ANALYSIS: The lesson of the Lehman collapse is that banks have been cosseted for too long: why should the US taxpayer bail out greedy and incompetent US financial institutions?
THE NEWS that Lehman Brothers, one of the top investment banks in the world, has filed for bankruptcy should not have come as such a shock. It was known for quite some time that this bank had been contaminated by risky mortgage-backed assets. There were several write-downs and profit warnings.
Indeed, the bank had tried to sell off its investment management division late last week, but then decided to put the entire company up for sale. Apparently the two main suitors, Barclays and Bank of America, wanted the Fed (essentially, the US central bank) to guarantee part of the asset base. (The Fed had done something similar for JP Morgan when it bought Bear Stearns).
On this occasion, the Fed obviously refused such a guarantee, and the two suitors walked away from the fire sale. It is probably the attitude of the Fed (and US Treasury) that has contributed most to the shock effect.
But it has to be remembered that debt guarantees and other forms of bail-out can only be done by placing taxpayers' money at risk, and no government agency can do this lightly. The other concern is one of moral hazard. If banks come to believe that bail-outs will be automatic they will have little incentive to keep risky assets off their books. After all, no other kind of business can dip into the pockets of taxpayers when the going gets rough. Arguably, banks have been cosseted for far too long.
The markets may believe that the Fed's hard-nosed attitude is not due to either of the above reasons but to the fact that the Fed may know of more distressed banks out there, and that it decided to draw the line somewhere. This possibility is probably what has really spooked the markets. Uncertainty, of course, is frightening in itself.
The purchase of Merrill Lynch by Bank of America for $50 billion caused less of a shock. It was known that Merrill Lynch also had mortgage-related debt on its books and an associated liquidity and share-valuation problem. The purchase was done at $29 per share, which was well up on recent values, although way down by reference to the peak. Shareholders are probably not too unhappy with the deal.
However, it does appear as if there may be fairly substantial job losses and this could impact on Ireland since Merrill Lynch has a significant presence in Dublin. Its International Bank Ltd (which is Merrill Lynch's primary non-US operating bank) is headquartered in the International Financial Services Centre, and is regulated by the Irish Financial Regulator. It is to be hoped that job losses can be contained.
What of wider implications? In the US, lower share prices tend to produce a negative wealth effect. In other words, people feel poorer and they consume less. This can slow down the economy. The only bright spot here is that in Ireland the wealth effect is not so pronounced.
The shares of the main Irish banks had just recovered on the news of the rescue of Fannie Mae and Freddie Mac when they were hit by the latest news.
They fell substantially yesterday and will probably continue to languish for a considerable time.
There are rumours that they are being targeted by foreign speculators engaged in short-selling - these speculators make money if the shares fall.
But apart from this, it is understandable that bad news from the US will make the ordinary shareholder nervous, especially as Irish banks have lent so much money for housing and property development.
It is important, however, to bear in mind that several US banks were greedy, incompetently run, and that the US system of regulation failed almost completely. It might also be added that the dot.com equity boom fed into the property boom and that both booms were facilitated by the Fed. Interest rates were kept far too low for most of the period and inflated the bubbles. How regulators failed to recognise the dangers inherent in the subprime market in the middle of a property bubble is impossible to explain.
From a fundamental perspective, things were never that bad in Ireland. Irish banks have not had to raise more capital from existing shareholders; if and when they have liquidity problems, they can access funds from the European Central Bank. They can also pledge their existing mortgage assets in exchange for these funds. This was something Northern Rock could not do because the UK is not in the Economic Monetary Union.
Also, we have been reassured time and again by the Central Bank of Ireland and the Financial Regulator that the Irish banks are virtually free of the subprime mortgages which have caused all the problems in the US. The governor of the Central Bank has said "the direct and indirect exposure of Irish banks to US subprime mortgages is negligible".
He also added that there was no sign of a material increase in loan arrears and that there was no write-down of assets; in fact, the assets were of good quality. He went on to say that the Irish banks were well capitalised and that frequent stress-testing had shown that the banking sector's shock absorption capacity remained strong.
The Financial Regulator examines the books of all the banks regularly with a fine-tooth comb and is fully engaged in the stress-testing exercises - which hypothesise very difficult scenarios - and then assess the banks' abilities to deal with them. No one else in the country would have anything like the detailed knowledge of the financial sector.
The Central Bank's and Financial Regulator's assurances are the best indicators Irish shareholders are going to get.
• Michael Casey is a former chief economist at the Central Bank and a former member of the board of the International Monetary Fund