Global Trends by Martin Khor

Monday 29 September 2008

Another crisis week for global finance

Last week saw a deterioration in the situation in money markets as banks denied loans to other banks, and the United States Treasury’s bail-out plan faced criticisms from Congress leaders and the public.


The United States’ financial crisis continued to play out in high drama last week, as hopes of a bail-out plan that could give relief to the global markets’ jitters, if not solve the banking crisis at the root, went up and down like a see-saw or rather roller-coaster.

The emergency plan drawn up by the Treasury Secretary Hank Paulson and Federal Reserve chairman Ben Bernanke quickly ran into trouble, with many influential economists attacking it, and then leading members of Congress throwing cold water on it.

It is clear the plan in its original form will not survive.  Members of the US Congress were working over the weekend to get a modified or alternative plan out before the New York stock exchange opens on Monday.

It is feared that if there is no deal by then, the stock markets will dive.  That will cause more trouble for financial institutions as the value of their assets will be reduced further, bringing some closer to or over the brink of insolvency.  On Sunday it was announced a deal in Congress has been reached and requires touching up and legislative text.

Last week, there were more signs of the crisis in Western countries. Money markets, through which banks lend to one another, froze as each bank feared for the safety of loans it may give out, not knowing and doubting the state of health of the other banks.

This has a serious effect because many banks do not rely only on deposits for their funding requirements and require loans, usually from other banks in the money market, to function.

The cost of borrowing on the money market has shot up, and there is expectation of  a worse drought of funds in future.  The spread between three-month dollar London inter-bank rates and average overnight rates jumped to over 2%.   The cost of insuring against credit default has also increased significantly.

To counter the drying up of the money markets, the Bank of England announced it would expand its loans to banks by 50 billion sterling.

Meanwhile, there was more gloom from the biggest bank failure in history in the United States last Thursday, with the US government having to take over control of Washington Mutual, which was later acquired by JP Morgan Chase.

A few banks were in jittery state in other countries, with a run on a bank in Hong Kong (which was short lived after concerted action by the authorities and other players) and another financial institution in Britain reportedly facing difficulties.

The Paulson bail-out plan ran into trouble as critics pointed out a host of problems, which Congress has been trying to sort out.

The original plan would have given a “blank check” of up to US$700 billion to the Treasury Secretary to purchase “toxic securities” held by financial institutions, and his actions cannot be challenged in court.  The plan does not mention taking equity share in the institutions participating in the bail-out.

The plan is supposed to address the problem of under-capitalisation of the banks, and the risk of insolvency.  Ad hoc measures on a case-by-case basis was seen as not being able to prevent a systemic crisis or breakdown.

The major criticism is that the plan bails out the chiefs, executives and shareholders of banks that have caused the crisis through greed and perhaps fraud, at the expense of the tax-payers who are already suffering from the effects. 

According to opinion polls and media reports, many Americans are outraged that they, the victims of the crisis, are being asked to pay hundreds of billions of dollars (or over a trillion, if the other bail-outs that have recently taken place are counted) in order to prop up the culprits and reward them with more funds.

What has been particularly galling is that the chief executives of failed banks have been given “golden parachutes” of millions of dollars to leave, and that managers and traders of the collapsed institutions like Lehman Brothers are given hefty bonuses even after the collapse.

A major problem is that the Paulson plan aims to achieve the re-capitalisation through the government purchase of the banks’ non-performing loans and toxic securities, in particular mortgages.

The key question is, at what price will the government make the purchases?  The securities are now worth much less than their face-value.  If the purchase is made at the current market price, then there will not be enough re-capitalisation. 

If the price paid is at the face-value, then it implies massive subsidization, to be paid by the tax-payer. The Fed Chairman indicated that the price would be at the value the securities would fetch in future.  But no one knows what the future value is, though the implication is that it would be higher than the present “firesale” value, and thus involve a significant subsidy.

The well-known economist Paul Krugman called the Paulson plan “cash for trash.”  At a hearing in the US Senate last week, most of the Senators were very critical of the plan, the Republicans even more so than the Democrats. 

And a meeting at the White House last Thursday, attended by the President Bush, Paulson, Congress leaders and the two presidential candidates,  “imploded” (a term used by the New York Times) instead of finalizing the bail-out deal.  The Republicans, rather than the Democrats, are reported to have rebelled against Bush and Paulson.

The Democrats are said to be more agreeable to the Paulson deal, provided it is modified to include strong oversight, a limit to employee compensation and “golden parachutes” for executives of participating banks, the possibility of government obtaining equity in the banks and not only purchasing their toxic securities, the authorization of the US$750 billion in installments rather than all at once, and a parallel programme to help house-owners facing default in mortgage payments.

The US Congress will come up with a plan to pass on to the President because the failure to agree on a bail-out would plunge the markets into a far deeper crisis.

But a bail out plan will not end the crisis, it may only give quick and temporary relief.  And there will likely be an angry backlash from ordinary people in “Main Street” that believe they face a bleak future while the rich elite in “Wall Street” are getting away scot free.