Chart 1: Worldwide Bank Write-downs and Credit Losses versus Capital Raised ($ billion)

993

1000

800

600

400

200

0 Asia Europe Americas World

51 31 318 292 548 670 918 Capital raised Write-downs

Source: World Economic Forum 2009, Figure 15.

mortgage-backed securities. It was assumed that banks were entities which had either stayed out of the markets for risky retail loans or had transferred such risks out of their balance sheets by securitising those loans and selling them on to others. Hence, the banking system, the core of the financial sector, was seen as relatively free of the disease the sub-prime crisis came to epitomise. Over time it became clear that the exposure of banks to these mortgage-backed and other asset-backed securities and collateralised debt obligations was by no means small. Because they wanted to partake of the high returns associated with those assets or because they were carrying an inventory of such assets that were yet to be marketed, banks had a significant holding of these instruments when the crisis broke. A number of banks had also set up special purpose vehicles for creating and distributing such assets which too were holders of what turned out to be toxic securities. And, finally, banks had lent to institutions that had leveraged small volumes of equity to make huge investments in these kinds of assets. In the event, the banking system was indeed directly or indirectly exposed to these assets in substantial measure. Not surprisingly, it is now clear that banks too are afflicted by losses on derivatives of various kinds, resulting in write-downs that have wiped out their base capital.

How Large Are the Losses?

Estimates of the losses banks have sustained and the volume of bad assets they carry on their balance sheets vary. In its update to the Global Financial Stability Report for 2008 (International Monetary Fund 2009), issued on 28 January 2009, the IMF had estimated the losses incurred by US and European banks from bad assets that originated in the US at $2.2 trillion. Barely two months earlier, it had placed the figure at $1.4 trillion. Loss estimates seem to be galloping and we are still counting.

Projections of likely total losses are even larger. On 21 January 2009, Nouriel Roubini and Elisa Parisi-Capone had in their RGE Monitor projected that global loan losses and write-downs on USoriginated securitisations would total $1.6 trillion on $12.37 trillion in unsecuritised loans (Agence France-Presse 2009). About $1.1 trillion of this is estimated to be incurred by US banks and brokerages. Another $2 trillion will have to be written off because of a fall in the value of financial holdings currently estimated at $10.84 trillion. US banks and brokers possibly carry

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losses of $600 billion to $700 billion out of this amount. As a result, the total losses of the financial system were estimated at $3.6 trillion, half of which were borne by US firms. If these assessments by Roubini and Capone are correct, the losses would overwhelm the US financial system, which, according to them, had a capitalisation of $1.3 trillion in commercial banks and $110 billion in investment banks as of the third quarter of 2008.

It needs noting that the equity base of most banks is relatively small even when they follow Basel norms with regard to capital adequacy. Banks can use a variety of assets to ensure such adequacy and the required volume of regulatory capital can be reduced by accumulating assets with high ratings (which we now know are not adequate indicators of risk). This results in the available regulatory capital being small relative to the risky asset-backed securities held by the banks, which in turn could lead to insolvency.

The IMF estimates that global banks that have already obtained much support, including capital, from governments would need further new capital infusions of around half a trillion to stay solvent. With that much and perhaps more capital going in, the case for public ownership of banking would be strong in some countries. By late January 2009, Bloomberg estimates, banks had written down $792 billion in losses and raised $826 billion in capital, of which $380 billion came from governments (quoted in IMF 2009: 2). Across the world, write-downs and capital raised as of 15 December 2008 have been estimated at $993 billion and $918 billion respectively, with the figures for US and Europe as of mid-December being $548 billion and $678 billion and $292 billion and $318 billion, respectively (World Economic Forum 2009 and Chart 1). The high level of capital raised in Europe relative to losses written down may be because of the faster moves by governments in the UK and Europe, especially the UK, Ireland and Iceland, to shore up bank balance sheets.

