Fear Is Back. Welcome

After three years of the international money markets being driven by naked greed, the impetus is turning into fear.

The pendulum has swung to the other side.

After three years of the international money markets being driven by naked greed, the impetus is turning into fear. Investors and economists alike shudder at the sight of uncertainty, paralysis, a breakdown of investments.

Yet fear, just like greed, is an integral part of the financial markets. And it had largely disappeared in the last few years: from the stock markets of the developed and emerging nations, from the blue-chip bond markets, from the junk-bond arenas, from the real estate market. It's hard to find a category where fear hadn't gradually dissipated.

In the world of business, fear is measured through risk premiums, which are the extra returns that investors demand on assets they buy. The riskier an asset, the higher the premium should be. Yet premiums had been pulling back in the last five years.

During the last two months, they made a comeback.

Here are some figures. The average premium that investors demanded from risky corporate bonds during the last 20 years had been 5 points above the yield on government bonds, a benchmark that represents the safest asset in the market. In June 2007, that risk premium had fallen to a nadir of 2.5 percent, half the multiannual average. In the last two months that premium has bounced back to 4.2 percent.

The average premium that investors demanded from emerging market bonds during the last 20 years had also been 5 percent above the yield on government bonds. By June, that had slumped to 1.5 percent and in the last two months it reversed to 2 percent; a lot, but still far from historic levels.

The sharpest leap in risk premium was in the American subprime mortgages market (meaning, to high-risk borrowers), where the number soared from 4 percent to 11 percent in two months, which is what triggered the global credit squeeze in recent weeks.

The pain is shared by all sorts of investors: mortgage banks, retail banks, investment banks, investment funds, hedge funds pension funds - all feel the credit crunch and a rising sense of fear.

But fear is good. Fear is necessary. Fear is what induces investors to demand compensation for risking their money.

Fear is crucial so that hundreds of millions of savers around the world will get the returns they deserve for their service to borrowers, be they companies or mortgage borrowers or leveraged funds.

The papers tout learned analyses about the credit crimp.

The analysts and economists point at the heightened prices of real estate, American consumers taking out secondary mortgages to finance a higher standard of living than they could afford, and the development of weird financial instruments.

But there's a far more prosaic reason for what we've been going through: the vast fortunes raked in during the last three years by the people who created the gigantic credit industry, or at least mediated.

1. Investment banks - which helped themselves to fees anywhere from 1.5 percent to 5 percent of each "loan" they organized for hedge funds, which used the money to buy mortgage portfolios. Private equity funds borrowed massively to buy other companies, and corporations borrowed trillions to finance dividends or buy back their own stock.

In 2005 and 2006, these managers' bonuses reached all-time highs, financing more Porsches, yachts and penthouses.

During the first half of 2007 they sewed their pockets deeper than ever, but after August they're working on adjusting to the idea of no bonuses this year.

2. Hedge fund managers - who take 1 percent to 2 percent of the assets under management as fees, and 20 percent of the fund's profit.

They borrowed to buy mortgage portfolios for hundreds of millions of dollars. Most of these loan portfolios aren't listed for trading on a stock exchange, allowing the hedge fund managers to book their values not based on "market valuation" but based on a statistical model, based on stats of the past.

The discrepancy between the market value of these mortgage loans and the "model" value is sometimes the difference between vast profit and miserable profit, or actual bankruptcy. But until the hedge funds had to sell their loan portfolios, they could merrily put them into their books according to the "model"-derived value: take 20 percent of the theoretical profit, and mosey off to buy a Picasso.

3. Private equity fund managers - who spent hundreds of billions of dollars on buying public companies, using gigantic loans. They were prepared to pay double-digit premiums over the market valuation of these companies because they had borrowed the cash at rock-bottom interest rates.

The low interest rates enabled them to resell the companies at a profit, to other investment funds or to the public through stock offerings. But mainly, like their hedge fund colleagues, these managers skimmed off 20 percent of the profit. Now that the music's stopped and risk premiums are rising, the chance of selling these companies at a profit is diminishing. But they're not about to return past bonuses to investors.

How much of an effect could that have? Look at the numbers: The average wage of top private equity fund managers was $217,000 an hour in 2006. Yes, you read right - per hour. Their average wage for the year was $657.5 million.

Fear-stricken central bankers hastened to inject cash into the terrified banking system, lending the banks cheap money so they could shore up the financial system.

But risk should be allowed to come true. Bankruptcies must unfold. A bad business, however big, must be penalized.

Without penalty, there is no fear. Without fear there is no risk premium. Without a risk premium, there are no profits, and without profits, the capital market will grind to a halt.