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The US once more became the lender of last resort for its banks and industries battered by the subprime crisis, extending a $85 billion bridge loan to global insurer AIG. Immediate danger averted, the American banking system is now in uncharted territory with bigger problems lurking ahead.

The AIG rescue came in a year that had seen the US Treasury and the Federal Reserve negotiate and orchestrate a series of costly rescues, each centering on the sub-prime crisis: Bear Stearns, Fannie Mae and Freddie Mac, and now AIG. Only Lehman Brothers was allowed to fail. The unorthodox US action, presented as designed to protect the world economy, may not close the curtain on the subprime fiasco and could prove to be the opening act of a different crisis.

Easy credit allowed housing prices to bubble, and investors assumed that mortgages were safe havens for their savings. A pattern has emerged of undercapitalized companies holding notes associated with the housing market, and federal officials coming to the rescue of several banks and companies, designating them as too big to fail. But in the process, the Federal Reserve could be encouraging companies to take risks and recklessly expand, sending signals that the US will come to rescue of anything “too big to fail.”

First, investment banks Bear Stearns and Lehman Brothers got into trouble. Bear had entered into derivative contracts for more than $13 trillion and had assets of more than $350 billion with net equity capital, excluding hard-to-value assets, of $12 billion. As it quickly sank, the Federal Reserve used billions of Bear’s risky mortgages and securities as collateral to arrange a takeover by JP Morgan for a fraction of Bear’s former value and prevent a market meltdown.

Lehman had bought a lot of highly leveraged real estate and mortgage debt. As values of these assets sank, their 3 percent worth of capital was wiped out. With only $600 billion in total assets and fewer derivative contracts, the Fed and Treasury decided that a failure would be manageable and did not commit federal funds. Lehman filed for bankruptcy. A third investment bank, Merrill-Lynch agreed to be taken over by Bank of America, a huge commercial bank, in a share exchange initially valued at $50 billion – though BOA’s share price fell after the deal was announced.

Fannie Mae and Freddie Mac are government-sponsored private firms created to promote a liquid market in mortgages and mortgage securities for homeowners. They owned or backed more than $5000 billion of these securities with a capital ratio of under 3 percent. Because home prices were falling and other players withdrew, these two firms accounted for most mortgages written and sold in 2008. When it became clear that their assets might be worth much less than their debts, the costs of borrowing rose and the Treasury moved in and put them into receivership. It’s unclear how much it will cost to ensure their debt is honored. The shareholders and preferred shareholders will lose most of their investments.

AIG is one of the largest insurance companies in the world with assets of more than $1000 billion. It misjudged the risk on insurance for derivative contracts and these losses impinged on their capital base of 8 to 9 percent. The New York state and federal authorities have discussed what kind of loans, by whom and on what terms, might be made to keep AIG operating. Because they have more capital, a profitable business and deep connections to other financial players, the Federal Reserve decided to arrange for up to $85 billion in loans to keep the firm afloat and will acquire four-fifths of the company! Because the AIG insurance covered trillions of dollars of debt instruments, the Fed and Treasury judged that its bankruptcy would cause chaos in world financial markets and cause more damage than the dangers raised by the bailout.

Financial institutions around the world connected with AIG might heave a sigh of relief, but those not working on Wall Street have reason to worry.

First of all, when banks lose capital they lose their ability to lend. Most commercial banks lend $10 for each $1 of capital. For investment banks, the amounts invested or lent can be $20 or $30 per dollar of capital. The International Monetary Fund estimates that total losses of financial firms could amount to $1 trillion, with perhaps half of that total already observed.

To the extent that these losses fall on financial firms rather than on funds held by those firms and to the extent that new investors do not make up the capital losses, the world economy can expect a credit crunch. That is, lending will shrink by trillions of dollars. This means that new investment, new jobs and income growth will be much less than previously projected. Many borrowers – even with good credit records – will not be able to get a loan at all. Growth around the world will slow and may reverse.

Unless a lot of investors are found to increase the capital of banks, it will take time to build up new capital and lending. The Treasury implored banks to buy preferred shares – lower return but supposedly safer – of Fannie and Freddie in the last year and then imposed losses on them. Few investors want to repeat that experience! The Fed will try to help by keeping short-term rates low and long-term rates higher, but that is in effect a tax on savers at a time when there’s too little overall savings in the US, especially given the high level of federal deficits. It will not be easy to get out of these difficulties quickly.

Secondly, there’s the question of what Wall Street will look like after the dust settles. It’s clear that many banks were over-leveraged and under-regulated, or at least not well regulated. There will be fewer investment banks, less leverage and more regulation in return for more access to Federal Reserve borrowing.

But over time, there’s a tendency for regulated firms to lobby so as to weaken the regulators. Fannie and Freddie did this, helping to ensure they could grow very large with little capital or effective oversight, even while many experts warned of the risks of their expansion. Investment banks persuaded Congress in 1998 to repeal Glass-Steagall, the Depression-era law that separated commercial and investment banking.

So, it’s quite possible that the steps taken to prevent another crisis will weaken. The US will have fewer banks with more access to Federal Reserve borrowing. More will become “too big to fail.” In that case, the danger of moral hazard and large-scale crises could be even greater. Will taxpayers decide that the next crisis is worth managing or just too expensive?

Third, there’s the question of who else will line up for loans. If financial firms can be bailed out, why not auto companies? They’ve lobbied against higher fuel efficiency standards for decades and now want $50 billion in federal loans to build fuel-efficient factories – though they already build more efficient vehicles overseas. Farmers and processors already get ethanol and crop subsidies. Shipping, renewable energy and utility companies will no doubt ask for subsidies and loans, too. But with a large federal deficit and looming health and pension burdens, it’s not at all clear that even existing commitments can be met.

Then there are millions of homeowners facing home foreclosure. They will ask why big firms can get help while they lose their homes. By attempting to offset the impact of creating hundreds of billions of dollars of toxic debt, the US has opened a Pandora’s box, and can expect many troubles to emerge before finding hope at the bottom.

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