Interconnectedness

The infusion of capital and the government’s presence in the banking sector is expected to increase because the recognition of losses tends to be gradual. The difficulty with bad derivative assets is that they have to be valued on mark-to-market principles. Since these assets are not all being traded, valuation is difficult and there is a lag in the recognition of the losses suffered through holding such assets. In the US, the process of price discovery began a long time ago when in August 2007 Bear Stearns declared that investments in one of its hedge funds set up to invest in mortgage backed securities had lost all their value and those in a second such fund were valued at nine cents for every dollar of original investment. Despite that early discovery, even by the beginning of 2009, loss estimates were still rising.

The Bear Stearns experience made clear that once losses are discovered even in an investment bank, the implications are systemic. Bear Stearns was a highly leveraged institution. In November 2007 it had $11.1 billion in tangible equity capital, which supported investments in $395 billion of assets, reflecting a leverage ratio of more than 35 to one (Boyd 2008). And its assets were reportedly less liquid than those of many of its competitors. Thus it was not just that the assets held by the investment bank were

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bad, but that there were many other institutions, including banks, that were exposed to bad assets through their relationship with Stearns. Yet, they were slow in recognising their potential losses. It is for this reason that the US government chose to “save” Bear Stearns by initially offering it an unlimited loan facility delivered through Wall Street Bank J P Morgan Chase, and then getting the latter to acquire the firm. As many recognised then, Bear Stearns was too “interconnected” to be allowed to fail at a time when financial markets were extremely fragile.

However, this lesson had not been learnt in full. When in September 2008, troubled Lehman Brothers Holdings Inc, the fourth largest investment bank on Wall Street, came to the table with requests for support, it was refused the same. This refusal of the state to take over the responsibility of managing failing firms was supposed to send out a strong message. Not only was Lehman forced to file for bankruptcy, but a giant like Merrill Lynch, which had also notched up large losses due to sub-prime related exposures, decided that it should sort matters out before there were no suitors interested in salvaging it as well. In a surprise move, Bank of America, which was being spoken to as a potential buyer of Lehman, was persuaded to acquire Merrill Lynch instead, bringing down two of the major independent investment banks on Wall Street.

This was, however, only part of the problem that Lehman left behind. The other major issue was the impact its bankruptcy would have on its creditors. Citigroup and Bank of New York Mellon were estimated to have an exposure to the institution that

Table 1: First Phase TARP Commitments by Programme as of 23 January 2009 ($ billion)

i nstitution suspected that every other institution was insolvent and did not want to risk lending. The money was there but credit would not flow through the pipe, with damaging consequences for the financial system and for the real economy.

It was at this point that realisation dawned that what needed to be done was to clear out the bad assets with the banks. Among the smart ideas thought up for the purpose was the notion of splitting the system into “good” and “bad” banks. If a set of bad banks could be set up with public money, and these banks acquired the bad assets of the banks, the balance sheets of the latter, it was argued, would be repaired. The bad banks themselves could serve as asset reconstruction corporations that might be able to sell off a part of their bad assets as the good banks got about their business and the economy revived.

This idea missed the whole point, because it did not take account of the price at which the bad assets were to be acquired. If they were acquired at par or more, it would amount to blowing taxpayers’ money to save badly behaved bank managers, since the assets were likely to be worth a fraction of what they were actually bought for. On the other hand, if some scheme such as a reverse auction (or one in which sellers bid down prices to entice the buyer to acquire their assets) was used to acquire the bad assets, then the sale prices of these assets would be extremely low and the so-called good banks would incur huge losses which they would have to write down, leading to insolvency (Elliott 2009). The only way out, it appeared, was if these banks just wrote down their assets and were saved from bankruptcy by the government

through recapitalisation or the injec-

capital injection seemed unavoidable,

the spectre of nationalisation.

Source: SIGTARP 2009, Table ES.1, 6.

was placed at upwards of $155 billion. A clutch of Japanese banks, led by Aozora Bank, were owed an amount in excess of a billion. There were European banks that had significant exposure. And all of these were already faced with strained balance sheets (Finan cial Times Reporters 2008). Soon trouble broke in banking markets with a spurt of bank failures seeming inevitable. Though indications of this problem had emerged at least a year-and-ahalf earlier, what was surprising was that the full import of the problem at hand was not recognised. As noted earlier, the perception was that the problems faced by these institutions – inadequate liquidity in the market and the need to mark down asset values because of the temporary problem created by the subprime crisis – could be easily addressed.

