WITH luck, the American government’s bank recapitalization plan will save the financial system, but it is probably too late to save the economy from succumbing to the combined impact of shrinking wealth and the credit crunch.
American officials unveiled a three-part rescue programme on Tuesday October 14th. Under the first part, the Treasury will inject as much as $250 billion into American banks, with roughly half initially going to nine big institutions. The capital would come in the form of non-voting preferred stock. Under the second part, the Federal Deposit Insurance Corporation (FDIC) would guarantee unsecured borrowing by banks for maturities of up to three-and-a-half years, at a relatively modest cost of 75 basis points. That would include interbank loans. Under the third part, the FDIC would guarantee without limit small-business bank deposits that do not pay interest. Also on Tuesday the Federal Reserve gave more details of its previously-announced commercial paper backstop programme, which should ease borrowing for big nonbanks, such as GE Capital.
The plan is undoubtedly bold: it marks perhaps the largest foray by the American government into ownership of private enterprise since the second world war. But it would have looked much bolder a month ago. As it is, America has only caught up to where Germany, France and especially Britain (in that case, last week) had already reached. To a great extent, Hank Paulson, the treasury secretary and Ben Bernanke, the Federal Reserve chairman, are making up for what were, in retrospect, miscalculations in their earlier efforts.
The early evidence is reassuring. The historic stock market rally on Monday, though it petered out on Tuesday, will impress the retail audience of small investors and politicians. But the more important verdict is from the wholesale audience in the credit markets, which has been encouraging. Borrowing costs for big financial institutions plunged on Tuesday, as measured by credit-default swap spreads. Libor, the rate at which banks lend to each other, also dropped, although it remains stratospheric. “This is definitely the end as far as the systemic aspect to the credit system goes,” said Gregory Peters, head of fixed income at Morgan Stanley.
Even if true, that will not alleviate the downward pressure on the economy. Bank lending is still constrained by a lack of balance-sheet capacity: banks have been forced to boost loans to companies that are shut out of the commercial-paper market while setting aside more capital for future loan losses.
The new capital injections should help. In theory $250 billion of new capital leveraged by ten-to-one could support $2.5 trillion of assets in banking system, serious money when total loans to non-financial corporations, households and state and local governments in America stood at $27 trillion on June 30th. But it is unlikely to spur a big expansion in new loans. Much of the credit restraint comes from nonbanks such as the captive finance-arms of carmakers. Moreover, fewer householders can meet the stricter underwriting standards that now prevail because they have lost the equity in their home, or their jobs. “The combination of declining wealth and a sharp tightening of credit availability is likely to induce a substantial recession in consumer spending,” said Peter Hooper and Thomas Mayer of Deutsche Bank on Tuesday. They project zero growth for America in 2009 and outright contraction for every other G7 country apart from Canada.
The programme should overcome the errors that, with hindsight, hampered earlier efforts to tackle the crisis. The most prominent was the decision to let Lehman Brothers fail. That sparked a run on money-market funds which held Lehman paper, and forced deleveraging by customers and counterparties who had trading positions with Lehman. It dramatically raised in investors’ minds the odds that other big banks could also fail, and those fears risked becoming self-fulfilling as their stock prices plunged, credit spreads exploded and lenders and depositors fled. The bank-loan guarantee and expanded deposit-insurance limits should eliminate that risk.
The authorities’ second mistake was to treat the crisis as one principally of liquidity rather than solvency and thus to focus on solutions that did not directly rebuild capital in banks. The focus was understandable: in aggregate American banks are well capitalised and it is not clear how many would have voluntarily accepted public injections of equity. Fed officials had discussed ways the government could inject preferred equity into banks that also issued common stock as far back as June. But Mr. Paulson worried that Congress would say no and in the process alarm markets more, according to some officials. A person close to the Treasury says that Mr. Paulson and Mr. Bernanke were in agreement on how to proceed. In any event, Mr. Paulson made sure the bail-out law implicitly allowed such injections. But not until the law passed and panic ensued did he conclude it was necessary, and Britain’s dramatic recapitalization plan last week all but forced his hand.
Thirdly, the plan marks a move away from ad hoc interventions towards a comprehensive solution. In contrast to earlier rescues for AIG, Bear Stearns, Fannie Mae and Freddie Mac, the recapitalizations announced on Tuesday are designed to encourage new private capital infusions, rather than punish shareholders. Under the terms announced on Tuesday, the Treasury will receive preferred stock on the same terms as other preferred shareholders and warrants for common stock equal to 15 percent of the preferred stock, convertible at the trailing 20-day average stock price when the preferred stock is issued. The preferred stock will pay a 5 percent dividend for the first five years, and 9 percent thereafter. Those are hardly onerous: they are less than the 10 percent yield Morgan Stanley will pay Mitsubishi UFJ Financial Group and that Goldman Sachs will pay Warren Buffett for their preferred-stock investments. The banks can buy back the Treasury’s stake after three years, sooner if they issue sufficient stock of their own.
While the American recapitalization plan has been called “voluntary,” some industry officials said they felt pressured to go along with it. Government officials dispute that: Mr. Paulson and Mr. Bernanke did appeal to bankers’ collective self interest and the importance of everyone participating, but had no power to compel them. In any case, the plan is hardly ungenerous: one official notes that even the strongest of the banks is getting capital more cheaply than in the market. The government will also keep its hands off management, and if it receives common stock, it will not vote with it. Bosses must abide by pay restrictions contained in the bail-out law, but none are being shown the door. While the British government has imposed lending targets on the banks that receive its capital, Mr. Paulson has settled for moral suasion. “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it,” he implored.
Aggressive as these actions are, they may not be the last. As the world falls into recession, loan losses will mount and banks may need yet more capital. Some emerging markets may be on the brink of another crisis on the scale of 1997-98. After 14 months, the defining characteristic of this financial crisis has been its tendency to change shape and return in ever more virulent form. But if the corner really has been turned, then attention in America will turn to the consequences of the bail-out, in particular: how will future administrations handle the responsibilities and temptations that come with being a big financial stakeholder? That only raises the economic stakes for the presidential and congressional elections.