The financial markets are in a mess. Lehman Brothers have gone bankrupt after 158 years of history. Freddie Mac and Fannie Mae have been expensively bailed out. Bank of America has swallowed Merrill Lynch. Bear Stearns was swallowed by JP Morgan Chase, helped by the Fed. The Fed is about to swallow AIG.
As Bush tried to explain the crisis in July, "Wall Street got drunk... It got drunk and now it's got a hangover." Two months later, it seems Wall Street is not just sobering up, it is detoxifying.
Researching the US mortgage market a year ago, I was surprised and baffled by the system. When interest rates are falling, borrowers can refinance their loan, i.e. adjust the conditions of the loan to bring down the interest rate. In most cases, refinancing also includes increasing the loan amount to reflect the increase in property value.
Most loans are fixed for 20 or more years. So when interest rates are rising, borrowers simply hold on to the loans. Borrowers can also choose from a wide array of mortgage options. In one mortgage option, borrowers don't have to pay anything for the first five years.
The system is almost risk free for borrowers. It seems too good to be true... and it was too good to be true. After a mortgage lender releases a loan, the mortgages are bundled together and sold as mortgage-backed securities (MBS). A big chunk of these securities were bought by Freddie Mac and Fannie Mae. The rest are bought by commercial banks, investments banks, mutual fund companies, trust funds and different financial institutions.
When property values started falling, the value of MBS fell. When borrowers started defaulting on their mortgages, these MBS became worthless. This is why all these financial institutions are in trouble. Well, there are other reasons why they are in trouble, higher interest rates, higher inflation and a weaker economy to name a few, but the sub-prime mortgage crisis is the main root of the current financial crisis.
Alas, the financial market is not the efficient market of financial academics’ myth-making. It is prone to animal spirits and self-fulfilling prophecies. If everybody expects markets to crash, then markets surely will crash.
Another problem is moral hazard. Since the authorities have given explicit or implicit guarantees to institutions that are "too big to fall", they have become reckless. In a market-based economy characterized by competition there should be no “too-big-to-fail” winners and no “too-big-to-fail” losers. Yet the Fed helped JP Morgan buy Bear Stearns by lending it money. If Bear Stearns had been allowed to fall, Lehman would not have hoped that the Fed would also help them.
Compounding Wall Street’s problems has been a lack of transparency. Financial institutions have refused to divulge how much they invested in these troubled assets. This is somewhat inevitable, because for an investment bank to disclose how much it invested in a particular sector is like telling other companies its investment strategy. But it has allowed them to hang on to the end, hoping to find an escape-hatch which never appeared.
Inefficient and under-capitalized banks and financial institutions must be allowed to collapse before the market can get better. More banks should be allowed to fail. More financial institutions should be allowed to collapse. They took high risks and their investments failed, why should taxpayers pay for their losses?
The opinions expressed in this commentary are solely those of the writer.