The Road to Capital Infusion

In what followed, central banks pumped huge amounts of liquidity into the system and reduced interest rates. In the US, the Federal Reserve offered to hold the worthless paper that the banks had accumulated and provide them credit at low interest rates in return. But the problem would not go away. By then every

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it takes the form of loans to banks or investments in preferred stock with no voting rights or limited voting rights. In the US, for example, the $387 billion first phase of the $700 billion Trouble Assets Relief Program (TARP) involved capital injections in various forms through a multitude of schemes (Office of the Special Inspector General for the Troubled Asset Relief Program 2009). Principal among these for the bank rescue effort were the Capital Purchase Program (CPP), the Targeted Investment Program (TIP) and the Asset Guarantee Program (AGP). More than 300 banks participated in the first in which capital was infused through purchases of “senior preferred stock” and acquisition of warrants that gave the government the right but not the obligation to buy common stock at a pre-specified price. As a senior preferred stockholder, the government is paid a fixed percentage return (before common stockholders are paid dividends) of 5% for the first five years and 9% thereafter but does not have normal voting rights.1 Firms can buy back the stock at prices at which they sold them after three years. In return for buying preferred stock, the government would be issued warrants.2 In the case of the TIP and AGP too, which were directed specifically at Citigroup and Bank of America, preferred stock,

Tangible Common Equity

These forms of financing ensured that banks could be supported by the government without actual takeover through common equity purchase. However, it soon became clear that the adequacy of these forms of financing depended on the volume of losses and write-offs and the resulting capital infusion required. If these were large, preferred stock, for example, was not good enough. Such stock or even loans are senior in the capital structure and are not the immediate means of covering losses, because holders of those kinds of financial assets need to be compensated first when losses force liquidation of some assets. Only holders of common equity immediately absorb losses when incurred and need to be provided for. So it is the common equity base that gets eroded first and it is when capital of this kind is reasonably adequate that solvency is guaranteed. In the final analysis, solvency depends on tangible common equity (TCE) which not only excludes non-tangible assets (such as goodwill) from the measure of assets but also preferred stock, including shares issued to the US Treasury.

The TCE ratio measures the ratio of tangible common equity to total tangible assets, and depending on circumstances relating to the balance sheets of banks and their bottom lines, the required level of the TCE ratio for solvency could be high. Estimates of required TCE ratios, therefore, vary, but analysts hold that banks with TCE below 3% of assets should consider raising more capital (Shen 2009). Not surprisingly, as banks and insurance companies such as AIG report larger and larger losses and write downs, the need to shore up their TCE ratios has increased. Further, since debt requires paying interest and preferred stock requires payment of fixed dividends, while dividends on equity are variable and only need to be paid out of profits, the presence of a large volume of debt and preferred stock affects the liquidity of the banks, whereas the presence of common equity does not.

An interventionist government can, of course, seek to buffer systemic effects by forcing creditors and preferred stockholders to bear the losses of firms they have financed. The difficulty is that if the government decides to enforce conversion of loans provided by private lenders into common equity, these lenders would lose the protection afforded to a holder of senior capital. Further, if large amounts of new common equity are issued in return for debt, there is a danger that the value of that equity could quickly fall below the price at which loans are converted to equity, transferring the losses from the banks concerned to the lenders and creating ripple effects that can have systemic implications for the financial sector as a whole. Those possibilities are real because bank bonds amount to a quarter of US investment-grade corporate bonds (Wolf 2009). It is for this reason that many like Greenspan suggested that nationalisation that protects creditors or holders of senior debt is the answer to the problem of widespread bank insolvency. Though debt-equity swaps are common means of dealing with bankruptcies, they may not be the best route to take in the current circumstances. Nationalisation recommends itself because it prevents the spread of fear and uncertainty among creditors to investors in the liabilities of banks, such as insurance and pension funds.

