge fund. [Citadel Investment Group, along with JPMorgan Chase, assumed Amaranth’s battered energy portfolio.] One has to be careful of saying that hedge funds are a problem; clearly they bring liquidity. What happened with LTCM and Russia in 1998 was caused by a lack of liquidity. You now have more players like hedge funds that are willing to provide liquidity to the market.

Worth: Nouriel, it sounds like the recessionary scenario you described would require a dramatic tightening of global liquidity.

Roubini: This is where there are two concepts of liquidity. One measure is low nominal annual interest rates. By any standard, interest rates are still low, and so there is marginal liquidity.

But if I’m right, and the housing market leads to an economywide recession, then you are going to see a liquidity problem within the banking system. The banks claim they have offloaded much of their $10 trillion in mortgages, but actually half of the assets on their balance sheets are in mortgages or mortgage-backed securities. About $5 trillion of mortgage capital is guaranteed by Fannie Mae and Freddie Mac. If even one-fifth of that went belly up, the cost in public debt would be $1 trillion. The savings and loans had only $200 billion of exposures in the 1980s when the S&L crisis occurred.

Bookstaber: Another risky area that is not getting much attention is the market for credit default swaps and credit derivatives. Because nothing bad has happened with this market, no one is paying attention. But the problem is, if there is a crisis, the market is not going to get a second chance. It is a huge market, and it links right into the money-center banks.

There are a lot of theories about how things could go wrong. Say a lot of credit default swaps are written on a corporation, and it runs into trouble. There would actually be an incentive for that corporation to issue a lot more debt, because the credit default swap holders would need it to make good on their swaps. The problem is that the corporation is not going to be able to issue new debt right away, so there won’t be enough to settle all the default swaps. If you had all the time in the world to solve the problem, you probably could work things out. But it’s like the engineering concept of tight coupling, where you have very tight links between a series of complex steps, and no time to intervene—like a shuttle launch. If you could press the pause button at some point and have everybody deliberate, maybe you could solve the problem, but during a crisis, you can’t.

It is through the very design of the financial markets that we end up with the risks that we have. In nuclear engineering, you have a similar sort of tight coupling, through faster and faster interactions combined with growing complexity, and, as a result, the very nature of the system is such that you expect to have a certain number of what are considered "normal" accidents. In the financial markets, every time we have a problem, we just add some more regulations or oversights, but that just adds complexity to the structure. So you have a paradoxical result, that more rules and regulations can actually increase the amount of risk.

Worth: So you worry about regulations like the new Basel II bank capital rules?

Bookstaber: That’s a great example, because rules like that set requirements on things like value-at-risk and minimum capital levels. You think, OK, that’s going to take care of bank risk, but then you have a blowup in some country in Asia, and suddenly all the banks have to liquidate their investments there because they are over their Basel II capital limits, because volatility has gone up and the value of their portfolios is dropping. But it gets worse: A bank will say, "I can’t do any more in Southeast Asia, but I do have some investments in Brazil; I guess I can liquidate them to meet my capital requirements." And then everybody starts selling Brazil, for no reason other than they all happen to have it in their portfolio and need the liquidity. So Brazil goes down. These types of regulations can cause a chain reaction.

THE PROBLEM lies in the word "surprise." A real risk is something that people are not expecting. —Ethan Berman

Roubini: But to say that regulation is always bad doesn’t make sense. The whole hedge fund industry is totally unregulated, and there is no transparency. There is no disclosure. You can say that the market is the best regulator, but investors cannot tell, in many cases, who is a good manager, and what the managers they hire are doing. So how can the market regulate them with no disclosure?

Today, the amount of derivatives—whether credit derivatives or interest rate derivatives or other types—outstanding is a multiple of what it was in 1998. If something systemic happens this time around, it’s going to be much uglier than LTCM. People say derivatives spread risk, but it’s not really obvious that risk is being diffused through the system or whether it’s being concentrated. If there are some key parts of the financial system in which risk has been concentrated, or some of the key players are doing most of the transactions, then if one of them goes belly up, we are in trouble.

Bookstaber: It’s a continuum; you can regulate up to a certain point until it starts to become self-defeating. My point is that, just by the very nature of how the market is designed, you are going to end up having another crisis. Hedge funds are probably going to somehow be involved in it because so much of the risk-taking today is by hedge funds.

