Part 7 (2/2)

Insuring depositors was just the beginning Many banks in the United States and Europe borrowedunsecured bonded debt As this debt caht of the financial crisis, it became next to impossible to roll over, particularly after the collapse of Lehman Brothers But since the inability to renew these debts would have destroyed banks as effectively as a run on their deposits, the European Union guaranteed its banks' bonded debt in October 2008 The sauaranteed the principal and the interest pay couarantees ca In the third quarter of 2009, the funds set aside by the FDIC dipped into negative territory Almost inevitably taxpayers will be asked to shoulder the burden in the fors and loan crisis While that kind of support has plenty of precedent, a host of other ed unprecedented aan with Fannie Mae and Freddie Mac As the two overned 400 billion to underwrite the takeover, thoughthis fateful step, the federal government made explicit that the debt of these two enterprises was indeed guaranteed by its ”full faith and credit”

Not for years e know the full fiscal cost of the rescue of Fannie Mae and Freddie Mac In overnment has put itself on the line to cover soations insured by the two institutions, along with another 15 trillion worth of debt that they issued Obviously, the govern these su prices continue to decline and overn considerable losses

The saand Econoed so hoes that were insured by the Federal Housing Adram associated with this allocation failed, President Barack Obama tapped some of these funds when he announced his own 75 billion plan to prevent foreclosures Needless to say, all these progra is certain: they will cost the taxpayers billions of dollars

The biggest bailout of all is really a cluster of separate bailouts and guarantees funded by the Troubled asset Relief Prograress allocated 700 billion to purchase toxic assets Instead, the money has been used to prop up a host of al the automakers General Motors and Chrysler and their financial arms, GMAC and Chrysler Financial All told, these bailouts of the auto industry amounted to 80 billion Some of this overnment to purchase an ownershi+p stake in the coinning A sizable portion of the TARP funds-some 340 billion-was funneled to nearly seven hundred different financial institutions, giants like Citigroup, Bank of America, and AIG as well as a host of smaller banks For theinstitutions consisted of overnment purchased preferred shares in a bank These shares provided a potential ownershi+p stake and a current steady dividend payovernment money, but it marks a radical departure and takes fiscal policy in new and potentially disruptive directions

A Capital Idea?

Banking is a business shrouded in mystery Few people really understand how banks and other financial institutions work, largely because they don't understand how a bank's balance sheet works So while so syste banks to access a lender of last resort-otherTo understand them, it's necessary to understand how a bank works

Let's begin with a hypothetical bank's balance sheet On the right side you have liabilities, and on the left you have assets What are a bank's liabilities? Put very crudely, a bank accumulates liabilities when it takes ets this money in two main ways The first way is to issue stock, which investors buy and thereby become the bank's shareholders The bank doesn't ”owe” the shareholders that money in return, but it does owe them a share of any profits That's why the shares are considered liabilities: the shareholders have an equity claim on the bank

The second way banks accu money, most obviously from people, other banks, and other financial institutions For exa it money Your deposit is a liability for the bank: you ive it to you The saoes for loans that other banks have made to the bank: they're liabilities The bank isthatbonds, for example These too are liabilities, or loans to the bank Most of these loans cost the bank: it pays interest on deposits, for example, and on bonds

What does the bank do with all the money it has raised from shareholders and borrowed from lenders? It creates the other side of the balance sheet: its assets For example, it loans money out to other banks, businesses, and homeowners These loans are considered assets because they are investive the bank a profit That oes for the other assets the bank accuovern So are the re in the vault, the building that houses the bank, and other tangible items But these odds and ends are just a small portion of the total assets of the bank They're also inert: they're notthe bank much money

That, in brief, is how banks work They raise e of lenders Having accumulated these liabilities, the bank then loans theassets It's able toall this money around because the rate at which it borrows is lower than the rate it charges when it lends If all this sounds sihtforward, that's because it isn't rocket science, no ht want you to think

Now comes the important part How much is the bank worth? That's pretty simple: it's the difference between the value of the assets and the value of the debt liabilities Put differently, it's the amount by which a bank's assets exceed its debt liabilities In banking parlance, that difference is the ”net worth” of the bank It's also known as its ”capital” or equity This capital belongs to someone: the bank's owners, or shareholders, who have a residual claiht: the bank owes its existence in no small part to these shareholders, who put up ht into the bank's equity when it issued additional shares They get a share of whatever profits the bank makes-in the foro up in value

