Applauded and replicated around the world for its decisiveness and firm action, the Gordon Brown Plan for financial system revival is proving to be seriously flawed in three major respects. Today we will talk about the first flaw, which essentially flows from providing help before assessing the problem. The second and third flaws, discussed tomorrow, are about how national guarantees compound what is an international problem and how Brown failed to address the uncertainty overhang in the market.
First, Brown recapitalised the banking system before we established what the toxic assets residing in the system were worth. Despite a first expensive round of bank recapitalisation we do not know how much more capital is needed to cope with these assets being written down to ?fair value?. That was what the US Troubled Assets Recovery Programme (Tarp) was meant to do. Unfortunately, Congress took some time to pass Tarp legislation. The extreme anxiety that created emboldened Brown to steal the US thunder and come up with an alternative plan for recapitalising banks, to alleviate global public concern about their solvency.
Predictably, that started a wave of competitive recapitalisations; leaving the US in danger of a massive shift in global deposits from American to non-American banks. To prevent that, the Fed-UST followed suit and went for premature recapitalisations in the US as well, using the US$700 bn for a different purpose to that for which it was originally approved.
Sadly, Brown jettisoned the reverse auction and asset reconstruction (ARC) features of Tarp. These two mechanisms were indispensable. An ARC would have bought toxic assets at a discount and accumulated them in one place. That would have allowed them to be de-synthesised and re-bundled into more appropriate packages with more transparent risks. In other words, the ARC could have separated out the sub-prime loans made to immigrant gardeners, from better quality loans to multiplexes, shopping malls, and office buildings. That would have allowed toxic assets to be rearranged, revalued and repriced more acceptably.
Eventually such transformed assets would have been sold back in financial markets at prices resulting in a profit for the ARC on the spread between the discounts at which they were bought and later sold. But, the speed with which the Brown Plan was replicated globally prevented this essential purgative from working. As a consequence, we are now left with toxic assets still on the books of global banks. They are perpetuating everyone?s concerns, not least of the banks themselves, about the credibility of their balance sheets and their ?real? solvency. That is continuing to impede inter-bank trust and unsecured interbank lending for all purposes including trade credit which is drying up.
To illustrate, the aggregate amount of toxic assets remaining on bank books are estimated to be around $3 trillion. The fire-sale price at which Merrill Lynch sold its toxic book before being taken over by BoA was $0.22. No one else wanted to sell at that price. Using the usual mathematics, these assets are unlikely to be worth more than $0.66. But the range of 22-66 US cents is too large for bank managements, regulators, rating agencies or auditors to arrive at a consensus on fair value. At the fire-sale floor price these assets would be worth $660 billion. That would result in a loss of $2.34 trillion requiring an equivalent capital write-down for the system. About $1 trillion has already been written down. A fire-sale price would create further capital funding requirements of $1.34 trillion. On the other hand, at the ceiling of that range, the assets would be worth $2 trillion resulting in a loss of $1 trillion. That would give much more comfort about the solvency of banks. The reality probably lies somewhere between those limits (45-50 US cents?) which would still create a requirement for a further $500 billion or so in new capital requirements.
To make matters worse, however, even the prime assets of global banks are now becoming shaky as the recession bites. That is increasing NPAs and provisioning as well as write-down requirements, necessitating a second round of capital fortification of unknown amount. It will accentuate uncertainty on the part of bank managements about how much more risk can be taken by lending in a downturn when corporate cash flows are worsening. That will defeat the intent of the recapitalisation exercise which was to get credit flowing easily again.
(To be concluded)
The author is an economics and corporate finance expert. He chaired the high-powered committee on making Mumbai an international financial centre
