| Despite
its second round passage, the collapse of the first-round
vote in the US Congress on a package to use $700 billion
of public money to bail out firms threatened by the
fall-out of the sub-prime crisis has two lessons. First,
that the White House, the Treasury and the Federal Reserve,
who were saying that intervention was inevitable to
avoid a financial meltdown, were making the case for
a specific kind of intervention that favoured Wall Street
but ignored Main Street. Having made huge profits on
speculation, Big Finance wanted the State to pick up
the losses when the bubble burst. Second, it showed
that whether the advocates of neo-liberalism were willing
to accept it or not, this was the end of the neoliberal
era, with the neoconservatives deciding that there was
no option other than bringing the State back in. Their
effort was to do so without giving the State a role
in regulating capital. The collapse and subsequent adjustments
to the bill indicates that they have failed.
The final version of the Bill, which reflected a deal
between Democrat and Republican negotiators, included
some modifications of and additions to the outrageous
demands originally made by the U.S. administration and
the Federal Reserve. These changes were necessitated
by the reservations expressed by both Democrats and
Republicans pressured by criticism from their constituents
that the deal planned to use taxpayers’ money to bail
out financial players who profited at the expense of
the system.
Despite the modifications, this is a bailout deal that
was not warranted. It is indeed true that the U.S. has
in hand a serious financial crisis, whose arrival was
recognised rather late by a conservative administration,
which along with its predecessors was responsible for
adopting policies encouraging the practices that led
to the crisis. It waited until the sub-prime mess precipitated
a credit crunch, with banks unwilling to lend for fear
of being loaded with more worthless financial assets.
As a result, the “toxic waste” consisting of mortgage-related
or mortgage-backed securities is threatening the viability
of a range of financial institutions and whole segments
of the financial system.
So, intervention by the state to stall a crisis, which,
in the words of Warren Buffet, could be “the biggest
financial meltdown in American history” was necessary
and unavoidable. Unfortunately, however, the bailout
in its current form does little to ensure that those
responsible for the crisis are penalised, does not put
in place regulatory institutions and conditions that
could pre-empt similar crises in the future, and is,
for a number of reasons, unlikely to deliver a resolution
of the crisis reflected in bankruptcies, bailouts, acquisitions
and mergers.
It is surprising, therefore, that Democrats, who dominate
Congress, while rejecting the request from a lame-duck
President for a blank cheque with a huge spending limit
and few conditions attached, backed the main contours
of the original draft Bill and acceded to many of the
demands of the George W. Bush administration.
One explanation is that this was an effort on the part
of the Democrats to show that they would not use their
majority to stall immediate intervention when the system
faces a crisis, even if that crisis was of the Republicans’
making. Eventually, it was the Republican caucus that
stalled the administration’s Bill in the first round,
on the grounds that it violated all the free-market
principles that conservatives claim to stand for. Many
Republicans did not want to be seen as endorsing the
view that it was the market-friendly push by past and
current Republican administrations that precipitated
this crisis.
But many Democrats, too, are supporters of liberal financial
policies. Therefore, bipartisan support for the Bill
was in all probability reflective of the recognition
by both Democrats and Republicans alike that unless
something was done to stall the unfolding crisis, a
return to intense regulation was inevitable.
Worthless Assets
But, in all probability, the only comprehensive plan
the Treasury had put on the table to resolve the crisis
will fail to deliver. What the plan does is give the
Treasury (and its private financial advisers, including
players who contributed to the crisis) the power to
buy not just the near-worthless or “impaired” mortgage-related
assets from financial institutions but also any other
assets from any other party so as to “unclog” their
balance sheets and get credit moving. Implicit in this
view is that there are two kinds of securities.
One kind consists of those that have lost value because
the mortgages or other loans they are backed with are
subject to defaults on payments, leading to foreclosures
in a market where the values of those assets are falling.
The second kind consists of those that have lost value
or whose value is unknown because the credit crunch
has frozen the market for these securities, leaving
them with no estimable market value. With some assets
being worthless and others being of unidentifiable value,
it is argued, the viability of many financial firms
is in question, depriving them of the funds needed to
keep their business going.
