Chapter 15: Executive Summary – The Financial Sector “Bailout”: Sowing the Seeds of the Next Crisis?

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section VI: The Bailout

Background The two-month period from September to November 2008 has been witness to the most extraordinary level of direct US governmental involvement in financial markets in over seven decades. In part, this intervention took on the form of ad-hoc institution-specific rescue packages such as those applied to Bear Stearns, Fannie Mae, Freddie Mac, AIG, and Citigroup. But a substantial part of the effort and huge sums of money have also been committed in an attempt to address the systemic problems which led to the freezing of credit markets. A multi-pronged approach has finally emerged with three key schemes:

  1. A loan-guarantee scheme administered by the Federal Deposit Insurance Corporation (FDIC) under which the FDIC guarantees newly-issued senior unsecured debt of banks out to a maturity of three years.
  2. A bank recapitalization scheme undertaken by the US Treasury in which the Treasury purchases preferred equity stakes in banks.
  3. A commercial paper funding facility (CPFF) operated by the Federal Reserve.

Chapter 7: Executive Summary – Corporate Governance in the Modern Financial Sector

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section III: Governance, Incentives and Fair-value Accounting

Background

The large, complex financial institutions (LCFIs) are highly levered entities with over 90% leverage. This highly-levered nature makes them prone to excessive leverage- and risk-taking tendencies.  By and large LCFIs also have explicit deposit insurance protection and almost always an implicit too-big-to-fail guarantee.  The presence of such guarantees – often un-priced and at best mis-priced – has blunted the edge of the debt monitoring that would otherwise exert an important market discipline on risk-taking by these firms.  Although there is mounting evidence pointing to weaknesses in equity governance of these firms, the high leverage they have undertaken and the failure of their internal risk management practices also suggest weakness and failure of regulatory governance.

The other part of the bailout: Pricing and evaluating the US and UK loan guarantees

Apart from taking equity stakes in selected financial institutions, the recent attempts to thaw financial markets also involve government guarantees on newly-issued senior unsecured debt of banks, an aspect that has received considerably less attention than the recapitalization and part-nationalization of banks. The guarantee schemes announced by the US and the UK are strikingly different in terms of which banks are covered, the optionalities they offer to the banks concerning protection, and, not least, the fees charged for this protection. We describe the two schemes in detail, analyze their features and discuss the outcomes likely to arise under each. Among other things, we find that while the UK scheme will break even (or perhaps even net a small profit to the UK Treasury), the US scheme involves, on a fair value basis, a huge cost to the taxpayer of upto $50 billion over the three-year horizon of the scheme.