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Warning flags flutter on economy

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"If the Fed doesn't stop raising rates soon, the recession flag could go up," warns Paul Kasriel, an economist at the Northern Trust Co., a Chicago bank.

Yet he, like many other economists, sees problems for the economy. "We have a very accident-prone global economy right now," Mr. Kasriel says.

Among the perils he and others see:

Risky mortgages, riskier derivatives

The Fed is concerned over the rapid expansion of nontraditional mortgages, such as interest-only loans and those where the size of the loan grows, rather than shrinks. The Fed and other US financial regulators have produced a draft "supervisory guidance" for participants in the US mortgage market. A final version of this guidance, when it emerges, could constrain the home-mortgage market later this year, Mr. Malmgren warns. Similarly, regulators are trying to tame the market for risky loans linked to commercial real estate.

In the international sphere, the Fed and banking regulators in Britain and other nations worry about the rapid expansion in recent years of high-risk "credit derivatives," now in the trillions of dollars. Such derivatives are often built around repackaging existing debt.

"Most of this market is concentrated in a little more than one dozen financial institutions, posing potential systemic risks on a scale never before experienced," Malmgren says in a monthly commentary. These financial instruments spread the risk of these loans among various creditors (hedge funds, insurance companies, pension funds, etc.). That's useful. But it doesn't eliminate the risk from rising interest rates or recession, he says.

"The Fed and other regulators have grown nervous about the proliferation of financial innovations as well as the types of market participants," Malmgren writes. As the world economy slows, "exits from these illiquid assets may get crowded from time to time."

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