| After
much dithering, high drama and every effort to avoid
the inevitable for fear that it would straightjacket
capitalism, governments in the developed industrial
countries have taken the first, major, necessary step
to begin resolving the financial crisis. They have,
effectively, nationalized a large part of the private
banking system.
These moves come at the end of a long series of interventionist
efforts that pointed in two directions. First was that
governments believed that the problem facing the financial
sector in the wake of the subprime crisis was not one
of generalised insolvency, but one of inadequate liquidity
resulting from fear and uncertainty. The second was
that to the extent that there were individual firms
faced with insolvency, the problem could be resolved
on a case by case basis, through closure (Lehman), merger
(Wachovia) or state take over (American International
Group). It was only when efforts based on these perceptions
failed to stop the slide that measures to deal with
generalised insolvency, such as buying out all impaired
assets or recapitalizing banks with public investment
were resorted to. But even these are focused on the
banking system. In a world where non-bank financial
institutions play an extremely important role and the
banks themselves are integrated in various ways with
these institutions, it is unclear whether these steps
would be enough.
The perception that the problem was one of liquidity
because financial markets were freezing up given the
difficulty of assessing counterparty risk yielded a
host of responses, especially in the US, that filled
the media with acronyms: MLEC (Master Liquidity Enhancement
Conduit), TAF (Term Auction Facility), TSLF (Term Securities
Lending Facility) and PDCF (Primary Dealer Credit Facility).
By the end of it the Federal Reserve in the US had offered
to accept as collateral the bundles of worthless assets
that were lying with financial firms, and extend its
credit facilities to entities outside the regulated
banking system. Interest rates too had been substantially
cut to make credit cheaper. When even this was not yielding
the expected results and halting a slide in stock markets,
recognition that other measures were needed dawned.
Some effort at dealing with insolvency was called for.
But even this was initially half-hearted and pursued
on a case-by-case basis. Further, the attitude was different
across cases. JP Morgan Chase was paid off to take over
Bear Stearns cheap. Lehman was allowed to go. Fannie
Mae and Freddie Mac were nationalized. AIG was rescued
with a huge infusion of public funds, triggering allegations
of conflict of interest on the grounds that this was
an effort at protecting Goldman Sachs that was substantially
exposed to the insurer. Treasury Secretary Paulson came
from Goldman and still holds a significant stake in
the firm. But as the number of cases multiplied and
the lack of a clear strategy became obvious, the danger
of a financial collapse intensified.
This was when the first signs of recognition that there
was a problem of potential generalised insolvency emerged.
The first response was TARP (Troubled Assets Relief
Program). Declaring that the system was faced with financial
collapse of a kind that could drive the economy to recession,
the Treasury Secretary backed by the Chairman of the
Federal Reserve, badgered Congress into authorising
a $700 billion bailout package, which was primarily
geared to buying out the near-worthless or “impaired”
mortgage-related assets from financial institutions,
as also any other assets from any other party so as
to “unclog” their balance sheets and get credit moving.
This plan too did not clearly recognise that generalised
insolvency was a potential problem. This was clear from
the fact that the bailout plan sought to use market-based
methods to buy up troubled assets. Since the prevailing
market price of those assets was close to zero, this
would imply that the institutions selling those assets
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 were
recapitalised with an infusion of new funds.
It was the UK, having experimented with liquidity infusion
and limited nationalisation, which first went beyond
the Bush administration. Gordon Brown announced that
his government would resort to an “equity injection”
to buy ordinary and preference shares worth £37
billion in three of the biggest banks in the country:
Royal Bank of Scotland, Lloyds TSB and HBOS.
Existing shareholders have the option of buying back
the ordinary shares from the government. But if they
do not, as seems likely, then the government would have
a stake of 60 per cent in RBS and 43.5 per cent in the
combined entity that would emerge after the ongoing
merger of Lloyds TSB and HBOS. This clearly amounts
to State takeover, which brings with it new obligations.
The three banks will not be able to pay dividends on
ordinary shares until they have repaid in full the £9bn
in preference shares they are issuing to the government.
The Treasury would appoint 3 new RBS directors and 2
directors to the board of the combined Lloyds-HBOS to
oversee the government’s interests. And there would
be restrictions on executive salaries and bonuses that
had ballooned during the years of the speculative boom.
