Recovery of the US economy would have been faster had the Troubled Asset Relief Program injected more capital into banks.As experience from the recent crisis shows, the estimates of financial sector losses and rescue costs can be deceptive.Panic-time estimates of losses should not be used to determine the extent of government intervention.
The subprime crisis of 2007 inflicted substantial losses on the financial sector as it unfolded over the next couple of years. These losses were estimated in trillions of dollars and so were the costs of rescue.
Governments poured money into distressed financial firms through expensive rescue programmes.
These programmes were thought necessary at the time, yet have been criticised as unabashed bailouts of the private sector.
Just how big were the losses and the rescue costs? Did governments spend too much or too little in their rescue efforts?
America’s rescue programme provides useful clues.
Following the collapse of Lehman Brothers in September 2008, the US Congress rushed through the Troubled Asset Relief Program (Tarp).
The provision made was a staggering $700 billion. Two years later, the programme has been wound up. The results should confound the critics.
Under Tarp, the US government was to buy toxic assets or illiquid assets off the books of banks and sell these once the market recovered. That didn’t really happen.
The Treasury realised that setting prices for illiquid assets was an impossible task.
If the prices were set too high, the Treasury would be accused of favouring banks. If they were set too low, banks in trouble would face even higher losses.
The purpose of Tarp was then modified.
The funds that Congress made available were used for other purposes — injecting capital into banks and General Motors and Chrysler, providing backstop facilities to the insurer AIG, helping to make the terms of some mortgages more favourable, etc. Only $470 billion of the funds made available were actually committed.
Did Tarp work? Answers differ as to how effective it was, but most people believe that it did prevent the US and the global economy from going over the precipice.
Tarp funds came at a time when private funding threatened to flee the banking system altogether.
Once capital was infused into banks, they were able to go out and raise funds from the public and shore up their capital.
Recovery would have been faster had the US government injected more capital into banks.
That would have made them more willing to lend. However, both the Bush and Obama governments shrank from stronger recapitalisation.
They made sure that the capital they injected did not give them control over the banks because the American establishment is allergic to the idea of nationalisation of banks.
Instead, they attempted to expedite recovery by cutting policy rates. Banks were allowed to rebuild their capital over time by borrowing virtually at zero cost and making easy profits. As a result, recovery in the US has stretched over more than two years and even today it remains anaemic.
This is one of those things that will be debated forever, but one thing is for sure.
The cost of Tarp is nowhere near the figure of $700 billion that shocked the American public.
As the economy recovered and banks started returning capital, estimates of the cost of Tarp began to be progressively revised downwards. The latest estimate is a mere $50 billion — or less than 0.4% of US GDP.
The estimates of losses in the financial sector themselves have been revised several times.
The IMF’s Global Financial Stability Reportestimated losses in the US at $1.4 trillion in October 2008.
By April 2009, the losses had been revised upwards to $2.7 trillion. In April 2010, the estimate came down sharply to $885 billion.
Global financial sector losses were estimated at $4 trillion in April 2009. A year later, they were revised to about half the figure — $2.2 trillion. How come?
The losses in the financial sector include losses on loans as well as securities. Losses on securities are estimated on a mark-to-market basis and hence fluctuate with movements in the markets.
After the Lehman debacle in late 2008, prices in the markets plummeted sharply, which is why losses peaked in 2009. As economies and markets recovered in 2010, losses tended to decline.
Financial sector losses and rescue costs are the not the correct way to estimate the costs of financial crises.
We must look at the output lost — what the growth rate would have been without a crisis and what it was because of a crisis.
But estimates of losses and rescue costs provide a rough measure of loss and they also determine the quality of government intervention.
As the experience in the recent crisis shows, these estimates can be deceptive.
Markto-market losses at the peak of a crisis tend to exaggerate the losses and rescue costs.
Markets tend to panic when they think that large financial institutions will fail. So these estimates of losses should not be used to determine the extent of government intervention.
Governments must simply do what it takes to prevent failures of large institutions.
They should not be intimidated by panic-time loss estimates.
Had the US government prevented Lehman from failing, had it made sure that banks were quickly recapitalised, the financial sector losses would have been even lower and economic recovery faster.
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