A wonderland of bailouts and zombie banks

We have fallen down the rabbit hole and, as they did for Lewis Carroll's Alice, things keep getting curiouser.

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke listen as  FDIC Chairman Sheila Bair speaks during a press conference at the Treasury Department in Washington, Tuesday, Oct. 14, 2008. (AP Photo/Gerald Herbert)
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We have fallen down the rabbit hole and, as they did for Lewis Carroll's Alice, things keep getting curiouser and curiouser. Thus does this week's bailout of Citigroup flummox many economists. The deal leaves the same crew at the helm, yet stands to leave the US government the capitalist flagship's biggest shareholder. Yet Citi's stock has risen 60 per cent since the deal's announcement. Investors believe the bailout is good for shareholders, even if diluted by Uncle Sam. After all, the bailout ensures that Citigroup will survive to throw good money after bad. That's why markets worldwide rose on the news, analysts say: Citigroup's failure would have created an enormous vortex in the already turbulent world of finance.

The US government will guarantee US$306 billion (Dh1.12 trillion) of Citi's property-backed loans and securities, thereby shouldering the risk. But those assets will remain on Citi's books, thereby allowing the bank to keep receiving the payments they generate. Citi can then presumably sell those government-guaranteed loans more easily to investors, thereby strengthening its capital base, and at the same time help revive the market for such securities.

Oddly, that is precisely what the Treasury secretary, Henry Paulson, and the Federal Reserve chairman, Ben Bernanke, aimed to achieve with the original version of the $700bn troubled assets relief programme (TARP). TARP funds were supposed to be used to buy up assets that banks couldn't sell on the market. The transactions, which would have been likely to be conducted at prices well below their face value, would have forced banks to write down losses on the sales. Even those that didn't sell would have been forced to realise losses thanks to accounting principles that oblige them to mark their assets to established market prices, or "mark to market".

But TARP was re-crafted, almost immediately after its passage by a reluctant Congress, into a scheme to buy $350bn in direct bank stakes, TARP II. Some say this was made necessary by US politics - TARP I appeared to involve taxpayers absorbing losses incurred by greedy bankers. It didn't. But explanations take such a dreadful time. The partial nationalisation of banks was instead made necessary by the decision of Gordon Brown, the British prime minister, to do so with his own country's banks. With trust between banks already at a low ebb, government backing instantly became an absolute essential for survival. After all, no bank looks healthy next to a bank backed by the mint.

Thus, when Mr Paulson and Mr Bernanke sat down with the heads of America's largest banks on Oct 13, they obliged even relatively healthy Wells Fargo to take government funds. But as previous crises in Japan and Asia have shown, recapitalising banks - whether by capital injections or consolidation - doesn't make their bad assets vanish. Instead, as has happened in Europe and the US, it can simply create undead banks, unable or unwilling to risk money by lending it. Such zombie banks can be the death of an economy.

Citi's rescue, therefore, represents the failure of TARP II. Even after receiving a $25bn capital injection from the government, Citi was still holding on to toxic assets it could not sell, and which impeded further lending. Now the US government is taking some of the risk out of those assets, just as it had hoped to use TARP I to reduce the risk of trading toxic assets. But the US government has now had to go a step further and is trying to reduce the risk of lending to the US consumer. A day after the Citi bailout, it announced an $800bn programme that turns the US government into America's biggest bank. The Fed will now buy $600bn in mortgage-backed debt from government-linked agencies, thereby enabling them to lend more to the unadaptable housing market. It will also lend $200bn to institutions that in turn make student loans, car loans or issue credit cards.

Like many other countries, the UAE now finds itself pulled into this saga, after watching from a safe distance. After following the Fed by cutting rates and extending liquidity to banks with little improvement in lending, the Government has been compelled to take over two mortgage lenders, Amlak and Tamweel, and fold them into a government-owned bank, Emirates Development Bank (EDB). Together with the creation of Abu Dhabi Finance, this should pump government money into the housing market, hopefully enabling creditworthy borrowers to keep buying homes from property owners who may desperately need to sell them to pay debts of their own. EDB will be getting an unknown amount of cash from a new, unnamed federal agency with an as-of-yet undisclosed mandate. A flotilla of investment bankers has reportedly arrived to help iron out the details. Let's hope they study the missteps the US has made and don't stop at just pumping petrodollars into the country's banks. A few months ago, after all, it seemed unthinkable that the Gulf could suffer a liquidity crunch, or that property prices could fall. It seems inevitable, therefore, that at some point the credit crisis will push some, if not many borrowers, into default. The UAE will therefore need an agency or programme to buy the bad debts created and any related securities, with a clearly defined mandate and terms. Such an agency should be established before these toxic assets emerge and choke the country's banks. In the bizarre financial Wonderland into which we've stumbled, it may prove wisest to establish the sentence first, the verdict afterwards. warnold@thenational.ae