Now let's look at how banks can get into trouble in a financial crisis So far we've focused on how things go aith the liability side of the balance sheet, when a bank can no longer borrow money, or when the money it borrows is available only at exorbitant rates That can happen if depositors panic and pull out their money, or if other banks refuse to renew loans, or if no one wants to buy the bank's bonds During the recent crisis, the Fed found enious ways to allow banks to borrowanyone who lent to the banks that he would not lose his overnment backstopped most components of the liability side of the balance sheet: it replenished equity claiuaranteed the deposit liabilities and fully guaranteed the unsecured debt of banks

But what about the other side of the balance sheet, the assets? The Fed can do everything within its power to make it easy for the banks to borrow money, but if the bank's assets are worth less with every passing day, then the bank's capital or net worth declines too When a bank's liabilities outstrip its assets, the bank's net worth sinks to zero It is insolvent, or bankrupt

As the recent financial crisis worsened, many of the assets that banks had on their balance sheets did start to lose their value Some of those assets were loans that went bad; others consisted of the securities derived froes and other loans As hoes and these losses rippled throughout the financial food chain, the value of everything from loans to local real estate developers to collateralized debt obligations started to fall And as the value of these assets fell, the re capital withered away

Banks in the United States and Europe therefore needed to raise overnn wealth funds, which purchased newly issued ”preferred shares” Their naive the investors any voting rights; they ave them a certain share in the banks' current and future profits Money flowed into the banks' coffers and temporarily restored them to some measure of health But asset values continued to decline, so banks raisedshares to theh In the fall of 2008 the value of bank assets continued to fall, and no one was interested in pu any more capital into banks

At this point, policy makers had a number of options They could have let the banks (and other nonbank financial institutions, such as bank holding companies and broker dealers) fail Thereafter they would have been restructured in or out of court or through the FDIC receivershi+p process Typically, when that happens, some of a bank's unsecured creditors-its bondholders, for exaree to convert some of the money that the bank owes them into shares, or equity in the bank These ”debt-for-equity swaps” are not exactly a bargain for anyone the bank owes : those who have lent it et a stake in it once it resumes operations And it will be able to resuive part of its debt, its liabilities decline relative to its assets Voila! Now the bank has so

This approach is the equivalent of letting the s out Bad banks fail, are restructured, and are reborn The saovernment unilaterally declare certain banks insolvent and then take theovernood assets, dispose of the bad ones, and relaunch the bank This was the ”nationalization” option that Sweden used in its own banking crisis in the early 1990s, and the United States effectively used when it took over Continental Illinois, a big bank that fell in advance of the savings and loan crisis

But in the recent crisis neither of these approaches got a serious hearing, and after the failure of Leh bondholders shoulder any losses lost its appeal Instead, the Treasury opted to use soislation to buy stakes in banks and thereby ”inject” capital into theest beneficiaries included behean Chase, Goldiven tens of billions of dollars Hundreds of other, sovernovernment-and by extension, the Ae swaths of the financial syste, partial nationalization of the financial syste-terest banks have already paid back the TARP funds at this writing, and the government has divested itself of those institutions Others-including ional banks-remain dependent on TARP and nificant fiscal costs on future taxpayers

For the banks that have yet to return the money, the core problem remains the sa a pall over their financial future The govern its equity stake in the banks, but absent soe in the banks' asset base, that could turn out to be throwing good money after bad

Toxic Waste

The question of what to do with the banks' bad assets has loo as loans continued to sour, and as long as securities derived from those loans continued to lose value, the banks would be unable or unwilling to lend Rather than letting the banks continue to struggle with these toxic assets, policy makers floated a variety of proposals, all of which had the ai the banks free to resu proposal called for banks to undergo radical surgery This would entail taking a troubled bank and splitting it into two banks: a ”good” bank that included all the solid assets, and a ”bad” bank that contained everything else The good bank could then go on to make loans, attract e for ridding it of the toxic waste, the bank's shareholders and unsecured creditors would take a loss proportionate to the assets spun off into the bad bank In turn, the bad bank would be run by private investors who hoped to profit from the orderly liquidation of its assets

