Vantage Point with KEITH COLLISTER

Today's column will continue to review the five main lessons that could also be applied to Jamaica from the subprime debacle in the United States. My previous two columns focused on the importance of investor due diligence in financial markets, and the dangers of a lack of transparency.

Today, we will look briefly at the issue of high leverage. The next two columns after this will look at the issue of hubris and the risk of lax standards on the part of both lenders and regulators in both the U.S. and Jamaica.

Highly leveraged

The American epicentre of world financial markets is deleveraging.

Currently, some highly leveraged investment vehicles, such as the Bear Stearns hedge funds investing in mortgage securities, are being forced to liquidate as lenders make margin calls they can't meet.

Lenders close out positions and unwind repurchase agreements, which, in the case of the collapsed multibillion-dollar Bear Stearns funds, meant investors were nearly totally wiped out.

Five years ago, risk was much more highly priced than it is today. Many international investors saw an opportunity to borrow cheaply in the short-term markets and buy higher-yielding, longer-duration, less-liquid assets like the various derivatives of mortgage-back securities and emerging market debt. These firms took the duration mismatch, spread and illiquidity risk, in return for an interest premium of over three to four per cent.

As spreads tightened, the firms made massive capital gains on these longer-term, riskier assets as their yields fell. As more and more money flowed into this game, spreads got tighter until risk spreads in virtually all risk-asset classes hit all-time lows earlier this year.

Now, the institutional lenders who have provided the liquidity (leverage) are pulling back. This has even affected the U.S. huge commercial paper markets, which have seen a reduction in U.S. commercial paper outstanding by nearly US$250 billion, or about 12 per cent in the last three weeks.

Was excessive leverage also partly responsible for Jamaica's financial crisis? In the recent U.S. crisis, American firms bought higher-yielding, longer-duration, less-liquid assets, thus incurring duration mismatch, sprea

d and illiquidity risk, financing much of this activity through short-term repos. So, how is this relevant to Jamaica's financial crisis?

In the case of our banks, in the 1990s, their investments in very high-interest loans were typically backed by real-estate collateral, so in the absence of cash-flow lending the loans were really highly illiquid 'potential real estate'.

Indigenous banking sector

This was compounded by the fact that local entrepreneurs had apparently been allowed, either by omission or commission, to create an indigenous banking sector that was extremely highly leveraged.

Capital-to-asset ratios as low as 2.0 per cent, or even lower, were seen even before the crisis began.

This meant that the real equity of the entrepreneur was supporting assets of 50 times that amount -a leverage ratio of 50:1.

As the crisis began, the leverage ratios very quickly became 100:1, the type of leverage often associated with the collapse of funds investing in international capital markets where very high borrowing is possible, e.g. foreign exchange, or even infinity as the local institutions' very limited capital was quickly wiped out.

In the case of insurance companies, what was called a mismatch of assets and liabilities quickly emerged as some insurance companies began financing their heavy exposure to longer-duration, less-liquid real-estate investments with high-interest, short-term securities.

At one point, this meant that real-estate investments with an annual single-digit cash yield were being financed by insurance companies issuing securities at interest rates up to five per cent per month. The insurance companies collapsed as they incurred massive 'cash' losses on financing their real-estate investments. The situation was much worse for those real-estate invest-ments that were actually losing money. Does this sound familiar to anyone?

United States Federal Reserve Chairman Ben Bernanke said at the Kansas City Fed's annual symposium in Jackson Hole on Friday that he will "act as needed'' to limit damage to consumer spending and economic growth that may arise from a deepening housing recession, or "disruptions in financial markets.''

The Fed will cut rates on September 18. He made it clear, however, that the central bank won't rescue investors from bad decisions.

"It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."

The local stock market has been rallying for the past two days after Gleaner pollster Bill Johnson put the Jamaica Labour Party (JLP) ahead at 42 to 38 per cent just outside of the poll's usual three per cent margin of error.

Institutional investors

Unlike the apparent views of most institutional investors, who, for the most part have been taking their traditional 'wait-and-see' approach, I do not believe that the final election result will be close, with the most likely result being that the JLP will win a comfortable majority of between 36 and 40 seats.

Institutional investor hesitation is also likely to reflect some uncertainty as to the likely thrust of the economic policy of a JLP government, as opposed to 'more of the same' if the PNP wins, unsurprising in view of the fact that the party has been out of power for 18 years.

The JLP will need to be able to articulate a credible position on economic management, particularly on debt and spending, to local and international investors almost the day after September 3.

While Jamaican eurobonds have also been rallying sharply this week, particularly the 2039 issue mostly held by foreigners, the rally preceded the local stock-market rally and is probably not a view on a JLP victory, but the result of a generally improved tone in emerging markets, parti-cularly, and the technical factor of the need to find assets to replace the US$225 million Jamaican bond issue that was repaid last Friday.

keithcollister@cwjamaica.com. See Pages 8 and 9 for more on the subprime issue.