Wilberne Persaud, Contributor

Wilberne Persaud, Financial Gleaner Columnist

Hindsight is always 20/20; some say even better - telescopic! It can't be overstressed really that in matters of financial sector regulation, there's no room for ideological or technically unwarranted regulatory practice. Capitalism and its essential lubricant, freedom to innovate in financial services, require regulatory oversight. Many are the well known reasons for this. Once such influences intervene, there is going to be disaster, one way or the other.

The notion of 'too big to fail' was never officially invoked in the Federal Government's support of Bear Stearns' forced sale. With Fannie Mae and Freddie Mac, however, Secretary of the Treasury Paulson stated the rationale that "failure would be harmful to economic growth and job creation". He made no mention of 'moral hazard' and troubling issues of equity, which doubtless would surface.

Commensurate support

CEOs and executives of enterprises gone belly up are allowed to keep gains and compensation packages worked out during their regime which, through bad decisions, caused failure.

On the other hand, consumers, home buyers in distress, pension fund holders tend not to have commensurate support as their net worth plummets.

So why the reversal for Lehman Brothers? We're certainly going to hear the basic reason. Moral hazard - the problem of rewarding an entity for cavalier risk-taking - exists when an implied or assumed guarantee of support, gives decision-makers an incentive to take unusual risks. If they win, all profit to them. If they lose, all loss to the guarantor. In the end this means the taxpayer.

We can paint a scenario - in what some may call the 20/20 blinding clarity of hindsight - of the catastrophe in the financial system that Alan Greenspan refers to as "outstripping anything I've seen". Recall Greenspan left the Fed Chairmanship in 2006. He is 82 years old so 'anything I've seen' refers to more than half a century. Risking oversimplification in general terms, here's what happened:

1. Regulators allowed innovative new financial products particularly in the mortgage market.

2. These products rapidly became generalised as mortgage debt ballooned.

3. Real estate values skyrocketed as low interest rates provided low cost funds.

4. Overexposure to mortgage-backed securities and derivatives in a crumbling market leads to crisis.

In a page one column entitled 'Lender Lobbying Blitz Abetted Mortgage Mess', The Wall Street Journal's [December 31, 2007] free online content reports: "During the housing boom, the subprime industry succeeded at more than just writing mortgages. It also shot down efforts by some states to curtail risky lending to borrowers with spotty credit.

Political donations

Ameriquest Mortgage Co, until recently one of the nation's largest subprime lenders, was at the centre of those battles. Working with a husband-and-wife team of Washington lobbyists, it handed out more than $20 million in political donations and played a big role in persuading legislators in New Jersey and Georgia to relax tough new laws. Those victories, in turn, helped blunt efforts by other states to crack down on reckless lending, critics of the industry contend."

Granted the Journal's critique occurs after the fact. Its opinion could have little impact. Regardless, now the question is what to do? Reportedly, after an unsuccessful approach to Korean investors, Lehman Brothers initiated discussions with Barclays and Bank of America. Both prospects walked away. Barclays wanted the Federal Reserve to backstop troubled assets that could come with a purchase. The Feds declined and the deal evaporated. United Kingdom regulators are also said to have frowned upon the deal. Bank of America, in the end, chose to snap up Merrill Lynch instead for $50 billion.

Financial intermediation has changed dramatically over the last few decades. The picture of a bank located in a posh building with executives talking to potential borrowers and clients making loans and keeping them on their books is no longer valid for the bulk of loans issued. Bear Stearns and Lehman did not take deposits from folk walking in off the street. They were non-depository investment banks. But they made huge loans interlocked internationally with other institutions. If they bought and packaged loans among which were some bad ones that could likely go sour that would be fine. But given non-regulation the Journal describes they could end up with whole packages of duds. The really alarming elements for the markets then turn on uncertainty and fear-holders of these securities don't know their true value so confidence evaporates.

NEGATIVE REACTION

On Monday, stock markets reacted negatively. Washington Mutual and AIG, household names and major financial institutions had their credit ratings downgraded. Across Europe, China and Asia only a holiday provided respite to some of the anticipated fallout. China's Central Bank reacted immediately by lowering interest rates. The Fed did not, presumably because inflation is a potential problem. Also a rate cut with little impact would itself be a bad signal.

World financial system will remain wobbly

Confidence will only be restored when it becomes clear how the Lehman sell-off pans out, how AIG garners capital funds and finally, how the US housing market slump bottoms out. Until then, the world financial system will remain wobbly. How soon is this likely? Honestly, no one knows. But those who know first will make big gains. For there is one certainty-conditions shall improve. Once investors figure out that bottoming out is near, a buyers' market will fuel confidence. We are in for troubled times until - your guess is as good as mine, mid 2009? Longer? Jamaica cannot avoid some of the fallout which it can ill afford with an immune system impaired by collapsed investment clubs.

wilbe65@yahoo.com