The Treasury view, backed by the Federal Reserve, is
that if financial institutions were relieved of the
first set of securities, their balance sheets would
improve and they would be in a position to resume trading
or lending and the values of the second set of securities
would automatically improve and stand revealed, resulting
in a further improvement in the balance sheets of the
institutions holding them. This, it is argued, would
return credit and asset markets to normality, restore
values of “unimpaired” or frozen securities, and stop
the wave of bankruptcies, state takeovers, acquisitions
and forced mergers that have transformed the U.S.’ financial
landscape over the last month.
It would also, supposedly, restore the value of many
of the securities acquired by the government, allowing
it to sell them and recoup the taxpayers’ money that
was to be used to finance this bailout of institutions
that failed or are performing poorly because of lack
of due diligence and transparency, unsound and excessively
speculative financial practices or even sheer malpractice.
In a move aimed at indicating that the requirements
of taxpayers are being taken care of, the final draft
required the President to work out means to recover
any losses that would be incurred after five years in
the sale of assets acquired under the programme.
The problem is that the information available in the
Bill on the bailout is inadequate to answer a number
of questions. First, which would be the securities that
the government would buy out and to what extent?
The $700 billion figure was the limit set for acquisitions
of the troubled assets, whose total value has been guesstimated
at upwards of $3 trillion.
That figure would have been even higher had the Treasury
been given the discretion to add on any other assets
it considers worthy of similar support. It should be
expected that the money would be used to buy the worst
assets and “unclog” the system so that the less impaired
and frozen securities can find their value. The private
financial sector too would lobby for such a move since
the worst assets are the securities they want off their
books. This implies that the assumption is that $700
billion is enough to clear the system of these securities
though the basis for that assumption is by no means
clear.
The second question that arises is the manner in which
prices of the securities to be acquired are set. The
bailout plan seeks to use market-based methods, including
reverse auctions in which sellers looking for a buyer
bid down the price at which they are willing to sell
their assets. Since the most impaired securities are
near worthless, their prices should be closer to zero
for every dollar worth of such assets in terms of their
accounting or par values. Setting them there would also
permit the government to acquire a substantial volume
of securities when seeking to unclog the system or to
even save a part of the taxpayers’ money it is authorised
to spend to achieve this objective.
The problem, however, is that if this were done, the
institutions that are selling these assets at near-zero
prices would have to take large write-downs onto their
balance sheets and reflect these losses. This would
undermine their viability and result in failure unless
they are recapitalised with an infusion of new funds,
as happened in the case of Washington Mutual, a troubled
mortgage bank that had to be seized by federal regulators,
shut down and then sold off to JPMorgan Chase &
Co. This is the largest bank failure in U.S. financial
history, yet the going price for Washington Mutual was
a mere $1.9 billion, with no payments to holders of
$30 billion in debt and preferred stock.
WaMu, as the institution is informally called, had a
troubled loan portfolio of $307 billion. JPMorgan expects
to write down about $31 billion of bad loans and raise
$8 billion in new capital to recapitalise the bank and
successfully integrate it into its own operations. There
are other instances where recapitalisation is being
ensured through an early sell out (Merrill Lynch) or
through a large infusion of capital, as happened with
Goldman Sachs, which is supported with capital from
Warren Buffet.
These experiences have two implications. First, they
show that recapitalisation is unavoidable when the asset
portfolios of troubled financial institutions are restructured
in the face of losses. Second, they also indicate that
as long as there are strong financial institutions or
investors who can take on the responsibility of recapitalising
weaker firms, the market is not so frozen that they
would not be able to mobilise the requisite capital
for the purpose. If, instead of looking at options of
this kind, the administration chooses to buy up assets
at low prices without recapitalisation, it may be providing
immediate support to beleaguered financial institutions
but not resolving the problem that spreading bankruptcy
is creating in the system.
One option would be for the government to buy the assets
at prices closer to par values on the grounds that the
resulting revival in financial markets would render
those prices, which may seem absurd in terms of current
conditions, sensible in the long run and defensible
from the taxpayer’s point of view. Figures as high as
80 cents to the dollar are rumoured to be in circulation.
This would mean that financial institutions would be
able to take much smaller write-downs and would not
need significant recapitalisation. But it also means
that the Treasury may have run through the $700 billion
rather quickly, even before enough of the “toxic waste”
had been cleared.
In fact, many financial firms would be willing to dump
even some of their less impaired or good (but frozen)
assets at those prices, leaving the worst assets in
the system. If this is not to happen, the administration
should choose to buy the worst assets at high prices
even when better assets are available at the same price.
