Keith Collister, Contributor

The financial crisis that began in sub-prime mortgages - mortgage lending to high-risk borrowers in the United States - is now spreading to other sectors, and across the globe in what looks like an emerging global credit crunch.

The world's major central banks have provided emergency assistance of over US$400 billion to international financial institutions, of which Europe's central bank pumped out nearly one quarter or US$100 billion in a single day. The Federal Reserve has just made a rare intra-meeting cut of the discount rate on Friday by half a per cent because "financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward." It is now also expected to cut the Fed funds rate at its next meeting on September 18.

International stock markets have fallen in response to spreading nervousness, with the U.S. stock market benchmark, the Dow Jones Industrial Average, now down around 10 per cent from its July high.

Panic in investment markets is nothing new. The current turmoil in the investment world, however, has the smell of potential crisis, such as that which existed before Wall Street's 30 per cent plunge during 1987's Black October, the panic of 1998 involving the collapse of long-term capital management, and the bursting of the tech stocks bubble in 2000. All these events involved the "financial market gods" punishing hubris and excess.

This was why I drew attention to Bear Stearns' funds troubles in my July Vantage Point column. There were several reasons why I thought it was extremely important for Jamaicans to follow this closely.

The Sub-Prime Mortgage Crisis

Sub-prime and other poor-quality loans are packaged in portfolios that are widely distributed throughout the world's investment institutions by investment banks such as Bear Stearns, even as far as little Jamaica, with the result that no one has a comprehensive knowledge of who is exposed to major financial riskbecause of overexposure to these instruments.

There is massive uncertainty about the value of the bad credits now contained in mortgage securities, whose price is supposed to be set by trading. However, the investment bank that created the security frequently acted as a market maker on both sides of the transaction, effectively setting the price. Because there are now no buyers, as is the case with the worst credits, valuation becomes a matter of opinion.

On Wall Street, Bear Stearns is known as a superior trader and a bond house particularly strong in the area of mortgage-backed securities. It was, therefore, a particularly bad sign that a firm such as Bear, with a huge informational advantage, still managed to have two of its in-house sub-prime mortgage funds blow up, in what appeared to be a classic case of hubris (betting against the market when the credit problems were becoming obvious) and excess (leveraging up the bet to meet investor greed for higher returns).

The U.S. mortgage market has in fact been at the centre of an orgy of financial speculation, most obvious when you merely consider what a "no documentation" or liar loan actually means, e.g., exactly what it says.

This has been coupled with further massive excesses in the world of leveraged corporate finance, where 'no covenant' corporate loans - similar to borrowing from your bank without any conditionality - and 'junk' bonds (the name says it all) were the order of the day.

In my view, the U.S. private-equity boom is now over, at least for the time being. That boom has been a major source of the recent strength of stock markets, particularly in the U.S., because private equity groups have been competing for, and bidding up, the prices of companies they want to acquire.

The private equity boom has been driven by easy access to cheap credit because 'gearing up' has been the key company strategy to 'realise value'. We have even seen some examples of this global phenomenon recently in the Caribbean, with several billion U.S. dollars of large corporate issues being placed on terms impossible two years ago.

The major global investment banks made very heavy commitments to provide credit for corporate deals, called underwriting, but are now no longer able to 'pass the parcel' to the investment funds. One estimate is that they have had to take 'junk' bonds and other corporate loans of up to US$300 billion on to their books over the past couple of months. These banks are now suffering from a bad case of risk aversion to anything that is not rated investment grade. This new credit environment is going to limit availability of credit and raise its cost for all except the strongest borrowers.

These are the same banks that provide the margin loans to our local financial sector that allow them to buy more of Jamaica's Eurobonds, thereby pushing up the prices of our debt - the so-called Jamaica bid. The extent to which global risk aversion prompts them to reduce their credit lines to Jamaican financial institutions (for which there is currently no clear evidence) needs to be watched extremely carefully.

U.S. stock market will remain under pressure

In my view, this "take-over premium" will now be eliminated, with the result that the U.S. stock market will remain under pressure, suffering from continued volatility. Because of the size and scale of the crisis, despite what will be the entreaties of your U.S. broker that it "is now safe to go back into the water" after what will likely be sharp rallies during an ongoing bear market, the crisis in not going to end in just a few weeks, and probably has several years to run.

The Jamaican stock market

While I still expect the Jamaican stock market to rally post election, any honeymoon period for a new Government could be unusually short. It is not a good sign that Jamaica has been unable to take full advantage of the extremely favourable international economic environment of the past four years, and the economic environment in the U.S. is now darkening, as I had predicted at the beginning of the year.

The sub-prime debacle in the U.S. has given us another lesson, if we even needed it, of the dangers of a lack of transparency, the associated importance of investor due diligence in financial markets (particularly with respect to requiring independent valuations of assets), the risk of lax standards on the part of both lenders and regulators (who, all over the world shut the door after the horse had bolted), hubris, and high leverage.

Another Finsac?

The most important issue is transparency, as with transparency you can operate with the principle of caveat emptor, or 'let the buyer beware' at least at the wholesale institutional, or informed high net worth individual level.

Jamaica's financial crisis was due to a combination of the same factors of lax regulation, lack of transparency (conglomerate structures clouded the true situation), hubris (notably the 'edifice complex' of some entrepreneurs and non- responsiveness of some policy makers), and high leverage (most institutions had a very low level of capital even before the crisis. )

The area I want to concentrate on today, however, is investor due diligence. In the run-up to the financial crisis, many greedy investors put their money with obviously shaky institutions at rates of almost five per cent per month. The banks then charged interest rates of double this very high cost of funds to compensate both for their high costs and the clearly very high probability of default, the default rate of which the banks then disguised by a process of 'ever greening' the loans, postponing recognition of arrears and thus their designation as bad loans. This was onlypossible due to a lack of transparency in the banks accounts. These investors were then bailed out by a blanket government guarantee, justified by the need to protect the financial system.

Bailout

This 'bailout' will not happen twice. The signal that all was not well was the exceptionally high rate of return some banks were offering this form of risky behaviour was rewarded once, the problem today is no longer with the traditional local financial institutions, which are well regulated. Today's investor can also do very significant due diligence on the investments of the major quoted money-market players, as their audited accounts require very significant disclosures. Thus, any financial crisis will not be like the one that created FINSAC, threatening the payment system. However, significant financial risks are emerging that may affect Jamaica later this year. Let those who have ears to hear, hear.

keithcollister@cwjamaica.com