The US mortgage meltdown has been grabbing world business news headlines for months now. There was a time in mid March this year when the world financial system seemed to be at risk.The extent of the crisis came to light when Bear Stearns was about to go bust, and would have almost certainly done so, had not the Fed stepped in. Bear Stearns has disappeared for good, taken over by JP Morgan, but the financial system has survived. The Fed took a bold decision and became a lender of last resort to investment banks also, in addition to commercial banks.It offered hundreds of billions of dollars worth of liquid securities in exchange for illiquid securities, that these banks were saddled with, as collateral. Other measures were also taken to boost liquidity in the financial system.
The net result has been that the financial crisis no longer appears as threatening as it once was. Warren Buffet said Saturday,'The worst of the crisis in Wall Street is over.' He supported the action of the Fed in bailing out Bear Stearns, terming it to be 'proper.' While revealing losses on derivative contracts at the annual meeting of shareholders of Berkshire Hathaway, he said he was confident that these contracts would return substantial profits in the long run.
Since on March 16th the Fed became the lender of last resort to investment banks, it follows that these securities firms must start working as safely as commercial banks. This implies greater supervision of their activities, particularly of their SIV's , or structured investment vehicles. It must be understood by everyone that risky assets held off balance sheet pose as big a risk to their parent companies as similar assets on the balance sheets. They are held off balance sheet only to avoid regulatory supervision.The example of Enron is not very old, and the present crisis has thrown up numerous instances from Citigroup to Merrill Lynch, who have survived only by selling part of themselves to sovereign wealth funds from the Middle East and Asia.
The next issue which needs to be addressed is of excessive leverage. Bear Stearns had leverage of about 35 to 1, while the normal leverage for banks is 10 or 12 to 1. It had built up total positions of about $13.4 trillion,which is greater than the US national income , or equal to a quarter of world GDP. All this was built up on an asset base of about $80 billion only! The moment the value of the underlying asset base declined slightly, the entire structure collapsed, as investors pulled out their money.If such activities are controlled this would drastically reduce the profitability of such investment banks and also reduce their size, but it would be a small price to pay for the security and stability of the financial system.