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Published on March 19, 2008

US authorities have done the right thing in swiftly bringing in JP Morgan to swallow up fellow Wall Street firm, Bear Stearns. There is no point in dancing around the problem. Bear Stearns made the wrong bets. It went broke. So it has to be taken over by others or declared bankrupt. This is the name of the game. In the early 1990s, Japan hesitated to deal drastically with its banking system, causing the economy to suffer for a protracted period. In 1997-1998, the Thai authorities did not have the strong political will to tackle insolvent finance companies and banks. This also caused the overall Thai economy to suffer. It took six to seven years before the Thai economy recovered from the crisis. The bailout of the financial system cost some Bt1.6 trillion from the public purse.

Bear Stearns was practically living on a life support system provided by the US Federal Reserve. It had to borrow from the Fed to meet a financial run because institutional investors and creditors no longer had confidence in its balance sheets. Bear Stearns was most vulnerable to the sub-prime mortgage crisis because about half of its portfolio accounted for mortgage-backed securities. So Bear Stearns had no choice but to bow to the takeover of JP Morgan. If this deal had failed to take place, it could have caused systemic risk to the US financial system and the global financial market as a whole.

Mortgage-backed securities and other related financial instruments are structured on the underlying US housing loans, which have been going sour due to US economic weakness. US housing prices have gone down by 7-10 per cent. They might drop further by 15-20 per cent. The housing market is worth about US$13 trillion. Given falling housing prices, it is difficult to quantify the value of mortgage-backed securities and other related financial instruments. That's why we have not seen the bottom yet. So far the US financial institutions have written off some US$200 billion from the bubbles that have burst through the sub-prime mortgage loans and related financial instruments. Total damage has been estimated at US$400 billion. That means the problem is only halfway over. More financial institutions might go under. The Fed has slashed interest rates to ease the credit crunch. But the problem lies more in the insolvency of the financial institutions and the bad loans. The quicker the bad loans or troubled firms are declared, the better the US economy will be. Lowering the rates alone won't solve the problems.

An interesting policy issue emerging from the collapse of Bear Stearns is why US regulators, who are supposed to adopt the highest standards in regulating the financial system, failed to detect symptoms of the looming financial crisis. US regulators have been blamed for failing to keep up with financial innovations such as mortgage-backed securities. But they might have adopted the stance that in the free market place, financial institutions must put in place a voluntary system to maintain prudential business practice. If they go broke, so be it. But the collapse of Bear Stearns shows that that is not the case. Bear Stearns is over-leveraged, so its clients, the hedge funds, are made vulnerable. The Fed has to step in with a bailout by providing up to US$30 billion in guarantees to the firms' illiquid assets to JP Morgan. This is unprecedented since World War I. It has also launched a special funding facility for troubled investment banking firms, who can borrow short-term loans by pledging mortgage-backed securities and other related instruments as collateral.

The Fed, in essence, is not bailing out Bear Stearns, but it is worried about the systemic risk associated with the firm's collapse to the US economy and the global financial markets as a whole. After this financial crisis, there should be an shake-up in the regulation and supervision of the US financial system. The over-leveraging of hedge funds or the investment banking firms will have to be curtailed. Better supervision will have to put in place to improve prudential practice in sync with financial innovations.

The Nation