Essay on Benefits of U.S Bank Bailout

The bankruptcy of the investment bank Lehman Brothers in 2008 was a key milestone of the American financial crisis, triggering a full-scale global recession. It is essential to note that this occasion spread panic in financial markets and could cause a chain reaction. However, due to the effective and strict policy the U.S. government, as well as the Federal Reserve, with the help of hundreds of billions of taxpayer dollars the financial architecture has not changed much from 2008.

With the aim to describe the main benefit of U.S. bank bailout in 2008, I would like to analyze the situation with Lehman Brothers – one of the biggest, oldest and respectful investment bank in the world. Due to many reasons, only after the collapse of Lehman, authorities understood all seriousness of situation.

As a matter of fact, top management of Lehman Brothers in general was aware of consequences of bankruptcy of the investment bank. “The mass destruction of wealth on a global scale will inevitably affect all financial institutions, as well all assets of retail investors and retirees will be destroyed”, as stated in Bungled Bank Bailout Leaves Behind Righteous Anger. Namely these words were presented by top management of Lehman Brothers to the government officials with the aim to emphasize the criticality of the situation. However, in this case, the government remained faithful to the principles of capitalism and the market economy. As a result, after the bankruptcy of Lehman Brothers, the largest in history, global stock markets by the end of September 2008 have lost more than $ 3 trillion, the drop in the MSCI index was 7.2%, and by March 9, 2009, it reached the bottom – 46%. In particular, LIBOR rate on overnight dollar loans jumped from Friday, September 12, to Tuesday, September 16, to 4.29 percentage points which was hitherto unprecedented value, as stated in One year since the US bank bailout.

It is essential to note that in September 2008 nobody has a clear vision of the situation and the consequences were unforeseen. Particularly, neither bankers nor regulators failed to see how ambitious are the consequences of Lehman bankruptcy and how they could hit on the related sectors – primarily mutual funds market and the market for corporate bills. The first one (total assets – $3.6 trillion) in addition to bank deposits was considered as the most reliable target for savings. But very soon, the shareholders of Reserve Primary Fund, the largest U.S. money market fund with assets of $62.5 billion, have applied to the output of $18 billion, after it became clear that the fund had in assets Lehman bills by $785 million.

No wonder that Reserve Primary Fund tried to stop taking applications for repayment, but the chain reaction was already began. It can be said that market funds money were the main participants in the bill market (40% of purchases according to the Federal Reserve). Consequently, stop of their work has led to the fact that companies from a broad range of sectors and sizes have lost the opportunity through the issuance of promissory notes to raise funds in the current activity – from salaries to utility bills. Banks, with the help of bills sponsored issuing long-term loans, had dried up this source too.

As well, the bankruptcy of Lehman blow to the repo market, where the bank had signed a lot of deals, including the security of mortgage bonds. This forced the Fed announced on September 15 that it will take from the banks repurchase not only high-quality investment grade securities, but also mortgage bonds. The Fed also had been counterparty in the market bills. As a fact, very soon the bankers and corporate borrowers faced with a new problem – falling collateral values ​​and, consequently, margin calls. Lending market fell and bankers simply did not understand how to assess the credit quality of the borrower and collateral. By late 2008, the Fed lowered interest rates to near zero, while the European Central Bank (ECB) and the Bank of England – to 1% and 0.5% respectively. In 2009, the Fed and the U.S. Treasury announced a program to support the liquidity of the financial system and the participants to $13.2 trillion. ECB began to issue unlimited amount of loans to commercial banks. As a result, in a year world GDP fell by 3.9%, as declared in The Price of Too Big to Fail.

Of course, after such huge infusion from taxpayers, society started to discuss financial sector reform with the aim to prevent such situations in future. However, this reform had stalled. The main point with concerned people most of all was the idea of ​​implementing a bonuses limiting because banks made good money on a market recovery in the spring and summer 2009 and once again began to allocate more funds for staff rewards and attract employees. This has caused an explosion of criticism in society and among politicians. Other ideas implied the control of the derivatives market of almost $600 trillion, an increase in capital requirements, risk and international supervision of large trans-national banks. Moreover, some influential economists, such as former Federal Reserve Chairman Paul Volcker and Chairman of the Bank of Israel Stanley Fischer, believed that the government should limit the expansion of banks. Soon after Geithner in January was appointed Minister of finance, President of the Independent Community Banks of America Camden Fine told him that the giant banks like Citigroup and Bank of America are a threat and the government should separate them and sell in parts. This idea was not included in the plan on the reform of the financial sector, which was presented in spring to Barack Obama administration. Authorities of leading countries several times discussed the idea of ​​creating a committee of regulators from different countries, who would monitor the activities of international banks. Meanwhile, Bank of America assets grew from $1.46 trillion in 2006 to $2.25 trillion at July, 2009, as stated in Bungled Bank Bailout Leaves Behind Righteous Anger.

