Government Bailout: an ultimate panacea for resolving crisis

8/14/2019 Government Bailout: an ultimate panacea for resolving crisis

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Government Bailouts: The Ultimate Panaceafor Resolving Crisis

Name: Amarnath Sarangula

MBA 1st year, Department of Management Studies

IIT Roorkee

Team: Scholar

E-mail: [email protected]

Phone: +91-9759490100


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Government Bailouts: The Ultimate Panacea for Resolving Crisis

Abstract:

This paper analyzes the system of financial bailout by Governments from the perspective of

short term socialization of losses and long term privatisation of profits. Government

bailout as ultimate panacea is explained by taking examples of Swedish and Mexican bailouts inearly nineties, in which they were rescued by International Monetary Fund (IMF) and

superpowers. In the present scenario the crisis is too big to be handled by IMF or any other

sources of fund, so problem boils down to how it is to be handled when ultimate panacea

doesnt work. This paper explains the structural mistakes that could have been avoided by the

Central Banks in bailing out Financial Institutions. This also clarifies how UKs and US bailout

schemes set benchmarks for both the extremes, first the UK style that uses market information in

its operation and looks to separate healthy and unhealthy institutions, Second, the US one-

solution-fits-all style.

In this state of confusion, what kind of Financial Innovation and Restructuring will help to

avoid future crisis (if any)? One does not need an econometric model to analyze this problem,

Perhaps the best method for analyzing this question is to employ the philosophical approach taken

by Frdric Bastiat (1801-1850)1

in his various publications. In order to strengthen free market

mechanism and to minimize the government intervention in recapitalizing the troubled financial

institutions two alternate approaches can be suggested. First, is to identify and sell troubled

institutions to healthier ones and the second, is to bifurcate troubled institutions piece-meal,

selling their healthier assets to other institutions and converting the ones for which there is no

current private interest into "bad banks".

There is nothing new except what is forgotten Mlle Rose Bertin2

1

Claude Frdric Bastiat (June 30, 1801 December 24, 1850) was a French classical iberal theorist, political economist, and

member of the French assembly and the philosophical approach taken by him in his various publications, most notably essay onWhat Is Seen and What Is Not Seen (1850)2

MADEMOISELLE ROSE BERTIN French milliner to Marie Antoinette (1744 - 1813)


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Introduction:

How we got here - where we are now

In the late 90s and early 2000s interest rates were low and banks had large amounts of

cash on hand.

At the same time the housing market was doing very well.

Due to this home ownership became very attractive, increasing the demand for mortgages

and increasing competition among mortgage lenders.

To capitalize on the increased demand and avoid competition mortgage lenders began to

lend to people with less than perfect credit, a practice known as subprime lending.

Due to the higher probability of foreclosures with subprime borrowers, lenders had to

charge higher interest rates. One way they did this was to use adjustable rate mortgages

(ARM) which have low interest rates in the first couple of years and higher ones in later

years.

Beginning in 2006 home values began to decline. At the same time many lenders sold

subprime loans to mutual funds and hedge funds as investments.

The financial firms made enormous investments in these mortgage backed securities and

lost billions. Large names such as Merrill Lynch and Bear Sterns either merged with other

companies or closed their door completely.

Over the past few months US financial markets have been in a crisis, fuelled by the lack of

credit and panic of investors.

The US government has decided to intervene with a $787 billion dollar bailout plan to save

US financial markets.

The question remains, is government bailout justified to save US financial markets?

What doesBailout3

mean?

A situation in which a business, individual or government offers money to a failing

business in order to prevent the consequences that arise from a business's downfall. Bailouts can

take the form of loans, bonds, stocks or cash. They may or may not require reimbursement.

3

The meaning of bailout in www.investopedia.com


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Proposed US Bailout Plan:

US politicians had agreed on a bailout plan for Wall Street that will cost the US taxpayer

$840 billion4, but what does it actually entail? The bailout was suggested by US Treasury

Secretary Henry Paulson as a way of averting financial catastrophe in the US, and by association,

the rest of the world. The plan will involve the Government buying distressed assets (mainly

products based on mortgage debt that have lost value as US house prices have fallen) from banks.

So how will it work?

The US will, ironically, finance the bailout via the financial markets. It will issue US$700

billion in US Treasuries and hopes to be able to sell the assets it is taking over back to the market

once their value has increased, potentially at a tidy profit. Additionally, banks that are given

bailout money will have to give shares in return, again offering taxpayers a potential profit if the

banks in question recover.

Bailout: a historical perspective

The Mexican Bailout

According to the conventional view, the International Monetary Funds bailout of Mexico

in 1995 was a success because it restored confidence in the collapsing peso, led to a quick

economic recovery, and possibly stemmed the outbreak of a global systemic financial crisis. The

bailout, moreover, helped keep Mexico on a market oriented track.