Worth: Spreads in the credit default swap and leveraged markets have been historically tight for a long time now, despite the Fed’s 17 quarter-point rate increases. That seems to contradict predictions of a credit downturn in early 2007.

Ethan Berman: Clearly the market is telling you there is no problem whatsoever. You can’t deny that spreads are too tight on many fronts—and the argument that spreads are tight because interest rates are really low was more true several years ago than it is today. But people still believe it.

A very valuable aspect of the growth credit derivative market is that less and less credit is being concentrated in a few hands. That is a good thing. The bigger concern is that people don’t understand the risk they are taking. Many individual investors have credit exposure that they don’t realize is credit exposure because it is in some bundled package, and they don’t have the tools to measure or manage that.

When markets aren’t particularly transparent, there tends to be big winners and losers. I know of hedge funds that have literally bought a credit and sold the same credit at the same time with two different dealers and made money. And, by the way, both of those dealers made money as well. That isn’t representative of the largest part of the credit market by any measure, but it shows how the lack of transparency leads to irrational pricing.

Bookstaber: The question with default swaps is whether the people holding them are leveraging them to the extent that they don’t quite understand what risk they have, and what small event might trigger a liquidity crisis.

JUST BY the very nature of how the market is designed, you are going to end up having another crisis. —Richard Bookstaber

The same is true, though with a much longer timeframe, with housing. If for some reason interest rates go up and all of a sudden the housing sector softens, people will suddenly realize that their mortgages are going to cost them twice as much as their monthly paycheck and—by the way—their house isn’t worth what it was worth last year. Then you have a slow-motion cascade. People who were banking on the value of their houses as their savings for retirement have to dip into their stocks instead. Then you have everyone liquidating stocks, and that is a big problem. If the stock prices start to drop as a result of all the selling off, you have to liquidate even more.

Berman: But I don’t see housing and credit as being the problem, because they pass what we might call a "predictive stress test"; everyone is ready for the crisis and runs their stress scenarios to ensure they can survive those events. The problem lies in the word "surprise." A real risk is something that people are not expecting.

People have not, for instance, been running scenarios on what happens when oil prices unexpectedly go down to $30 a barrel. I pick oil, but it could be any of the commodities people have been investing in. How many people own oil that do not need it? A lot. A lot of investors have wealth that was created by the run-up in oil, and if oil falls, that wealth disappears. The same is true for companies. There is not a chance in the world that Exxon is prepared for $30 a barrel. Another development no one is expecting is a stronger U.S. dollar.

Worth: Is there any likelihood of a stronger dollar soon?

Bookstaber: Oh yes. It has nothing to do with the trade deficit. If I were God, I would have a stronger dollar, because developing countries need as much help as possible in speeding up their export growth.

Glassman: You have to ask yourself why central banks in other countries are buying dollars. Well, if you choose not to hold those dollars, your currency is going to rise against the dollar. Guess what that means if you’re China? If your currency rises, dollar-denominated companies such as Liz Claiborne and JPMorgan don’t want to invest in projects in China anymore. The Chinese know that a stable currency to the dollar is in their interest at this stage of their development. There will be a point when China won’t be buying U.S. Treasuries, but this is a development story, and it will take several decades.

Roubini: I think there are many good reasons why the Chinese, at some point, are going to stop holding dollars, and their currency is going to appreciate. The longer they wait and the more they accumulate reserves, the more an appreciation is going to cause a capital loss on their dollar reserves. If they have $1 trillion in U.S. dollar reserves, will they let their currency appreciate 20 percent and suffer a $200 billion loss?

The biggest risk is that the Chinese let the yuan appreciate rapidly, which would cause a dollar free fall. They are getting worried about their economy overheating. If they raise interest rates with their current exchange rate, they will be in trouble, because they will create an active investment bubble that eventually can lead to a hard landing. Therefore, it is in their own national interest to let their currency appreciate and slow down the rate in which they accumulate currency reserves.

Worth: Some think all the liquidity from petrodollars and foreign central banks is dampening volatility. Everyone worries about volatility rising. But who would suffer if volatility were to drop even further?

