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Stabroek News

Lessons for Jamaica from US subprime debacle
published: Sunday | August 26, 2007


Vantage Point with KEITH COLLISTER


The exterior of the Countrywide home loans office in San Mateo, California, Friday, August 17. It's never been tougher to close a deal than during the past few weeks as lenders have gone bankrupt and the skittish survivors become more discriminating to avoid further trouble. - AP

It was unfortunate that Hurricane Dean probably made last week's Vantage Point column, headlined "Major 'financial hurricanes' approaching, overseas and locally" one of the least read for the year.

In brief, that column argued that the subprime debacle in the United States had five main lessons that could also be applied to Jamaica: the dangers of a lack of transparency; the associated importance of investor due diligence in financial markets (particularly with respect to requiring independent valuations of assets); the risk of lax standards on the part of both lenders and regulators (who, all over the world, shut the door after the horse has bolted); hubris; and, high leverage.

The column noted that Jamaica's financial crisis was due primarily not exclusively, to a combination of the same factors of poor investor due diligence, lax regulation, lack of transparency, hubris, and high leverage.

Concentrating on the issue of investor due diligence, I noted that in the run-up to Jamaica's financial crisis, many investors had put their money with obviously shaky institutions at rates of almost five per cent per month (the signal that all was not well was the exceptionally high rate of return some banks were offering at that time), and were then bailed out by a blanket government guarantee. The column's key point was that another potential local financial crisis was approaching that might affect Jamaica later this year.

For the sake of clarity, it needs to be repeated that any new local financial crisis would bear no resemblance to the one that created FINSAC, as it is very unlikely to involve what are now highly regulated entities such as Jamaica's banks, securities dealers and insurance companies.

The need for transparency

This week, I want to concentrate on the critical issue of transparency. During the financial crisis, some banks charged interest rates of up to double their very high cost of funds - as high as triple-digit interest levels in some cases - to compensate both for their high costs and the clearly very high probability of default.

The default rate was then disguised by a process of 'ever greening' the loans, postponing the recognition of arrears and thus, their designation as bad loans, which was only possible due to a lack of transparency in the published accounts of the banks.

My recent conversation with a prominent banker as to how they dealt with the problem loans of their institution just before Jamaica's financial crisis hit is very instructive. The then Governor of the central bank, Jacques Bussiere, had telegraphed his intention to rein in money supply and credit in an effort to reduce the inflation that had been raging in the economy, and privately warned the bankers about the likely impact on the credit markets.

Some banks took note and started to adjust their credit standards. In addition to the traditional methods of actively pursuing collateral and financial guarantees, these institutions were very proactive in their remedial loan-management strategy. Loans that were deteriorating, violating financial covenants or in default, were aggressively restructured.

In the then highly competitive banking market, with over 40 banks desperately competing for business, pressure mounted to keep loans, fee income and reported earnings growing (big bonuses were on the line after all). As a result, credit standards were relaxed or reduced. Sub-standard borrowers were able to get refinancing and in many cases, even higher loan limits because they had what was considered to be the 'good collateral' of real estate.

Effectively, many problem loans moved to institutions that were still aggressively lending. The combination of high interest rates and economic recession then subsequently overwhelmed these financial institutions, who now had non-performing loans and substantial exposure to substandard borrowers. High interest rates also punished collateral values. The institutions that survived focused on lending primarily to companies with good cash flow, and second, with assets to secure the loans.

The key point, however, is that problem borrowers were able to get a loan from the huge number of financial institutions then desperately competing for business to maintain their 'reported' earnings.

When they moved to another institution, this allowed that institution to be paid out in full, removing the problem loan from their books. One way to describe this behaviour is as a good example of the 'greater fool' theory, where you get repaid because someone takes over your position. The key question is whether this sounds familiar to anyone.

The international environment

Last week's column noted that the financial crisis that began in subprime mortgages - mortgage lending to high-risk borrowers in the United States - is now spreading to other sectors, and across the globe in what looks like an emerging global credit crunch. It also argued that a cut in the Fed Funds rate should now be expected at the Fed's next meeting of September 18. World central bankshave now pumped more than US$400 billion in emergency funds into the money markets to combat the subprime contagion, which appears to be having the desired effect in helping unfreeze global financial markets.

