Is the worst yet to come?

The financial market is in a mess. The 158 year old investment bank, Lehman Brothers went bankrupt. The US government bailed out Freddie Mac and Fannie Mae, America's mortgage giants. Bank of America, the largest commercial bank in the US, swallowed Merrill Lynch. Bear Stearns was swallowed by JP Morgan Chase, with the help of the Fed. The Fed is about to swallow AIG.

As Bush  tried to explain the crisis in July, "Wall Street got drunk... It got drunk and now it's got a hangover." Two months later, it seems Wall Street is not just sobering up, it is detoxifying. It got high while authorities are watching investors take drugs.

When I was researching about the US mortgage market a year ago, I was surprised and baffled by their system. When interest rates are falling, borrowers can refinance their loan, i.e. adjust the conditions of the loan to bring down the interest rate. In most cases, refinancing also include increasing the loan amount to reflect the increase in property value.

Most loans are fixed for 20 or more years. So when interest rates are rising, borrowers would simply hold to the loans. Borrowers can also choose from a wide array of mortgage options. In one mortgage option, borrowers don't have to pay anything for the first five years.

The system is almost risk free for borrowers.  It seems too good to be true... and it was too good to be true. After a mortgage lender has released the loan, mortgages are bundled together and sold as mortgage-backed securities (MBS). A big chunk of these securities were bought by Freddie mac and Fannie Mae. The rest are bought by commercial banks, investments banks, mutual fund companies, trust funds and different financial institutions. 

When property values started falling, the value of MBS fall. When borrowers started defaulting on their mortgages, these MBS became worthless. And this is why all these financial institutions are in trouble. Well, there are other reasons why they are in trouble including higher interest rates,  higher inflation and weaker economy but the sub-prime mortgage crisis is the main root of the current financial crisis.

One problem in Wall Street is that there was a lack of transparency, something heard more referring to governments. Financial institutions refuse to divulge how much they invested in these troubled assets. For an investment bank to disclose how much it invested in a particular sector is like telling other companies their investment strategy.

The financial market is not as efficient as economists hope it should be, it is prone to the influence of animal spirits, self-fulfilling prophecies and voodoo dolls and feng-shui. If everybody expects markets to crash and pull out their investments and then the market will surely crash. These financial institutions think that if they keep their losses until the worst is over then they might survive the crisis.

And now here are the problems. Monetary and fiscal authorities failed to exercise their supervisory and regulatory power. The US government bailed the Freddie Mac and Fannie Mae this year that should have been done last year. The Fed helped JP Morgan buy Bear Stearns, by lending it money. If Bear Stearns was allowed to fall, Lehman would not have hoped that the Fed would also help them.

The problem is called in economics as moral hazard problem. As authorities give explicit or implicit guarantees to institutions that are "too big to fall" they become reckless. In a market-based economy characterized by competition, there are always winners and losers. There are No too-big-to-fall winners and no too-big-to-fall losers.

Inefficient and under-capitalized banks and financial institutions must be allowed to collapse before the market can get better. More banks should be allowed to fall. More financial institutions should be allowed to collapse. They took high risks and their investments failed. And no matter what happens, it is small investors like me who will pay eventually.