Moreover, it should be noted that global financial ties were severed. A complex system of interdependent channels through which the world’s savings were sent to the capital investment in the real economy, in August 2007, abruptly went wrong. Discovery of the fact that the financial institutions, which enjoyed huge borrowings, held in their portfolios of poorly secured high-risk mortgage securities, shocked market participants. For a whole year the banks were doing everything possible to meet the needs of investors in terms of increasing the “cushion of capital”. But these efforts were in vain, and after the bankruptcy of Lehman Brothers, announced September 15, 2008, the system collapsed. Banks, fearing for their own solvency, ceased to issue loans. Issuance of corporate bonds, short-term debt and a wide range of other financial products generally decreased. Economic activity financed by loans was effectively frozen. The world was faced with a major financial crisis. For decades, the holders of debt obligations of banks in the United States feel safe under the protection of relatively small equity cushions, which allows the bank to lend safely to and fro. As a fact, frightened investors demand a much larger financial cushion for credit (without insurance) of any financial intermediary. When the balance sheet totals of the bank in the end come to a level that corresponds to current market imperatives, it can achieve – at least temporarily – a historic high for the last 75 years. It is not difficult to guess that these sky-high levels will become a base from which will build a new regulatory system. One measure of the market assessment of the potential risk of bank failure and, therefore, their need for additional capital is spread between three-month Libor rate and the overnight index swap (OIS). In 2007, this spread was only 10 basis points, the last fall he reached 90 points. Before – almost 12 months to mid-September – spread, though increased, but remained in the normal range. However, Lehman Brothers defaulted noticeably pushed it up – October 10, it reached a record 364 basis points, as declared in The Fed’s Swap Bailout of the Eurozone. That is why drastic measures were needed and the U.S. government declared unprecedented bailout in the U.S. history.

It is important to note that on October 3, 2008 rescue programs troubled assets (TARP) in the amount of $700 billion passed the Congress, but not suppressed splash spread LIBOR/OIS, following the collapse of Lehman. In mid-November, the spread seems to have stabilized, but this happened at a frighteningly high. How much additional capital, private and sovereign, must be from banks and other financial intermediaries to investors found that their risk associated with deposits in these institutions and the acquisition of their debt is not excessively high – that, in fact, is a mandatory precondition for the crisis? Infusion in October to $250 billion in assets of U.S. banks through TARP (resulting capital ratio increased by two percentage points) to halve the growth spread LIBOR/OIS was made after the collapse of Lehman. Based on the relatively moderate write downs possible, by simple linear extrapolation, it leads to the conclusion that even $250 billion would be spread back to its normal pre-crisis levels. So investors required banks to have a capital ratio of 14%, while in the middle of 2006, it was only 10%. Of course, a linear extrapolation gives only a very rough approximation. But the latest data does suggest that the Treasury allocated $250 billion, despite the usefulness of this event only lasted for part of the way to the levels that are necessary to resume normal lending, as stated in Lessons from U.S. Bank and Greek Bailouts.

In turn, state loan eventually acted as a counterparty of a large segment of the financial intermediation. However, for reasons that go far beyond the scope of this essay, I am absolutely convinced that the provision of state credits should be a temporary measure. And if so, where is the source of new private capital, which will bring the state loans from the financial system? The most reliable method is a partial restoration of the ruined in 2007, the global stock market capitalization of $30 trillion – it would allow banks to raise the capital they need. Now the markets are overwhelmed by this fear, which they have not experienced since the beginning of XX century. Because of the fact that the human nature is still the same, we can count on changing trends in the markets in a year. Although the capital gain is not a source of financing the real economy, it could improve the financial statements. This is best seen in the context of the consolidated balance sheet of the global economy. As a result, the market value of the world’s material and intellectual assets is reflected in the form of capital. Obviously, the higher the capitalization of global stock market is, the greater is the amount of capital that can go on the recapitalization of financial institutions. Lower stock prices may hinder this process. However, there was a clear understanding of the fact that the bank system should survive under any circumstances.

To sum it up I would like to say that despite the hard criticism in society, the U.S. bank bailout was a necessity. Everybody had seen the consequences of Lehman Brother bankruptcy to the economy and the Government was forced prevent further collapse of our economic system and allow the biggest bailout in the U.S. history. It is essential to note that there was a clear understanding of the fact that the bank system should stand in any case. Of course our financial system in general and bank system in particular is far away from ideal and has a lot of negative sides. For example, our economy still can not find a source of new private capital, which will bring the state loans from the financial system and it is impossible constantly to inject another $trillion in the economy. However, I believe that our financial system should be changed by evolutionary rather than revolutionary means – that is why personally I believe that U.S. bank bailout in 2008 was justified. Thereby, we were able to save our present posture of affairs and win some time to change the rules of financial sector interaction for everybody and become more responsible for our deeds.