US must heed world view on financial crisis
The collapse of investment bank Lehman Brothers has triggered a sweeping shake-up of the United States financial system as the global credit crisis continues to escalate. Even before Lehman filed for bankruptcy, Bank of America agreed to take over Merrill Lynch in a US$50 billion deal closed with dizzying speed. The fallout has already been felt in world stock markets. There are concerns it could trigger runs on other financial houses and spill over to the investment arms of big banks. More failures seem inevitable.
US Treasury Secretary Henry Paulson precipitated the shake-up by refusing to agree to pour any more taxpayers' money into Wall Street bailouts. This follows the government takeover of troubled mortgage providers Fannie Mae and Freddie Mac and a cash lifeline to facilitate the sale of stricken investment bank Bear Stearns. It therefore marks a turning point in the financial turmoil stemming from the sub-prime mortgage crisis in the American housing market. The financial system is now in shock. Events in the coming days and weeks will be critical to the outcome for the global economy. This will be a test of American political and financial institutions. In just four months the country will have a new president and a fresh administration. But a start must be made on addressing issues fundamental to confidence in the markets.
Meanwhile, to ease pressure on liquidity and help maintain the market stability, the US Federal Reserve has relaxed collateral requirements for loans to investment banks, and 10 of the world's biggest banks are to establish a US$70 billion emergency fund. But unless the US housing market can be stabilised, there are fears that many more lenders could face financial distress. The US government therefore may have to take even more aggressive steps to protect its banking system. Former Fed chairman Alan Greenspan has suggested another Resolution Trust Corporation, which stepped in to take over and guarantee the debts of insolvent savings and loan institutions nearly 20 years ago. It has also been suggested that Wall Street could pool resources to isolate problematic assets from the market in special vehicles where they could be wound down in an orderly way.
Such ideas are bitter prescriptions for the world's most sophisticated capital market. But no one knows where the downward spiral will end. Securitisation of mortgages so that the risk can be off-loaded has proved an effective means of raising money and expanding credit in a rising market. But it remains subject to the principles of sound banking and prudence. When things go wrong and securities lose value, credit can shrink.
Reform has to start where the problem began. Clearly the rules need rewriting, with capital requirements particularly in mind. The question is whether the US has the political will and determination to rein in its financial establishment. Granted Mr Paulson, who quit the top job at Goldman Sachs for the treasury, has taken a courageous decision. But sentiment had turned against further use of taxpayers' money for bailouts unless systemic risk demanded. The fear of moral hazard prevailed. If investors were bailed out yet again, they would expect it and feel encouraged to take imprudent risks.
A presidential election campaign is not the ideal time for making important decisions that affect markets. Hopefully, for the sake of America and the world, US President George W. Bush can reach some consensus with the two candidates on the way forward. Global financial officials should be consulted on how to address the problem. After all, it remains true that when the US sneezes, the rest of the world catches a cold.
