Capitalism in Transition? C.P. Chandrasekhar

After much dithering, high drama and every effort to avoid the inevitable for fear that it would straightjacket capitalism, governments in the developed industrial countries have taken the first, major, necessary step to begin resolving the financial crisis. They have, effectively, nationalized a large part of the private banking system.

These moves come at the end of a long series of interventionist efforts that pointed in two directions. First was that governments believed that the problem facing the financial sector in the wake of the subprime crisis was not one of generalised insolvency, but one of inadequate liquidity resulting from fear and uncertainty. The second was that to the extent that there were individual firms faced with insolvency, the problem could be resolved on a case by case basis, through closure (Lehman), merger (Wachovia) or state take over (American International Group). It was only when efforts based on these perceptions failed to stop the slide that measures to deal with generalised insolvency, such as buying out all impaired assets or recapitalizing banks with public investment were resorted to. But even these are focused on the banking system. In a world where non-bank financial institutions play an extremely important role and the banks themselves are integrated in various ways with these institutions, it is unclear whether these steps would be enough.

The perception that the problem was one of liquidity because financial markets were freezing up given the difficulty of assessing counterparty risk yielded a host of responses, especially in the US, that filled the media with acronyms: MLEC (Master Liquidity Enhancement Conduit), TAF (Term Auction Facility), TSLF (Term Securities Lending Facility) and PDCF (Primary Dealer Credit Facility). By the end of it the Federal Reserve in the US had offered to accept as collateral the bundles of worthless assets that were lying with financial firms, and extend its credit facilities to entities outside the regulated banking system. Interest rates too had been substantially cut to make credit cheaper. When even this was not yielding the expected results and halting a slide in stock markets, recognition that other measures were needed dawned. Some effort at dealing with insolvency was called for.

But even this was initially half-hearted and pursued on a case-by-case basis. Further, the attitude was different across cases. JP Morgan Chase was paid off to take over Bear Stearns cheap. Lehman was allowed to go. Fannie Mae and Freddie Mac were nationalized. AIG was rescued with a huge infusion of public funds, triggering allegations of conflict of interest on the grounds that this was an effort at protecting Goldman Sachs that was substantially exposed to the insurer. Treasury Secretary Paulson came from Goldman and still holds a significant stake in the firm. But as the number of cases multiplied and the lack of a clear strategy became obvious, the danger of a financial collapse intensified.

This was when the first signs of recognition that there was a problem of potential generalised insolvency emerged. The first response was TARP (Troubled Assets Relief Program). Declaring that the system was faced with financial collapse of a kind that could drive the economy to recession, the Treasury Secretary backed by the Chairman of the Federal Reserve, badgered Congress into authorising a $700 billion bailout package, which was primarily geared to buying out the near-worthless or “impaired” mortgage-related assets from financial institutions, as also any other assets from any other party so as to “unclog” their balance sheets and get credit moving.

This plan too did not clearly recognise that generalised insolvency was a potential problem. This was clear from the fact that the bailout plan sought to use market-based methods to buy up troubled assets. Since the prevailing market price of those assets was close to zero, this would imply that the institutions selling those assets would have to take large write-downs onto their balance sheets and reflect these losses. This would undermine their viability and result in failure unless they were recapitalised with an infusion of new funds.

It was the UK, having experimented with liquidity infusion and limited nationalisation, which first went beyond the Bush administration. Gordon Brown announced that his government would resort to an “equity injection” to buy ordinary and preference shares worth £37 billion in three of the biggest banks in the country: Royal Bank of Scotland, Lloyds TSB and HBOS.

Existing shareholders have the option of buying back the ordinary shares from the government. But if they do not, as seems likely, then the government would have a stake of 60 per cent in RBS and 43.5 per cent in the combined entity that would emerge after the ongoing merger of Lloyds TSB and HBOS. This clearly amounts to State takeover, which brings with it new obligations. The three banks will not be able to pay dividends on ordinary shares until they have repaid in full the £9bn in preference shares they are issuing to the government. The Treasury would appoint 3 new RBS directors and 2 directors to the board of the combined Lloyds-HBOS to oversee the government’s interests. And there would be restrictions on executive salaries and bonuses that had ballooned during the years of the speculative boom.

