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Armageddon could still be some way off

Armageddon could still be some way off
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First Published: Wed, Oct 01 2008. 12 05 AM IST

Updated: Wed, Oct 01 2008. 12 05 AM IST
It is easy to see why investors freaked out when the US House of Representatives drove a stake through the Bush administration’s $700 billion (Rs32.83 trillion) plan to reanimate the banking industry. The demise—at least for now—of Henry Paulson’s Troubled Asset Relief Programme (TARP) will cause more pain—and not just for Wall Street fat cats.
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The non-appearance of the US government as a willing buyer for hundreds of billions of dollars of toxic assets will accelerate the painful process of deleveraging, bringing with it more bank failures. That, in turn, will shrink the size of the private sector balance sheet that consumers and companies have come to rely upon.
Monday’s whopping 7% collapse in the Dow Jones Industrial Average and a spike in equity volatility suggest investors fear this could spell financial Armageddon. But it doesn’t have to be. The past week’s rescues of the US banking industry’s two biggest problem children—Washington Mutual Inc. and Wachovia Corp.—offer hope that some combination of free-market capitalism and existing mechanisms for government assistance will provide some solutions.
That may not offer bank shareholders much comfort. They will probably suffer from the lack of the treasury’s plan, which helped them by offering banks a way to offload troubled assets for more than they were valued by the market. Reducing banks’ losses would indirectly have boosted the capital of the banking system. But TARP did not specifically address the root cause of the crisis —declining housing prices. Paulson might be right in arguing that TARP was needed to keep the credit system humming along, and with it the US economy. But Democrats struggled to persuade constituents, who saw a Wall Street bailout, that they would benefit. Many Republicans, meanwhile, saw TARP as violating free-market principles for which the party once stood.
Yet there may be a way forward. Take the way government agencies engineered the rescue of Wachovia over the weekend. Citigroup Inc. is paying $2.1 billion for the bulk of the Charlotte-based bank’s businesses and taking on its $700 billion of assets. For a bank with its own difficulties, this might seem foolhardy. So, to grease the wheels, the Federal Deposit Insurance Corp. (FDIC) has essentially given Citi an insurance policy against outsized losses on the $312 billion of Wachovia’s mortgage-related and other assets regarded as dicey.
That’s sort of what TARP was supposed to do. And as was proposed for TARP, FDIC is getting a mix of preferred stock and warrants worth $12 billion that allows it to benefit from any upside in Citi’s value, while boosting the bank’s capital ratios. Citi is also raising $10 billion from its own shareholders to finance the deal. The end result is a hybrid of risk-taking by the US taxpayer and Citi’s shareholders. FDIC, created in 1933 in response to the bank runs during the Great Depression, insures deposits in member banks and thrifts for at least $100,000, and provides coverage for retirement accounts up to $250,000.
Of course, Citi chief executive Vikram Pandit might have struggled to sell the Wachovia deal to his board without the government’s bailout plan on the horizon. But it would equally have been irresponsible for Citi—or for Warren Buffett’s Berkshire Hathaway Inc. and Mitsubishi UFJ Financial Group Inc., which invested, respectively, in Goldman Sachs Group Inc. and Morgan Stanley in the past week—to have agreed to a deal predicated on US congressional approval.
These deals—along with JPMorgan Chase and Co.’s acquisition of Washington Mutual in another FDIC brokered deal—show that willing buyers can be found for distressed institutions with government mechanisms that are already available. The more the government helps, up front or through some sort of insurance, the less risible the price a saviour will offer.
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First Published: Wed, Oct 01 2008. 12 05 AM IST