Mexico: Selected Economic Indicators5

1990 1991 1992 1993 1994* 1995**

(percent change)

Real economic growth 4.5 3.6 2.6 0.4 3.1 1.5

Consumer prices (end of year) 29.9 18.8 11.9 8.0 6.9 19.0

(percent of GDP)

Overall fiscal balance 2.8 0.5 1.6 0.7 -- 0.5

Primary fiscal balance 7.3 5.0 5.8 3.9 2.6 3.4

Gross domestic investment 21.9 22.4 22.8 20.6 21.6 21.0Gross national savings 15.5 14.3 13.9 14.1 13.7 16.6

External current account balance (deficit 3.2 4.8 6.8 6.4 8.0 4.3

Net public external debt 31.7 26.1 30.5 31.1 29.2 27.1

Sources: Mexican authorities and IMF staff estimates *Preliminary. **Program.

4 http://www.reuters.com/resources/archive/us/20081007.html5

IMF EXTERNAL RELATIONS DEPARTMENT, http://www.imf.org/external/np/sec/pr/1995/pr9510.htm


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As shown in the table, we can observe the transformation of economy of Mexico in early nineties.

The economy had plunged between 1990 and 1994, after International Financial Support, in

which, apart from the IMF's US$17.8 billion stand-by credit, the United States is expected toprovide US$20 billion, the G10 central banks through the Bank for International Settlements (BIS)

US$10 billion, and the commercial banks US$3 billion.

Swedish Experience:

Public debt rose from about 30 percent of GDP to close to 75 percent from the mid-1970s to

the early 1990s

During this period, the debt dynamics was clearly not on a sustainable path. As is well known,

solvency requires that the debt to GDP ratio rise at a rate lower than the difference between the

nominal interest rate and the nominal growth rate of output. However, in Sweden the debt to GDP

ratio grew at an average rate of 5.2 percent over 197594, far exceeding the difference between

interest and growth rates (averaging at 0.7 per cent over the period6).

This led to banking crisis in the early 1990s and had similar macro economic conditions as

the current U.S. crisis. In September 1990, the Swedish banking system began to unravel when

one finance company could not roll over a maturing marknadsbevis7. The default of one finance

company spread to the whole marknadsbevis market, which in turn reached the banking industry.

The Swedish government made extensive use of the good bank, bad bank model to address its

6The rate of growth of the debt to GDP ratio exceeded the difference between interest and growth rate also between 1975 and 1990

(when the debt to GDP ratio was at a through).7

Since Swedish finance companies cannot issue bonds or received deposits, they are financed directly by bank borrowings and

company investment certificates that are called, marknadsbevis.


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problem institutions. The Swedish bailout included guarantees on all retail deposits, senior and

subordinated debt, problem assets, loans and new equity issues. If a bank accepted an aid package

it had to open its books fully and submit to government directed restructuring and cost cutting.

Thus, Sweden legally mandated transparency.

Present Scenario of US Bailout:

According to reports in Washington, the Obama administration may be close to devoting

as much as $100bn of the second tranche of the troubled asset relief programme funds

to creating an aggregator bank8 that would remove toxic securities from the balance sheets of

banks. The plan would be to leverage this amount up 10-fold, using the Federal Reserves

balance sheet, so that the banking system could be relieved of up to $1,000bn (770bn,

726bn)9 worth of bad assets.

The proposal suffers from the same shortcomings: the toxic securities are, by definition,

hard to value. The introduction of a significant buyer will result, not in price discovery, but in

price distortion. Moreover, the securities are not homogeneous, which means that even an

auction process would leave the aggregator bank with inferior assets through adverse selection.

Even with artificially inflated prices, most banks could not afford to mark their remaining

portfolios to market so they would have to be given some additional relief. The most likely

solution is to ring-fence10 their portfolios, with the Federal Reserve absorbing losses that

extend beyond certain limits.

The other part of the bailout: Pricing and evaluating the US and UK loan guarantees

To lick the wound caused by the banks and financial institutions, Governments on both

sides of the Atlantic have taken a two-pronged approach bank recapitalisation and loan

guarantees. Specifically, the US, the UK and some European governments are re-capitalising their

troubled financial institutions. They are also trying to kick-start interbank lending by announcing

plans to guarantee all new senior unsecured debt out to three years.

The recapitalisation has received plenty of attention, but the loan guarantees have largely flownunder the radar despite the huge sums involved.

8 http://www.ft.com/cms/s/0/51a282ac-e66c-11dd-8e4f-0000779fd2ac.html?nclick_check=19

http://www.reuters.com/resources/archive/us/20081007.html10

A protection-based transfer of assets from one destination to another, usually through the use of offshore accounting. A ring

fence is meant to protect the assets from inclusion in an investor's calculable net worth or to lower tax consequences.


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This raises questions:

Are there taxpayer costs to loan guarantees?

How big are the costs to taxpayers likely to be?

What are the relative merits of the US and the UK schemes?

The US and UK Guarantee Schemes

In the UK, nine financial institutions have been identified as initially eligible for loan

guarantee (though more may be added later at the discretion of the UK Treasury). Senior

unsecured borrowings of these institutions made on or prior to 13 April 2009 will be guaranteed

by the UK government for a period of 3 years or maturity of the issue, whichever comes first.