Specialist emerging markets website www.shibuimarkets.com, in its Friday morning market update, agrees. "Emerging market bonds bounced overnight from recent lows helped by the news that Bank of America invested $2 billion in Countrywide. They have been selling off for a couple weeks, pushing risk premiums to the highest we have seen in two years. Increasing losses from investments in sub-prime mortgages are triggering a global credit crunch, leading investors to flee riskier assets such as emerging-market bonds, currencies and equities."

Countrywide

Countrywide is the U.S's largest specialist mortgage lender, and is thus at the centre of the sub-prime crisis. Whilst Bank of America's $2 billion convertible preference share investment in Countrywide is encouraging, it also suggests substantial potential dilution of existing shareholders. This is particularly noteworthy as Countrywide was probably the best capitalized and managed of an admittedly very badly managed sector, so in my view the rest of the specialist mortgage lending sector is probably essentially decapitalised.

In this regard, it is noteworthy that U.S. investment bank Lehman Brothers, rumoured to be under significant pressure, has shuttered its sub - prime mortgage unit, firing 1,200 employees. Lehman was the biggest underwriter of U.S. bonds backed by mortgages.

The Fed to the rescue

The Fed made a rare intra - meeting cut on August 17th of their discount rate by half a per cent to 5.75 per cent. The real reason for the cut in the discount rate (the cost of direct loans from the central bank) appeared to be to improve liquidity in the $1.1 trillion market for asset-backed commercial paper, which at the time appeared to be suffering from contagion from the sub - prime mess. The flight to quality (a move by investors tothe safest instruments, U.S. treasuries), which drove down U.S. three month treasury yields to just over 3.6 per cent on August 21st, now appears to have ended with 3 month yields rising to nearly 4.23 per cent on Friday (still significantly lower than August 8th 4.93 per cent).

One prominent Wall Street investment banker believes the worst of the recent market sell-off may be over for now. He advises that trading levels and spreads of the big financial firms have recovered substantially this week, investment grade deal flow is rapidly returning to normal and liquidity is starting to come back to the markets. The junk bond market has essentially unwound two years of spread compression, removing the effect of the liquidity bubble.

Emerging market bond prices have corrected as well yields have not risen nearly as much, reflecting the healthier and less leveraged dynamics of both their issuers and investors. Many of the sovereigns have risen 60 to 90 basis points (nearly 1 per cent) above their previous risk premiums above U.S. treasuries.

Jamaican Bonds

U.S. Investment Bank Bear Stearns, which is also the second biggest underwriter of U.S. bonds backed by mortgages, has reiterated its underperform outlook on the performance of Jamaica's bonds, the equivalent of sell. Bear downgraded Jamaica to underperform on April 3 when it became evident that the government had missed its fiscal targets again (investors should note that Bear Stearns is not a rating agency).

One well-respected Jamaica watcher described the past week as having seen very little trading in Jamaican Eurobonds, making determining the prices of Jamaican bonds almost like "putting one's thumb in the air".

The Jamaican Economy and Stock Market

Whilst Jamaica was actually lucky to avoid a direct hit by Hurricane Dean, nevertheless the economic environment in the U.S. is now darkening as I had predicted at the beginning of the year. While our critical tourism infrastructure is apparently relatively undamaged, the likelihood that the U.S. consumer will come under further pressure could negatively impact the tourism winter season.

Jamaica Producers

Agriculture got hit again by the hurricane last week, with banana's apparently taking a particularly hard hit. As a result, JP now appears to be considering whether it should take the decision to abandon banana production for export, continuing banana farming only for the domestic market and banana chips.

JP's stock has the potential for a turnaround if it can stop its agricultural bleeding, particularly if this gives the market confidence that the new CEO Jeffrey Hall is prepared to make the hard decisions to get their core operations back to profitability. The stock has already jumped $4, perhaps related to Friday's article on JP's potential decision, so I would adopt a wait and see approach for the moment.

Cable & Wireless

Cable and Wireless can't seem to get a break. America Movil, the biggest cell phone operator in Latin America, has said it is negotiating a deal to buy Jamaican cell phone company Oceanic Digital. Carlos Slim, Mexican billionaire and rumoured to be the world's richest man, is a ferocious deep pocketed competitor, and is likely to want to reverse Oceanic's also ran status. I would still not buy C&W even at its current price.

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