Bookstaber: All the broker-dealers would have a harder time. There is a joke that ran on Saturday Night Live where in the parody of the news they said: "Today on the New York Stock Exchange there was no trading. Everyone has what they want." If volatility is lower, there is less need to trade, so the broker-dealers will be hurt, and the hedge funds will be hurt because most of these guys are liquidity providers. They are there to provide liquidity to people when they need to trade. And there is not much reason to trade, so the spread is not there.

HEDGE FUNDS last year were complaining they were not doing well because there was not enough volatility. Now they are saying they like volatility, but not too much. —Nouriel Roubini

Roubini: Last year, hedge funds were complaining they were not doing well because there was not enough volatility. Now they are saying they like volatility, but not too much. It is an excuse for them not being that great. There has been a proliferation of below-average funds and managers.

Worth: Investors have put enormous sums into hedge funds and private equity. Are there enough talented fund managers to justify this?

Bookstaber: With all the different kinds of hedge funds out there, I think it’s a question of whether or not there are too many of them in any one area. There are, for example, only so many convertible bonds, and there are a lot of convertible arbitrage hedge funds chasing after them.

My feeling is that one area where the game is not going to be over any time soon is in equities, at least not in specialized areas. If you are in a specialized area, you are taking advantage of the fact that it’s a new market and other people aren’t quite up to speed yet. When they figure it out, your advantage is gone.

Glassman: I think you are going to see hedge funds making bigger bets on individual companies, including public companies. We all have theories on whether we can beat the market. If there is an individual who can beat the market, you are going to be far better off investing with that individual, even with the high fees.

Roubini: But 90 percent of hedge funds cannot beat the market. And in this world, it is becoming tougher, because the real alpha types are doing well, but they are the minority. And poor performers can always close their fund and start another. The performance records don’t reflect the ones that closed down.

Berman: I think we are going to be in an environment of fairly low returns and low volatility for a while, but I don’t think people have adjusted to a world of lower expected returns. Investors are going to look for that edge, which they will find in hedge funds or variations. For this reason, the trend toward alternative asset classes will continue.

I think insurance is going to be an important new instrument. Underwriting protections against hurricanes in the Gulf of Mexico, for example, is not correlated to the stock market, the currency market, interest rates, etc.

Worth: That lack of correlation is one of the reasons we see advisors touting art, for one thing, as an asset class.

Bookstaber: The articles on art as an investment class always rub me the wrong way. An asset class has to have a real economic rationale. When people talk about getting these tangibles that are not inherently income producing, I always think they are playing into some sort of short-term bubble.

Worth: Speaking of bubbles, do you think the U.S. recovery since 2001 been driven by credit rather than actual growth?

Glassman: It’s always that way. Easy credit was what the Fed was supposed to provide, and it helped restore psychology and turn the economy. The economy is performing well, except for housing, and that’s because prices got out of line.

The economy is more resilient than people expect. When the stock market crashed in ’87, half the world thought civilization was ending. Think how you felt when the terrorists struck on 9/11. But we watched how the economy absorbed these shocks. What bin Laden doesn’t realize is it’s not about destroying property, it’s about destroying ideas—the idea of how the economy is based on the energy of human beings, and giving them the freedom to take advantage of that energy.

Worth: But isn’t there a better way to minimize economic swings than Greenspan’s approach of waiting until after a crash to dump a lot of liquidity into the markets?

Glassman: That’s a very financial markets perspective. If you look at how the Fed managed the real economy, it performed quite well. And prices in stocks are back to where were they were—what we once called a bubble. But we don’t call it that anymore; valuations have come back in line.

Worth: Will we ever learn from bubbles?

Berman: It’s funny how people always justify the bubble that they’re invested in. The reason they used to justify the technology boom was the Internet. Some people said the real estate market was different this time because there is a limited stock of housing. What happened? Has all the land been cut in half now?

Glassman: Think of a baseball team that has won 10 games in a row. What are the chances it will win the 11th game? The truth is a huge amount of money is made by investing in momentum. And overall, momentum trading has positive returns. So there is a very good reason why there will always be bubbles.

Photo Illustrations by C. J. Burton.

Additional Information
 Top Risks to Your Wealth in 2007: The Economy
 Top Risks to Your Wealth in 2007: Public Policy 
 Top Risks to Your Wealth in 2007: Energy 
 Top Risks to Your Wealth in 2007: Competition