The US program, administered by the FDIC (Federal Deposit Insurance Corporation),

works very differently.All banks, depository institutions, and savings and loan companies are

eligible to participate in the program. Institutions notwishing to participate in the program must

inform the FDIC by 12 November 2008. If an institution does not opt out of the program,

then allsenior unsecured loans issued by it between 14 October 2008 and 30 June 2009 will be

guaranteed by the FDIC for a maximum period of three years or until maturity of the debt,

whichever comes first?

Possible Alternatives:

Sale of troubled institutes to the healthier ones:

A possible alternative could be the selling of troubled financial institutions to the healthier

ones, the sale of Bear Stearns to JPMorgan in March is a good example of this method. This way

of selling doesnt require any tax payers money, perhaps it is more of holistic approach to deal

with this problem where external entities are not involved.

Government-assisted sales to healthy institutions are an attractive way of deploying public

funds. They provide capital to the system, and entrust the complex task of orderly management

and liquidation of troubled assets to the healthier parts of the private sector. Whether this

mechanism suffices by itself to resolve troubled assets and institutions depends to an extent on the

condition and willingness of healthy institutions and to some extent also on moral suasion powers

of regulators. On the one hand, healthy banks stand to gain substantially from such sales. On the

other hand, they may also try to extract their pound of flesh from governments and Central Banks.


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Good Bank, Bad Bank Model

A good bank, bad bank model is emerging as an option for removing troubled assets from

banks. While this approach has not been widely used in the U.S. banking sector, the good bank,

bad bank model has been used internationally with some success. The theory behind this model is

that confidence can be restored in the good bank, leaving the bad bank to focus on the liquidation

of the troubled assets. Transparency is essential and indeed often legally mandated for this

approach to work. We can use the above mentioned method11 to value these troubled assets.

In a good bank, bad bank scenario, a bank is divided into two parts. The good bank retains

performing assets, while non-performing assets are transferred to a bad bank shell. The good bank

can now operate more efficiently and raise capital with greater ease and at lower rates. The bad

bank can then direct all of its efforts at loan recovery and self-liquidation12 Funds recovered from

problem loans are channelled into dividends and/or interest payments to shareholders of the

residual asset bad bank entity. The bank may choose the exact form of the bad bank structure.

Mr. George Soros13 says In my view, an equity injection scheme based on realistic

valuations, followed by a cut in minimum capital requirements for banks, would be much more

effective in revitalizing the economy. The downside is that it would require significantly more

than $1,000bn of new capital. It would involve a good bank/bad bank solution, where appropriate

11

Senior unsecured borrowings of the troubled institutions made on or prior to 13 April 2009 will be guaranteed by the UK

government for a period of 3 years or maturity of the issue, whichever comes first.12 The management of bad loans differs from the handling of normal credits and, in many cases, requires specialists who are skilledin liquidations.13

George Soros is Chairman of Soros Fund Management, LLC and founder of The Open Society Institute.

http://www.georgesoros.com/


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Conclusions:

Since any attempt at a bailout will result in a negative-sum game, the simple fact is that if a

trillion dollars is taken out of the more productive sectors of the economy and channelled into the

less productive sectors, the result must necessarily be a negative-sum game. All bailouts are a

form of subsidy, but in present scenario, it can be advised to go with three Tier approach.

The first is to identify and sell troubled institutions to healthier ones, possibly with government

support in the form of loans or first-default-loss protections. The sale of Bear Stearns to JPMorgan

in March is a good example of this method. The second is to restructure troubled institutions

piece-meal, selling their healthier assets to other institutions and collecting the ones for which

there is no current private interest into "bad banks", restructuring those assets, and resolving them

over time. This is trickier given the complexity of institutions involved. The third is to leave

everything to free market mechanism, in which Government intervention is totally absent and letthese troubled institutions fail in the nature of economic cycles.


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REFERENCES

1. Bastiat, Frdric (1850). What Is Seen and What Is Not Seen, in Selected Essays on

Political Economy, reprinted in Selected Essays on Political Economy, Irvington-on-

Hudson, NY: foundation for Economic Education, 1964 and The Bastiat Collection,

Volume 1, Auburn, AL: The Ludwig von Mises Institute, 2007.

2. Keynes, John Maynard (1936) The General Theory of Employment, Interest, and

MoneyNew York: Harcourt, Brace & World.

3. The First Global Financial Crisis of the 21st Century A VoxEU.org Publication.

4. Barajas, Adolfo, Giovanni DellAriccia and Andrei Levchenko (2007), Credit Booms:

The Good, the Bad, and the Ugly, unpublished manuscript, Washington, DC: International

Monetary Fund.

5. DellAriccia, Giovanni, Deniz Igan and Luc Laeven (2008), Credit Booms and Lending

Standards: Evidence from the Subprime Mortgage Market, CEPR Discussion Paper No.

6683, London: CEPR.

6. Goodhart, Charles and Avinash Persaud (2008), How to Avoid the Next Crash,Financial

Times, 30 January.

7. www.reuters.com

8. www.cepr.org

9. www.voxeu.com

10. www.moneycontrol.com

11. http://www.aba.com/default.htm

12. www.instrategy.com

13. http://www.federalreserve.gov/

14. www.wikipedia.com

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Government Bailout: an ultimate panacea for resolving crisis