As a result there is increasing pressure in the case of a number of financial institutions to convert preferred stock acquired by the government (and not the private sector) into common equity. Conversion of that kind is bound to increase the share of common equity held by the government in the banks. The moment that exceeds 51% it amounts to nationalisation. Even when the share of government equity is lower than 51%, it can be large enough to give government significant influence or even control over the banks concerned. With the material basis for influencing or even determining bank decisions and behaviour, the government cannot absolve itself of the responsibility of ensuring that banks provide credit to facilitate a recovery, that such credit is not concentrated in the hands of a few sectors and sections and that bank managers behave in ways that are socially acceptable. The pressure to oversee and regulate the payment of salaries, bonuses, retrenchment benefits and pensions to managers in service or asked to quit for overseeing failure in the nationalised banks is only the more discussed set of responsibilities that the government cannot avoid.

What is of significance is that this responsibility now holds in a wide segment of the banking system. The US Treasury is putting 19 banks with assets of more than $100 billion through a stresstesting programme, aimed at assessing the losses they are likely to sustain under alternative scenarios regarding the projected fall in gross domestic product (GDP) in the second and third quarters of 2009. This would be the basis on which the question of whether and, if so, how much of additional capital these banks would require would be answered. Initially this capital is to be provided through the issue of convertible preferred securities to the Treasury, to be replaced with capital raised from private sources in the form of common equity. If that does not happen within a specified period (currently six months), these securities will be converted into equity on an “as-needed basis”.

Many see this as an attempt to postpone the decision to issue common equity to the government in the hope that nationalisation can be averted. If conversion occurs, such nationalisation is inevitable given the scale of the government’s holding of preferred equity and the volume of losses that banks are estimated to be carrying. Thus in the case of Citigroup, by mid-February the government held $52 billion worth of preferred shares, which was five times the firm’s market value as of 20 February 2009 (Son 2009). Bank of America, which had received $45 billion in TARP funds in exchange for preferred shares and warrants, would be 66% owned by the government if its entire stake were converted to common equity. The figure would be 69% in the case of Regions Financial Corp in Birmingham, Alabama, which had received $3.5 billion from the US government. And, it would be a huge 83% at Fifth Third Bancorp, which had received $3.4 billion from TARP.

Conversion of the government’s preferred stock, loans and warrants to common equity would create a socialised banking system particularly because the banks involved include the big ones. In the US for example, the four biggest commercial banks – JP Morgan Chase, Citigroup, Bank of America and Wells Fargo –

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hold 64% of the assets of all US commercial banks. According to reports, in January 2009, Bank of America, the largest US bank in terms of assets, had TCE that stood at 2.83% of tangible assets, Citigroup had a lower 1.5% ratio, and J P Morgan Chase had TCE equal to 3.8% of tangible assets (Shen 2009).

Scepticism that the threat of insolvency in banking can be solved with the help of private capital also arises because of the sizes of these institutions. It was partly that problem that encouraged governments outside the US to accept back-door nationalisation in the case of institutions that are too big to fail. Though the financial crisis originated in the US, nationalisation occurred first in Iceland (were the need was immediate), Ireland and the UK, where banking majors Royal Bank of Scotland and Lloyds Group are now under dominant public control, and others are expected to follow.3

Resistance to Nationalisation

Yet resistance to nationalisation in the US continues. Thus, when at the end of February 2009 mounting losses at Citigroup necessitated strengthening its common equity base, the government sought to do it through means that kept its stake below 40%. Without getting the bank to issue fresh equity, the US offered to swap up to $25 billion of its $45 billion preferred shares in Citigroup for common equity. Simultaneously, it required other holders of preferred stock (such as the Government of Singapore Investment Corporation and Saudi Arabia’s Prince Alwaleed) of around $27 billion to convert to common equity.4 This would increase Citigroup’s common equity by $52 billion without additional investments by the government and save the firm about $3 billion in dividend payments. As a result of the conversion, the government would have a 36% stake, the existing shareholders’ stake falls to 26% and non-government holders of preferred stock get 48%.5 C iti’s tangible common equity rises to 8.1% of risk-weighted assets but ownership remains private, with the government’s stake below 40%. But this too could amount to merely postponing the problem. Once the government’s stress test is completed, valuations of real estate-backed assets may fall and risk weights may rise, resulting in a need for more common equity, requiring the government to convert the balance of its preferred stock to common equity and n ationalising the company in the process (Lex 2009).