The decision to nationalize was forced on the UK government
because the problem facing the banking system was not
just one of inadequate liquidity resulting from fears
generated by the subprime crisis. Rather credit markets
had frozen because the entities that needed liquidity
most were those faced with a solvency problem created
by the huge volume of bad assets they carried on their
balance sheets. To lend to or buy into these entities
with small doses of money was to risk losses since that
money would not have covered the losses and rendered
these banks viable. So money was hard to come by. This
is disastrous for a bank because rumours of its vulnerability
trigger a run that devastate its already damaged finances.
What was needed was a large injection of equity to recapitalize
these banks after taking account of losses. Wherever
the sum involved was small, a private sector buyer could
play the role, otherwise the State had to step in. Thus,
in the case of some banks recapitalization through nationalization
was unavoidable because, as UK chancellor Alistair Darling
put it, “this is the only way, when markets are not
open to certain banks, they can get the capitalisation
they need”. Others such as Barclays hope they can attract
private investors so as to avoid being absorbed by the
government. It expects to raise £6.6 billion from
private investors, but the prospects are not certain
given the fact that it has decided not to pay a final
dividend in 2008, so as to save £2 billion. That
may not be the best signal to send to prospective investors.
What needs to be noted, however, is that nationalization
is not the end of the matter. In addition, the UK government
has chosen to guarantee all bank deposits, independent
of their size, to prevent a run. It has also decided
to guarantee inter-bank borrowing to keep credit flowing
as when needed.
Once the UK decided to take this radical and comprehensive
route, others were quick to read the writing on the
wall. What followed was a deluge. Germany with an estimated
bill of €470 billion, France with €340 billion, and
other governments with as yet unspecified amounts pitched
in, with plans to recapitalize banks with equity injections,
besides guaranteeing deposits and inter-bank lending.
The banking system was being saved through State take-over,
not just with State support.
Finally, the US, which was seeking to avoid State acquisition
fell in line, but in a form the shows the influence
that Wall Street exerts over the Treasury . It too has
decided to use $250 billion of the bailout money to
acquire a stake in a large number of banks. Half of
that money is to go to the nine largest banks, such
as Bank of America, Citigroup, Wachovia and Morgan Stanley.
The minimum investment will be the equivalent of one
per cent of risk-weighted assets or $25 billion—whichever
is lower. With capital adequacy at a required 8 per
cent, this is indeed a major recapitalisation. Further
the government, through the Federal Deposit Insurance
Corporation, is guaranteeing all deposits in non-interest
bearing accounts and senior debt issued by banks insured
by the FDIC.
However, Wall Street’s influence has ensured that this
intervention is biased in favour of Big Finance. The
support comes cheap: banks will pay a dividend of just
5 per cent for the first five years, only after which
the rate jumps to 9 per cent. During that time, they
have the option of mobilising private capital and buying
out the government. Interestingly, the government is
not taking voting rights and would be able to appoint
directors only if the bank misses dividend payments
for six quarters. While there are restrictions on payment
of dividends to ordinary shareholders before clearing
the government’s claims and limits on executive compensation,
the government only reserves the right to convert 15
per cent of its investments into common stock. In sum,
the American initiative overseen by Henry Paulson, an
old Wall Street hand from Goldman Sachs, has virtually
cajoled the banks to accept a government presence, unlike
what seems true in the UK and Europe.
Whether it is occurs in part-punitive fashion or as
a sop, the back-door takeover of major private banks
is a desperate attempt to stall the financial meltdown
in the advanced economies resulting from the decision
to allow private financial players unfettered freedom
to pursue profits at the expense of all else. While
this threat has forced governments to drop their neo-conservative
bias against State ownership and markets that hollered
at government intervention in the past have now applauded
such action, the threat of recession has not receded.
Even if the banks are safe, though there is no definite
guarantee as yet, there are many other institutions
varying from hedge and mutual funds to pension funds
that have suffered huge losses, both from the subprime
fiasco and the stock market crash, eroding the wealth
of many. Moreover, housing prices are still falling
sharply. The effects of that wealth erosion on investment
and consumption demand are only now unravelling, indicating
that there is much to be told in this story as yet.
What may be necessary is one step more - the refinancing
of mortgages to stop the foreclosures that underlie
the financial crisis.
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