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Nouriel Roubini: Bailout benefits only banks and their unsecured creditors
There were many other options.
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By Nouriel Roubini
Roubini's Global EconoMonitor
Sunday, September 28, 2008
Is purchasing $700 billion of toxic assets the best way to recapitalize the financial system? No. It is rather a disgrace and ripoff benefitting only the shareholders and unsecured creditors of banks.
Whenever there is a systemic banking crisis there is a need to recapitalize the banking/financial system to avoid an excessive and destructive credit contraction. But purchasing toxic/illiquid assets of the financial system is not the most effective and efficient way to recapitalize the banking system. Such recapitalization -- via the use of public resources -- can occur in a number of ways: purchase of bad assets/loans; government injection of preferred shares; government injection of common shares; government purchase of subordinated debt; government issuance of government bonds to be placed on the banks' balance sheet; government injection of cash; government credit lines extended to the banks; and government assumption of government liabilities.
A recent International Monetary Fund study of 42 systemic banking crises across the world provides evidence on how different crises were resolved.
First of all, only in 32 of the 42 cases was there government financial intervention of any sort; in 10 cases systemic banking crises were resolved without any government financial intervention. Of the 32 cases where the government recapitalized the banking system, only seven included a program of purchase of bad assets/loans like the one proposed by the U.S. Treasury. In 25 other cases there was no government purchase of such toxic assets. In six cases the government purchased preferred shares; in four cases the government purchased common shares; in 11 cases the government purchased subordinated debt; in 12 cases the government injected cash in the banks; in two cases credit was extended to the banks; and in three cases the government assumed bank liabilities.
Even in cases where bad assets were purchased -- as in Chile -- dividends were suspended and all profits and recoveries had to be used to repurchase the bad assets. Of course in most cases multiple forms of government recapitalization of banks were used.
But government purchase of bad assets was the exception rather than the rule. It was used only in Mexico, Japan, Bolivia, Czech Republic, Jamaica, Malaysia, and Paraguay. Even in six of these seven cases where the recapitalization of banks occurred via the government purchase of bad assets, such recapitalization was a combination of purchase of bad assets together with other forms of recapitalization (such as government purchase of preferred shares or subordinated debt).
In the Scandinavian banking crises (Sweden, Norway, and Finland), which are a model of how a banking crisis should be resolved, there was not government purchase of bad assets. Most of the recapitalization occurred through various injections of public capital in the banking system. Purchase of toxic assets instead -- in most cases in which it was used -- made the fiscal cost of the crisis much higher and expensive (as in Japan and Mexico).
Thus the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification. This way of recapitalizing financial institutions is a total ripoff that will mostly benefit -- at a huge expense for the U.S. taxpayer -- the common and preferred shareholders and even unsecured creditors of the banks. Even the late addition of some warrants that the government will get in exchange for this massive injection of public money is only a cosmetic fig leaf of dubious value, as the form and size of such warrants is totally vague and fuzzy.
So this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the financial firms (not just banks but also other non- bank financial institutions). With $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. Instead, the restoration of the financial health of distressed financial firms could have been achieved with a cheaper and better use of public money.
Indeed, the plan also does not address the need to recapitalize those financial institutions that are badly undercapitalized. This could have been achieved by using some of the $700 billion to inject public funds in ways other and more effective than a purchase of toxic assets: via public injections of preferred shares into these firms; via required matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first-tier loss in the presence of public recapitalization; via suspension of dividends payments; and via a conversion of some of the unsecured debt into equity (a debt-for-equity swap). All these actions would have implied a much lower fiscal costs for the government as they would have forced the shareholders and creditors of the banks to contribute to the recapitalization of the banks.
So less than $700 billion of public money could have been spent if the private shareholders and creditors had been forced to contribute to the recapitalization. And whatever the size of the public contribution, its distribution between purchases of bad assets and more efficient and fair forms of recapitalization (preferred shares, common shares, sub-debt) should have been different.
For example, if the private sector had done its fair matching share, only $350 billion of public money could have been used; and of this $350 billion half could have taken the form of purchase of bad assets and the other half should have taken the form of injection of public capital in these financial institutions. So instead of purchasing -- most likely at an excessive price -- $700 billion of toxic assets, the government could have achieved the same result, or a better result of recapitalizing the banks, by spending only $175 billion in the direct purchase of toxic assets. And even after the government will waste $700 billion buying toxic assets, many banks that have not yet provisioned for such losses and writedowns will be even more undercapitalized. So this plan does not achieve even the basic objective of recapitalizing undercapitalized banks.
The Treasury plan also does not explicitly include an Home Owners Loan Corporation-style program to reduce across the board the debt burden of the distressed household sector. Without such a component, the debt overhang of the household sector will continue to depress consumption spending and will exacerbate the current economic recession.
Thus, the Treasury plan is a disgrace -- a bailout of reckless bankers, lenders, and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown.
It is pathetic that Congress did not consult any of the many professional economists who have presented alternative plans that were more fair and efficient and less costly ways for resolving this crisis. This is again a case of privatizing the gains and socializing the losses, a bailout and socialism for the rich, the well-connected, and Wall Street. And it is a scandal that even congressional Democrats have fallen for this Treasury scam, which does little to resolve the debt burden of millions of distressed home owners.
Nouriel Roubini is professor of economics at the Stern School of Business at New York University.
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