Overall, therefore, the bank bailout plan has seen much change, but nationalisation is being resisted. Under the original TARP, the US government had essentially promised to buy out troubled assets from the banks. As detailed above, this evolved into a plan to recapitalise banks by buying preferred stock. Initially, this recapitalisation plan was combined with a guarantee programme that capped the losses that could result from damaged assets. Thus, a late November 2008 bailout package designed for Citigroup sought to cap the bank’s future losses on $306 billion of assets, while increasing its capital by $27 billion in return for preferred stock: the government was to absorb the first $29 billion of pre-tax losses on the assets, and a further 10% of any losses above that figure. Gary Crittenden, Citigroup’s chief financial officer, argued at that time that the eventuality that losses would rise above $29 billion was “a very remote possi bility” (Larsen and Cox 2008). On the other hand the US government’s

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guarantee allowed Citigroup to reduce the risk weights it attached to its assets to 20%, which freed up capital. Further, the $27 billion injection of capital was expected to boost the two most important measures of balance sheet strength: the Tier One capital ratio, and the ratio of total common equity to risk-weighted assets.

This was, undoubtedly, a multi-pronged approach to bank revival. However, as some analysts then pointed out, the US government’s preferred shares could not absorb any of Citigroup’s future losses until the common equity had been wiped out. And dividend payments on the US government’s preferred shares in Citigroup – which now total $52 billion – could absorb a substantial amount of the bank’s future profits. These expectations held good. It is not surprising therefore that as losses mounted preferred stock was converted into common equity. Yet, when the threat of inevitable nationalisation resulted in a sharp fall in the share values of the likes of Bank of America and Citigroup, which are surviving on government money, White House spokesman Robert Gibbs told reporters, “This administration continues to strongly believe that a privately held banking system is the correct way to go, ensuring that they are regulated sufficiently by this government” (Chipman and Runningen 2009).

Alternatives to Nationalisation

A number of arguments have been made against nationalisation (Blinder 2009). The two most powerful ones are that since the problem of valuation of assets would not go away with nationalisation, the amount of taxpayers’ money that may have to be pumped could prove enormous and indefensible. The other is that there are more than 8,300 banks in the US and once the nationalisation process starts it would be impossible to draw the line to limit the process. This again would amount to skimming the taxpayer far too much.

To deal with this dilemma of the immediate need to nationalise but perceived constraints to and ideological objections to doing so, there are two options that are being recommended. The first is to use regulatory devices to ensure that bank managers, shareholders and creditors adopt policies that can restore the viability of and confidence in the banking system. The government as regulator has enough measures at hand to ensure that stakeholders behave in a fashion that suits the system. This could include getting creditors and private holders of preferred stock to convert to common equity.

The second route being recommended is that of temporary nationalisation.6 Take over the ailing banks by buying into common equity, it is argued, but only till such time as their health is restored and they can be privatised so that the government’s investments using taxpayers’ money is largely, if not fully, recouped. The expectation that investments can be recouped may be belied for long, leading either to losses for the taxpayer or a continuation of nationalised banking.

However, the Swedish experience during the banking crisis of the early 1990s is often quoted as an example of what can be done. A combination of a real estate bubble financed with credit and an interest rate shock resulted in large losses at Första Sparbanken, Sweden’s largest savings bank, in 1991. Other banks, including Nordbanken, the country’s third-largest commercial

6 There are other absurd proposals being gloated. One is a public-private partnership in which private sector investors would be persuaded with federal incentives to join a venture to buy toxic assets from the banks. The federal incentives could include a guaranteed floor value of the assets or subsidised financing. If so the scheme would amount to creating a “bad bank” by providing government guarantees for toxic asset sales at pre-specified minimum prices and financing the bank with interest subsidies and loans from taxpayers’ money (Elliott 2009).