The decision to nationalize was forced on the UK government because the problem facing the banking system was not just one of inadequate liquidity resulting from fears generated by the subprime crisis. Rather credit markets had frozen because the entities that needed liquidity most were those faced with a solvency problem created by the huge volume of bad assets they carried on their balance sheets. To lend to or buy into these entities with small doses of money was to risk losses since that money would not have covered the losses and rendered these banks viable. So money was hard to come by. This is disastrous for a bank because rumours of its vulnerability trigger a run that devastate its already damaged finances.

What was needed was a large injection of equity to recapitalize these banks after taking account of losses. Wherever the sum involved was small, a private sector buyer could play the role, otherwise the State had to step in. Thus, in the case of some banks recapitalization through nationalization was unavoidable because, as UK chancellor Alistair Darling put it, “this is the only way, when markets are not open to certain banks, they can get the capitalisation they need”. Others such as Barclays hope they can attract private investors so as to avoid being absorbed by the government. It expects to raise £6.6 billion from private investors, but the prospects are not certain given the fact that it has decided not to pay a final dividend in 2008, so as to save £2 billion. That may not be the best signal to send to prospective investors.

What needs to be noted, however, is that nationalization is not the end of the matter. In addition, the UK government has chosen to guarantee all bank deposits, independent of their size, to prevent a run. It has also decided to guarantee inter-bank borrowing to keep credit flowing as when needed.

Once the UK decided to take this radical and comprehensive route, others were quick to read the writing on the wall. What followed was a deluge. Germany with an estimated bill of €470 billion, France with €340 billion, and other governments with as yet unspecified amounts pitched in, with plans to recapitalize banks with equity injections, besides guaranteeing deposits and inter-bank lending. The banking system was being saved through State take-over, not just with State support.

Finally, the US, which was seeking to avoid State acquisition fell in line, but in a form the shows the influence that Wall Street exerts over the Treasury .  It too has decided to use $250 billion of the bailout money to acquire a stake in a large number of banks. Half of that money is to go to the nine largest banks, such as Bank of America, Citigroup, Wachovia and Morgan Stanley. The minimum investment will be the equivalent of one per cent of risk-weighted assets or $25 billion—whichever is lower. With capital adequacy at a required 8 per cent, this is indeed a major recapitalisation. Further the government, through the Federal Deposit Insurance Corporation, is guaranteeing all deposits in non-interest bearing accounts and senior debt issued by banks insured by the FDIC.

However, Wall Street’s influence has ensured that this intervention is biased in favour of Big Finance. The support comes cheap: banks will pay a dividend of just 5 per cent for the first five years, only after which the rate jumps to 9 per cent. During that time, they have the option of mobilising private capital and buying out the government. Interestingly, the government is not taking voting rights and would be able to appoint directors only if the bank misses dividend payments for six quarters. While there are restrictions on payment of dividends to ordinary shareholders before clearing the government’s claims and limits on executive compensation, the government only reserves the right to convert 15 per cent of its investments into common stock. In sum, the American initiative overseen by Henry Paulson, an old Wall Street hand from Goldman Sachs, has virtually cajoled the banks to accept a government presence, unlike what seems true in the UK and Europe.

Whether it is occurs in part-punitive fashion or as a sop, the back-door takeover of major private banks is a desperate attempt to stall the financial meltdown in the advanced economies resulting from the decision to allow private financial players unfettered freedom to pursue profits at the expense of all else. While this threat has forced governments to drop their neo-conservative bias against State ownership and markets that hollered at government intervention in the past have now applauded such action, the threat of recession has not receded. Even if the banks are safe, though there is no definite guarantee as yet, there are many other institutions varying from hedge and mutual funds to pension funds that have suffered huge losses, both from the subprime fiasco and the stock market crash, eroding the wealth of many. Moreover, housing prices are still falling sharply. The effects of that wealth erosion on investment and consumption demand are only now unravelling, indicating that there is much to be told in this story as yet. What may be necessary is one step more – the refinancing of mortgages to stop the foreclosures that underlie the financial crisis.