This could invite the criticism that this is misuse
of taxpayers’ money unless the $700-billion limit is
relaxed, making the whole process open-ended and unsustainable.
It is possibly for this reason that Treasury Secretary
Henry Paulson, an ex-Goldman Sachs man, tried to protect
himself and his successors in the first of the drafts
of the legislation that was to define and authorise
the scheme.
In the words of The New York Times, the original draft
gave the Treasury Secretary “the authority to buy any
assets from any financial institution at any price that
he deemed necessary to provide stability to the financial
markets”. The draft also asserted “that neither the
courts nor any administrative agency would be allowed
to question or review these decisions”. The recovery
scheme was based on the premise that an appropriate
set of bets could pull U.S. financial markets back from
the brink of disaster. So the person placing those bets
must be free of any fear that failure would make him
responsible for burning taxpayers’ money. Unfortunately,
the chances of failure are substantial. No Congress
can hand over such powers without oversight, which has
been allowed for in the final law.
The problem was not that there were no better options.
One would have been to combine some state support with
market-mediated solutions, which would reduce the cost
to the taxpayer of a process of financial restructuring.
The JPMorgan Chase takeover of WaMu showed that the
latter was possible. Many other options have also been
offered and discussed.
Thus, James Galbraith, a Professor of Economics at Austin
Texas (and son of the well-known John Kenneth Galbraith),
suggested that since the large, purely investment bank
that is not subject to capital requirements and is more
leveraged is now non-existent (with the closure of Bear
Stearns and Lehman Brothers, the merger of Merrill Lynch
with Bank of America and the conversion of Goldman Sachs
and Morgan Stanley into bank-holding companies), the
task of managing the current financial distress could
have been given to the Federal Deposit Insurance Corporation.
It could have been offered a substantial part of the
$700 billion to insure deposits even in excess of the
currently specified $100,000, foreclosing bank runs
and attracting capital that could help banks recapitalise
themselves. Where matters are more difficult, a part
of the money could be directly used for recapitalisation
of the institutions concerned, with share ownership
going to the government.
Getting share ownership for the government when bailing
out banks was a strategy adopted by the Swedish government
after its banking crisis in 1992. It got banks to write
down losses, required shareholders as opposed to taxpayers
to carry much of the burden and offered bailout funds
in exchange for equity. Equity ownership gave taxpayers
the hope of some returns when distressed assets were
sold or when shares were sold after successful restructuring.
There were some improvements in the final version of
the Bill, however. It recognised that if taxpayers’
money was being used, they should not merely be offered
the promise that this burden would be neutralised when
the government recoups the money through the sale of
acquired assets when market normality is restored, but
a stake in the banks they are bailing out so that they
can exercise both some supervision of the use of their
money as well as have the choice of retaining an equity
stake if these banks survive and recover.
It accepted the need to regulate and tax executive compensation
and severance packages in firms supported by the government.
And it provided for congressional oversight, with the
proviso that bailout financing would be released in
three stages, starting with an initial $250 billion.
Congress was to have the right to vote to hold back
a final tranche of $350 billion if the funds were not
being used effectively.
Finally, the bailout recognised the importance of backing
homeowners whose now-much-cheaper houses are being foreclosed
because they cannot keep to payments commitments on
mortgages that reflect the high values of the property
boom years and involve extremely high interest payments.
The Treasury, as owner of mortgages it has bought up,
can attempt to reduce foreclosures by trimming the principal,
cutting the interest rate or increasing the payback
period on mortgages. Besides being fair in itself, the
use of some of the money to help homeowners retain their
assets may have salutary effects on consumption demand,
which could limit the collateral damage of this financial
disaster on growth and employment.
All this notwithstanding, this historically unprecedented
bailout was one that subsidised finance, underwrote
losses generated by market forces, and left most others
directly or indirectly affected by the excesses of the
mortgage-lending boom untouched. It is partly to meet
such criticism that the Bill provided for the obtaining
of compensation from banks and other financial institutions
after five years in case the government loses money
on the impaired securities it purchases. This assumes
that these banks will be in a position to compensate
the government even if the securities that the latter
took over are not performing well. They probably will
not be.
Thus, there are reasons to believe that the current
package in the Bill will fail to address the crisis
adequately and restore stability. Meanwhile, globally,
markets are in a state of collapse, partly driven by
the expectations generated by the scaremongering used
to push through the package. The danger is that those
threats may actually be realised.
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