Opinion & Commentary
Bailing-Out or Crowding-Out?
Losses on subprime-related debt instruments have resulted in a liquidity crisis becoming a solvency crisis for many financial institutions, as impaired assets leave them chronically short of capital. The situation has been made worse by risk-averse credit markets, which have prevented otherwise solvent institutions such as Bear Sterns from rolling over their liabilities. As the global credit crisis has deepened, governments around the world have resorted to equity injections to prevent the failure of these institutions.
The main rationale for these equity injections is to prevent the failure of one or more financial institutions having wider systemic consequences that would destabilise the entire financial system. We should otherwise be cautious in making generalisations about these government-sponsored ‘bail-outs’, as there are important differences between each case, raising distinct sets of issues.
For example, in the case of Freddie Mac and Fannie Mae, the US government’s injection of equity capital and provision of expanded lines of credit simply makes explicit a long-standing, implied government guarantee. There is no point complaining about moral hazard in this case, since the moral hazard was already in place and was responsible for excessive risk taking that ultimately brought these institutions unstuck. The rescue of Freddie and Fannie reflects decades of political failure in not tackling reform of these government-sponsored enterprises (GSEs). The main criticism that can be made of this rescue is that the US government has not put forward a long-term plan for winding-up the two GSEs.
One of the remarkable things about the current crisis is the amount of new capital that has been raised amid what is said to be one of the worst financial crises since The Great Depression. In the year-ended September 2008, over $US 434 billion in new capital was raised by the world’s financial institutions. This new capital came from both private and foreign public sources, including sovereign wealth funds that have taken-up new equity stakes unrelated to domestic, publicly-funded rescue packages. Many of the world’s financial institutions have been able to raise new capital, even as they re-intermediated substantial off-balance sheet positions. In the current environment, this is a substantial and largely unrecognised achievement that highlights the continued resilience of private markets.
There is thus a serious question over whether the public provision of equity capital is crowding-out private capital. There is plenty of private capital willing to step-up to the plate, on the right terms and at the right price. Much of the dramatic restructuring of the US financial system seen in recent months has been driven by private merger and acquisition activity that has needed little prompting by the US or other governments. Merrill Lynch, Wachovia and Washington Mutual have all found buyers among the likes of Bank of America, JP Morgan Chase, Wells Fargo and Citibank. Major US investment banks like Goldman Sachs and Morgan Stanley have transformed themselves into universal banks, taking advantage of the repeal of the Glass-Steagall Act, showing how deregulation has actually made the US financial system more rather than less resilient.
But financial market participants also know they are in a position to drive a hard bargain with the authorities in the current environment. JP Morgan Chase was able to secure a favourable deal from the US Federal Reserve and Treasury in its acquisition of Bear Sterns. Financial markets participants understand that in many cases, they are likely to get a better deal from the feds than from the marketplace. In this case, the authorities underwrote the acquisition and existing shareholders in Bear were largely wiped-out, while JP Morgan Chase picked-up a bargain.
By contrast, Lehman Brothers was allowed to fail because it did not present the same level of systemic risk as Bear Sterns. Buyers of Lehman’s assets then quietly emerged, principally Barclays and Nomura, once a government-sponsored deal was off the table. If there were wider systemic consequences from the failure to bail-out Lehman, it was because of the seemingly inconsistent actions of the authorities, which added to the uncertainties already facing private investors.
This is in sharp contrast to the financial crises of the 1930s, 70s, 80s and 90s, when thousands of financial institutions failed. The repeal of the remaining elements of Glass-Steagall Act significantly strengthened the resilience of the US financial system to the current crisis and made much of the current crisis-induced restructuring of the US financial system possible. The deregulation and consolidation of the US banking system in recent years has greatly increased rather than weakened its resilience to the current financial crisis.
Government equity injections in the form of preferred stock can be done in a way that protects the taxpayer, ensuring that existing shareholders are more heavily exposed to any losses. Equity injections are a preferable approach to managing the crisis than the Bush Administration’s proposed Troubled Asset Relief Program (TARP), part of the $US 700 billion bail-out package that was initially rejected by Congress and which would aim to buy impaired assets from financial institutions. Major questions have been raised about how the TARP would work. If the TARP were to buy impaired assets at bargain basement prices, this might be of little help to the financial institutions it is meant to benefit. By the same token, the government should not over-pay for these assets either, lest taxpayers be stuck with the long-term bill. It is difficult to design a publicly-sponsored market mechanism that would improve on what private markets are already willing to pay.
Preferred equity positions in financial institutions create a buffer between these distressed assets and taxpayers which is not present when government directly acquires these assets. Given that the underlying securities are difficult to value in the absence of genuine private markets, temporary government equity injections would seem to be preferable way of dealing with the crisis. Contrary to popular perception, the impaired structured debt products on the balance sheets of US and non-US financial institutions are not worthless. Many of these instruments still have positive cash-flows attached to them. Unfortunately, the prices investors are willing to pay for these assets in the current environment are not always consistent with the continued solvency of the institutions holding them.
Walter Bagehot laid out the basic principles for the government’s lender of last resort function in the 19th century: lend freely, against good collateral, at a penalty rate. But these principles need to be formalised and applied in ways that are consistent and minimise both systemic risk and moral hazard. The main criticism that can be made of government equity injections into financial institutions to date is the lack of clearly articulated rules and principles governing these ad hoc interventions.
Dr Stephen Kirchner is a Research Fellow at the Centre for Independent Studies (CIS).
