* ECB cautions that market optimism may be overdone
* Constancio - get ready for change of mood
* Warning comes as debt-laden states see borrowing costs fall (Adds comments from Constancio)
By John O'Donnell
FRANKFURT, May 28 The European Central Bank has warned that investors' pursuit of higher profits could be creating new price bubbles, sounding the alarm as financial markets chase quick gains.
In a strongly worded message that underscored concerns in Frankfurt about the downside to runaway market enthusiasm, the ECB cautioned that the dash for higher returns could suddenly unravel, sending the investor herd charging in the opposite direction.
"I don't have any advice for investors but they should be aware of these risks and try to protect themselves," ECB Vice-President Vitor Constancio told Reuters on Wednesday, adding that the crisis in Ukraine, for example, could spoil the mood.
"Ukraine ... could derail the situation and put a cloud on European assets," he said. "Banks should be prepared."
With the financial crisis and any fear of a break-up of the euro all but forgotten, governments in debt-strapped countries from Italy to Ireland are finding it ever easier and cheaper to borrow.
European stock markets have seen stellar gains with those in Germany hitting record highs. Even Greece, which defaulted on a large swathe of its national debt just over two years ago, has started borrowing from investors again.
But in a closely watched biannual report that takes the pulse of the financial system, the ECB flagged concerns about governments' debts, which are at record high levels throughout the 18-country euro zone.
It warned that they could become unmanageable as economic reforms stall and growth stays low.
"As the search for yields intensifies, so do concerns regarding the build-up of imbalances and the possibility of a sharp and disorderly unwinding of recent investment flows," it said.
Investor demand for government debt could prove "fickle", it said, cautioning on fallout from any slowdown in China as well as the crisis in Ukraine.
Drawing comparisons between countries' low cost of borrowing with "levels last seen before the eruption of the ... second wave of the global financial crisis in 2010", the ECB said: "The challenge ahead is ... to ensure that the crisis conditions do not re-emerge."
Many central bankers have been privately concerned about an abrupt change of mood among investors, but the bank's Financial Stability Review delivered a more public warning.
It also flagged a boom in prices for prime commercial property, where deals have reached their highest level since 2008, in large part thanks to foreign buyers.
Banks, insurers and pension funds, it said, must prepare "buffers ... to withstand a normalisation of yields."
The problems described in the report represent a conundrum for the ECB, which together with counterparts in the United States and Japan has made the cost of borrowing ever cheaper, helping fuel the leap in confidence.
Its warning may encourage investors to take a more cautious stance. But it is unclear whether the possible perils would divert the ECB from taking further action to keep confidence buoyed as the economic recovery too remains delicate.
Constancio said that any such move was linked to the predictions over the coming two years for price inflation. This is staying stubbornly low, making the real debt burden on countries heavier. (Editing by John Stonestreet and Susan Fenton)