A Lesson in Bail-Ins
May, 15, 2020
With the COVID-19 crisis abating and governments reopening their businesses, it is time to assess this new economic environment. We have lived in a system where government bailout programs brought short-term relief but created long-term instability as debts multiplied and interest rates were suppressed to unsustainable levels. There are clear indications governments are planning to resolve future financial crises with investors’ and depositors’ funds; also known as bail-ins. More complex still, and less transparent, are the potential ramifications on the economic and government systems going forward.
Over the past 40 years, we have become accustomed to having central banks and governments intercede with public funds to bail out financial institutions that pose an economic threat. Over time, the costs in dollars has risen from billions for Chrysler in 1980, to tens of billions for Mexico in 1994, to hundreds of billions for the Asian financial crisis in 1998 to trillions for the 2008 financial crisis. This dramatic escalation in costs caused the central bankers to seek new solutions for the next financial crisis. The unanimous decision of the G-20 central banks in 2014 was to adopt bank bail-in laws. The principle of a bail-in is to use the investors’ equity and debt and customer deposits, in that order, to resolve financial company’s issues.
In 2018, a US group specializing in distressed debt approached Spain's Banco Popular to buy non-performing loans at a steep discount. The bank had financed a 1,200 home development project in Marbella on the Spanish Mediterranean Coast before the 2008 financial crisis. While the houses had been completed, only 200 had been sold at prices of €360,000 to €420,000. The US group offered to buy the loan on the remaining 1,000 homes at a price of €117,000 per unit. Bank officials charged with the sale thought the offer was fair but needed to review it with senior management. Management declined the offer because they were not yet required to write the asset down, although it had been on their books for more than a decade. Less than two months later, Banco Popular was sold to rival Santander for one euro in June 2018. What happened?
Banco Popular became the first bank to be wound down under the new European rules designed to avoid taxpayer bailouts. Because the bank had resisted writing down its bad debts, it needed to raise €7 billion in equity capital to repair its balance sheet. Unable to raise equity, saddled with €37 billion in non-performing loans, and facing an €18 billion run on deposits, the bank had exhausted its options. The bank was forced by the European Union’s Single Resolution Board to accept its sale for one euro. While the bank's 300,000 investors lost €850 million ($1.06 billion), depositors did not lose any money.
We are fortunate that US banks had the government's help to resolve their bad debt issues in 2008. The Troubled Asset Relief Program (TARP) allowed the Treasury to buy $700 billion in non-performing loans. The Federal Reserve had the larger role and created more money under its emergency authority. The Fed invested heavily in floundering institutions and guaranteed the values of shaky assets, including $2 trillion in money market funds. By 2009, the Fed owned 80% of AIG, 60% of GM and had stakes in 700 banks. The Fed advanced a staggering $4.6 trillion, but recovered $4.1 trillion leaving US taxpayers with a cost of $500 billion.
Today, the effect of the economic shutdown of non-essential businesses in response to the COVID-19 pandemic has already exacted an enormous cost. By the end of April, the Fed already committed to advancing $2.3 trillion to support households, employees, the financial markets and state and local governments. More legislation with trillions of dollars in spending authority is pending. We are living in a very different environment with an elevated level of risk.
The G-20, including the US and the EU, all signed onto the Bank Bail-In laws in 2014. Bank depositors are now legally treated as unsecured creditors in the world's largest economies. Fortunately, most US banks are in a relatively strong position compared to those in southern Europe. At the same time, investors are increasingly sensitive to the hidden risks in their investments and financial institutions. We are witnessing increasing financial insecurity. As Will Rogers famously said, "I am not as concerned about the return on my money as I am about the return of my money." We are monitoring the likely consequences of these developments and have developed strategies that offer investors increased financial stability. We are prepared to help investors assess the risks in their portfolios and the financial institutions that hold their assets.
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