This article is co-written by Ing. Werner Krauss – see information below
Cartoon: © Dave Granlund, www.davegranlund.com
The Problem of ‘Toxic Assets’
“Our job is to fix the problem in the financial sector at the least risk to the taxpayer,” U.S. Treasury Secretary Timothy Geithner stated the objective on Mar. 23. Supported by President Barack Obama, Geithner unveiled yet another bailout plan for the struggling U.S. financial system.
Rumours had it, that the Obama Administration would revive a plan that the Bush Administration had drafted in September 2008 but put back into the draw: Spending billions of U.S. dollars taxpayers’ money to free the financial system of ‘legacy assets’ – real estate loans as well as securities backed by loan portfolios – colloquially known as ‘toxic assets.’
Those assets cause “uncertainty around the balance sheets of these financial institutions, compromising their ability to raise capital and their willingness to increase lending,” so the Fact Sheet of the Public-Private-Investment Program of the U.S. Treasury, which confirms what has been rumored in early March.
According to the new bailout strategy, the U.S. government will spend yet another staggering U.S. $ 75 – 100 billion in order to help raise $ 1 trillion as to stimulate the economy and ‘flush’ the U.S. financial system of the ‘toxic assets.’
Geithner admitted that this plan fuels public anger as Wall Street seems to benefit at times where average Americans suffer. The financial sector has indeed been a major recipient to previous support: As an example, the Troubled Assets Relief Program (TARP) worth more than U.S. $ 700 billion, included $ 25 billion packages each for Citigroup, J.P. Morgan Chase and Well Fargo, the largest amounts ever given to any bank, among others.
“The (public) anger and outrage is perfectly understandable,” and he firmly added that “we have to make sure our assistance is not going to award failures.”
The bailout strategy for the banks is symptomatic how the United States plans to combat of a self-inflicted economic crisis: Enabling banks to lend money freely, as the federal interest rate is currently set at 0 – 0.25%. Therefore, freeing the financial markets of the ‘toxic assets’ will allow more money to be circulating on the market and – so the hope – facilitate increased public and private spending.
In short-term, the U.S. strategy might help stimulate economic activity, as the IMF projects a slump in economic growth by ‘only’ 2.6% in 2009, while the figures for Euro zone indicate a decline of 3.2%. However, the promotion of a spending-on-credit by the United States, inherited in the Federal Reserve’s policies of the 1990s, not only bears the serious danger of galloping inflation, but lays the foundation of yet a new financial crisis.
The U.S. financial sector was cause for the severe economic crisis currently at hand as the greediness of the U.S. financial institutions – Fannie Mae, Freddie Mac, Citigroup, AIG, to mention some of the most prominent – let to massive loss of reality of all those involved.
In a global economy, a significant number of countries as well as business sectors were hit hard by the recession that had, however, little or not benefited from the aggressive increase of market share, dramatic increases in Return-On-Investment (ROI) of the U.S. banks.
Banks in Austria, exemplary for most of the Western European counterparts, usually follow a conservative substance-oriented strategy of financing private houses and apartments as well as investment portfolios with low contingent liability and comparatively small surcharges on reference interest rates, resulting in fewer earnings for the banks, compared to the U.S. counterparts.
However, the financial crisis had swapped over from the United States to Europe, it even had a strong impact in Austria. The previous government was quick to respond with its own Bank Rescue Package, unanimously approved by the Austrian Parliament on Oct. 20, 2008. The package, worth EUR 100 billion, seeks to assure the banking sector and consumers alike, by providing EUR 15 billion of government subsidies in case of equity capital shortages of equity capital, with currently 9.3 % interest. At the time of writing, EUR 2.8 billion was spent, and among the banks applied for support were among the country’s largest institutions, Bank Austria, Erste Bank and BAWAG.
Days before the proposed Bank Rescue Package was approved by the Parliament, Constantia Privatbank (CPB) with EUR 10 billion client assets under management, had to be bailed-out by the Austrian government. In order to bridge serious liquidity problems of the institution, five Austrian banks and the Austrian National Bank provided a EUR 400 million loan and formed a special purpose entity that took over Constantia’s shares and continues with the bank’s operations.
The causes were not immediately connected to the financial crisis but a result of ongoing investigation by the Finanzmarktaufsicht (Financial Market Authority) into irregularities of the bank’s manager Karl Petrikovits, which in turn led to loss of confidence and substantial money withdrawals of the primarily wealthy customers.
The bank manages about 300 funds; a collapse of CPB would have had serious repercussions on the Austrian financial sector.
The bulk of the Bank Rescue Package, however, is budgeted for state guarantees in order to stimulate lending among the banks. According the Social Democratic Chancellor Werner Faymann of Mar. 10, EUR 10 billion were so far approved by the government, though he was quick to assure that Austria’s Bank Rescue Package were “no gifts for anyone.”
However, Faymann assured the Austrian financial sector that the measures implemented so far were sufficient, anticipating further turbulences on Central and Eastern European financial markets, like Romania or the Ukraine, where Austrian banks have a dominant market position.