Agence France-Presse (2009): “Global Banking Losses to Hit 3.6 Trillion Dlrs: Roubini”, 22 January. http://www.google.com/hostednews/afp/article /ALeqM5jAmJ_Prl0zODFJrmvFdmOb-X5W8A (accessed 8 March 2009).

Blinder, Alan S (2009): “Nationalise? Hey, Not So Fast”, The New York Times, 8 March.

Boyd, Roddy (2008): “The Last Days of Bear Stearns”, Fortune/CNNMoney.com. 31 March, http://money.cnn.com/2008/03/28/magazines/fortune/ boyd_bear.fortune/(accessed 20 December 2008).

Burton, John, and Jamil Anderlini (2009): “Singapore Left with Second Largest Citi Stake”, The Financial Times, 27 February.

Chipman, Kim and Roger Runningen (2009): “Obama Not to Blame for Market Decline, Gibbs Says”, Bloomberg.com. 20 February. http://www. bloom - berg.com/apps/news? pid= newsarchive& sid = aaOEu7wVI8iQ (accessed 9 March 2009).

Eckbo, B Espen (2009): “Scandinavia: Failed Banks, State Control and a Rapid Recovery”, Financial Times, 22 January.

Elliott, Douglas J (2009): Guaranteeing Toxic Assets: Choosing among the Options (Washington DC: The Brookings Institution).

– (2009): The Administration’s New Financial Rescue Plan (Washington DC: The Brookings I nstitution).

Financial Times Reporters (2008): “Lehman Brothers Files for Bankruptcy”, The Financial Times, 15 September.

Gup, Benton E and John R Walter (1991): “Profitable Large Banks: The Key to Their Success” in Donald Chew (ed.), New Developments in Commercial Banking, pp 37-42 (Cambridge, Mass: Blackwell).

International Monetary Fund (2009): “Global Financial Stability Report: Market Update”, GFSR Market Update, 28 January, http://www.imf.org/external/pubs/ft/fmu/eng/2009/01/index.htm (accessed 20 February2009).

Larsen, Peter Thal and Adrian Cox (2008): “Citi R evived But Its Ills Are Not Cured”, The Financial Times, 24 November.

Lex (2009): “Citi State”, The Financial Times, 27 February.

Office of the Special Inspector General for the Troubled Asset Relief Program (SIGTARP) (2009):

I nitial Report to the Congress: February 6, 2009

(Washington DC: SIGTARP).

Roubini, Nouriel (2009): “Time to Nationalise Insolvent Banks”, Project Syndicate: An Association of Newspapers Around the World, February. http:// www.project-syndicate.org/commentary/roubini11 (accessed 10 March 2009).

Shen, Linda (2009): “Obama Bank Nationalisation Is Focus of Speculation (Update 3)”, Bloomberg. com, 23 February. http://www.bloomberg.com/ apps/news? pid=email_en&refer=home &sid= an.TP4kSHkuo (accessed 8 March 2009).

Son, Hugh (2009): “AIG May Convert Preferred Shares to Common”, 23 February. http://www. bloomberg. com/apps/news?pid=email_en&refer=us & sid= aFvU7x_hoHYo (accessed 8 March 2009).

van Duyn, Aline (2009): “Thanks For the Memories, But They Don’t Tell the True Story”, The Financial Times, 19 February.

Viotti, Staffan (2000): “Dealing with Banking Crises

– Proposal for a New Regulatory Framework”, Economic Review, 3. Wolf, Martin (2009): “To Nationalise Or Not – That Is the Question”, The Financial Times, 3 March.

World Economic Forum (2009): The Future of the Global System: A Near-Term Outlook and Long-Term Scenarios (Geneva: World Economic Forum).

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