A version of this scenario was iot itself into trouble after a host of its real estate and industrial loans went bad Using financing from an investment bank, Mellon extracted its dubious assets and deposited the called the Grant Street National Bank Private investors with an appetite for risk capitalized the new institution, whose e bad loans, liquidating the assets, andthe return on these bum investments Unburdened of its bad assets, the newly reborn Mellon was back on its feet in short order; it attracted capital and began to ain Grant Street National Bank completed its work in 1995 and then shut its doors

That's arguably the most effective way to deal with the probleoverninal TARP plan The price it paid would be set by a ”reverse auction,” in which the sellers would ”bid” by posting the lowest possible price they would accept in exchange for ridding theovern a particular project: in theory, the co bidders helps drive prices doard

It's an interesting idea, but it's debatable whether this system would really price the assets fairly The banks participating in the auction would have every reason to resist seeing prices pluht even cooperate or collude with one another to make sure that this didn't happen Moreover, many of these assets-particularly structured financial products-are rather unique, held by only a handful of banks That seriously undercuts the reverse auction's pricing power For all these reasons, the govern for these assets and taking a significant loss on its invest the functional equivalent of a bank bailout, subsidizing the bad investment decisions of the banks with taxpayer overnment to for banks Let's say a bank has toxic assets originally worth soree to pay a deductible-for exaovernment would cover47 billion In exchange for getting a guarantee that it would take a hit ”up front” of only 3 billion, the bank would pay the governovernment could receive an equity stake in the bank equivalent to any losses above and beyond that first 3 billion

A version of this approach has been widely adopted in the United Kingdouaranteed several hundred billion dollars' worth of iroup Here's hoorks in practice In Bank of America's case, the pool of troubled assets totaled 118 billion, with a ”deductible” of 10 billion After taking that first hit, Bank of Ah it had to pay ”coinsurance” covering 10 percent of any additional losses; the governovernnificant equity stake in the bank

While preferable to a reverse auction, this approach still runs the risk of overnment subsidize the losses incurred by private banks In the Bank of Aovernment has assumed that it won't have to ”insure” oing to pay But if the cost of insuring those losses outstrips whatever revenue the govern into the deal, the end result will be the saovernovernment will lose money on the deal and subsidize the bad decisions of private bankers Taxpayers will foot the bill

For now, the proble with bad assets seems to lie with another approach The basic idea is to have the governree to purchase the toxic assets and thus remove them from troubled banks This is the idea behind the Public-Private Investram (PPIP, better known as ”Pee-Pip”), which went into operation in 2009 It's arguably one of the weakest ideas of the bunch The trillion-dollar prograives low-interest loans to private investors ant to bid at auctions in which banks sell their toxic assets The govern to inject capital into institutions that take part in this process

Unfortunately, these low-interest govern that in the event that things go badly, investors can walk away from them without penalty In practice investors have every incentive to overbid; after all, the governovernment is also the one stuck with the asset if it turns out to be a bulory and the profits when things go well, while the government-or more accurately, the taxpayer-shoulders the fiscal burden when things go awry

So far PPIP hasn't attracted overnment has effectively subsidized the banks in another way: by sanctioning the reulations that would have forced the real-world market value Thanks to this intervention, banks have been able to pretend that their crappy assets are worth far est It's like putting lipstick on a pig, but as long as the assets can be overvalued for accounting purposes, banks have little interest in unloading them

None of these approaches are perfect, but so off dud assets into a ”bad bank” This approachthe problem in private hands It also holds the line on ain But it requires that investors take a loss, with the pain felt now rather than later At the present tiness on the part of policy s up front That's unfortunate: kicking the can down the road runs the risk of letting banks slowly sink into a financial co zombies dependent on public credit

In retrospect, that dependency reached astonishi+ng levels In the course of the crisis, governments threw lifeline after lifeline They injected capital into banks and other financial firms and broadened the scope of deposit insurance They even insured the debt of banks, preventinghavoc on their creditors Theseoffer to buy up banks' illiquid assets for cash, or alternatively, to exchange theovernuarantee the toxic assets of sorams to directly or indirectly purchase those assets All this a, unprecedented intervention in the financial system Unfortunately, for all the obstacles that policythe financial systeenuine recovery

The Aftermath

In the early 1930s a financial crisis spawned a relentless cycle of deflation and depression Thousands of banks in the United States went under; three quarters of households with es defaulted; unemployment soared The help that arrived with FDR's New Deal was belated, and the econonated Many other countries followed a sih the rest of the 1930s until war ushered in recovery for some and destruction for others