Austrian National Bank Governor Ewald Nowotny believed that the measures taken by the Austrian government of supporting Austrian banks through the financial crisis will be sufficient. In an interview with the Austrian daily Kurier of Mar. 12, Nowotny optimistically stated that “the (Bank Rescue) package will not be fully capitalized.”
The Effects of Subprime
Austrian banks are less affected by the international financial crisis, pending the economic development in Central and Eastern European countries, however, the U.S. financial institutions are at the heart of the matter. Their method of financing follows short-term consumer-oriented policies exceeding the risks over the earnings by far.
The dealings on the subprime market on the part of the U.S. lending institutions, trigger of the financial crisis in 2008, for example, were anything but fair on neither private house owners nor national economies. Those responsible evidently knew of the immense contingency risks, which the IMF estimated in January 2009 at U.S. $ 2,200 billion contingent liability costs for the U.S. economy.
In Austria, in order to have a mortgage for homeowners approved, the banks verify two conditions: Firstly, the borrower has to be able to afford the repayment in the long-term, based on a financial assessment of monthly expenses; and secondly, the mortgage must not exceed 60 – 80% for the conservative estimated market value of the purchased property. This approach is crisis-resistant, and, among others, responsible for overall stable real estate prices in Austria.
On the other hand, it was custom for lenders in the United States to approve further mortgages for borrowers unable or unwilling to meet their payment schedule. Those bundled subprime packages were then sold to third parties or subsidiary companies, ensuring that the own mortgages are formally taken out, and at the same time, the banks and mortgage companies had earnings on the new mortgages.
But it was not just for the sheer number of new mortgages, but those were based on up to 300% of the property value, already deliberately overrated by the banks and mortgage companies as to take even higher earning from the house owners.
However, without selling the bundled subprime debts, the U.S. financial institutions would not have been able to close the annual balance sheet. The reason: Balancing the legally required equity-to-asset ratio – indicating a company’s leverage that shows the amount of debt used to finance the firm – which might otherwise drop below the limit.
Evidently, these financial dealings are unrighteous, wantonly negligent and fraudulent, and would – in case of an individual – be punished with life-time imprisonment and reparation payments.
The question as to why national governments and international financial institutions support the financial sector with billions of U.S. Dollars or Euros is a valid one and important to raise at this stage.
Evidently, national U.S. politics has its share of responsibility in this crisis: the authorities – the Federal Reserve in particular – knew of outsourcing and selling of non-performing mortgages, for example. However, the danger of set-backing the world economy as in the 1920s – mass unemployment and political riots and the rise of extremes on the political left and right followed by political instability – caused by the collapse of the financial sector, is an unacceptable risk.
Nevertheless, that does not remove the political responsibility of taking the right decision: either following the United States of trying to give everyone a slice of the cake so that as much money as possible is pumped into the economy; or the European approach of selective support based on evaluation of individual measures, like the continued emergency financial support for Hungary in an attempt to stabilize the Hungarian Forint.
From current perspectives, Europe has an overall better chance of overcoming and gain strength from the current economic crisis. The European way of providing financial services is signified by restraint as well as caution when imposing premium charges on prime rates.
For Europe as well as the United States, the economic development is severe and of similar dimension: As for Austria, the two Austrian economic research institutes, the Institut für Höhere Studien (HIS) and Wirtschaftsforschungsinstitut (Wifo), estimate a drop of GDP of 2.2 to 2.7 % (EU-27 estimates of -3%) for 2009 in their recent spring projection; the OECD estimates for the U.S. a decrease of 2.7%. The recovery is estimated as of 2010 for the United States with an increase of 0.5% – same as Austria with 0.4 to 0.5 % – while 0% is projected for the EU-27 in 2010.
Given those economic indications, the only pragmatic course of action is to subsidize the troubled financial institutions as to avoid a long-lasting economic depression. And for the United States, their bail-out strategy for the financial institutions is, for Geithner, evidently also the answer to the different approaches between Europe and the United States.
“We are the United States. We are not Sweden. We have a very complicated financial system.“ It is, however, the simplicity that caused the collapse of the U.S. financial institutions: Spending on credit without limits.
While the efficiency of the ‘toxic assets’ bail-out program remains to be seen in the nearer future, the European countries, at least, have not chosen to ‘reward’ those who caused or contributed to the global financial crisis with large subsidies.
While former BAWAG manager Helmut Elsner or CPB boss Karl Petrikovits in Austria find themselves in the court room or under criminal investigation for their offenses, a wider criminal investigation into the dealings of the U.S bank managers is still outstanding, but would nevertheless be essential as to prevent financial dealings that endanger the global financial sector.
This is an excerpt, the full article was published in April 2009 in The Vienna Review.
Ing. Werner Crauss, MSc, is a Management Consultant in Vienna. Founder and Managing Director of Crauss Development GmbH (www.crauss.at), he advises companies in business locations, real estate development and corporate assessments since 1997.