The best is saved for the last in this excellent article. It’s where the author (Espen Eckbo) describes bail-outs as a zero sum-game, if the tax payers do not get the best deal (that is, the biggest equity stake), someone else (shareholders, management..) will..
Do we really want to reward dysfunctional management and shareholders, the first especially have appropriated already more than enough, we would think.
And then, there is also the moral hazard problem in alternatives (like loan guarantees), as Willem Buiter explains in two other articles about bailout programs in The UK (and here) and The Netherlands.
Scandinavia: Failed banks, state control and a rapid recovery
By B. Espen Eckbo
Published: January 22 2009 19:29 | Last updated: January 22 2009 19:29
The Scandinavian financial crisis of the early 1990s followed a period of financial liberalisation in the 1980s. These policies included liberalisation of bank lending volume, removal of interest rate caps, modernisation of bank capital requirements, and the introduction of relatively high-risk financial products.
This liberalisation caused a rapid expansion in the volume of bank loans made available for speculative investment and banks became much more sensitive to creditor default rates. In this more fragile state, negative economy-wide shocks exposed the illiquidity of the banks’ loan portfolios and threatened the solvency of the banking system.
After a big drop in the world oil price in 1986, Norway (a significant oil-exporting country) experienced a shift in its current account from a surplus to a deficit, which in turn triggered a devaluation of the Norwegian krone in 1986 (Norway was pursuing a fixed exchange rate policy at the time). A recession began in 1988, which started a financial crisis among the country’s savings banks, followed by the collapse of major commercial banks and the real estate market in 1990-92.
Sweden also experienced a recession and the country’s largest savings bank collapsed in 1991, followed by a collapse of two of its largest commercial banks. Property prices had dropped and the country experienced a currency crisis in the autumn of 1992. The crisis ended in 1993 in both countries.
According to calculations by the International Monetary Fund, the cumulative fall in real gross domestic product over the crisis period was greater for Sweden than for its neighbour (5.3 per cent versus 0.1 per cent). Loan losses in the peak crisis year amounted to 2.8 per cent of GDP in Norway and 3.8 per cent in Sweden, while non-performing loans added up to 9 per cent and 11 per cent of GDP in each country, respectively. In Norway, it took two years for the banking sector to return to profitability, and four years before bank lending was back to its pre-crisis level. In Sweden, return to profitability also took two years but it took 10 years before bank lending reached its pre-crisis level.
Norway: the Government Bank Investment Fund
In Norway, the banking industry privately funds two guarantee companies, the Savings Banks’ Guarantee Funds and the Commercial Banks’ Guarantee Fund. These were drawn down during the initial phase of the crisis (by 1991). In addition, several of the banks were merged and others were bankrupted and placed under temporary public administration.
The government initially started to fund the failed banks through its new Government Bank Insurance Fund in January 1991. This insurance fund was an independent legal entity with a mandate to provide liquidity to the two private guarantee funds. The fund was allowed to impose conditions both on the private funds and the banks receiving bail-out money. These conditions concerned, among other things, management issues such as hiring and firing of key personnel, board composition and major investment decisions.
The Norwegian government also implemented a division of labour between the Government Bank Insurance Fund and the Norwegian Central Bank. The former would channel support to banks that were largely insolvent while the latter would provide liquidity in the form of loans to largely solvent banks.
In the autumn of 1991, the crisis reached systemic proportions with large losses reported by the three largest commercial banks. These three banks held about half of the total assets in the banking sector.
At this point, the Norwegian parliament created a second financing vehicle: the Government Bank Investment Fund (GBIF). While the insurance fund continued to pour liquidity into insolvent banks, GBIF began to purchase securities floated by banks that were still relatively healthy. This included purchases of “preferred capital”, an equity-like contract that was convertible into common stock. In preparation for GBIF’s purchase of this convertible preferred security, the Norwegian parliament amended the existing banking law, allowing the government to write down a bank’s common stock to zero against its losses. The purpose of the amendment was to prevent equity holders from holding up (forcing bargaining with) the government as it proceeded to bail out the banking system.
Subsequent common stock write-downs resulted in the GBIF becoming the sole owner of two of the three largest commercial banks, and the dominant owner of Den Norske Bank (DnB), the largest. By the end of the 1990s, the government had sold most of its banking shares to private investors, with the exception of a “negative majority” (34 per cent) held in DnB. The negative majority allows the government to block a takeover – perhaps a benefit for some local interests but at the cost of reducing international competition for Norwegian banking assets.
The Norwegian economy started to recover in 1993 and the banking crisis was essentially over. Research at the Norwegian Central Bank indicates that, based largely on direct cash flows, the overall benefit of the government’s intervention likely exceeded the direct cost (which included direct payments and interest rate subsidies) even without accounting for the value of various loan guarantees that never had to be called.
Sweden: the ‘good bank/bad bank’ model
The crisis in Sweden began with heavy losses reported by the country’s largest savings bank, Första Sparbanken, in 1991. Later that year, the third-largest commercial bank (Nordbanken) also began reporting big losses. At the time, the Swedish government owned 71 per cent of the bank’s common stock.
The government proceeded to purchase a new share issue and to buy out the private shareholders at the equity issue price. This was in contrast to Norway, where the private equity was forcibly written down to zero before the government proceeded to fund the bank.
In full control of Nordbanken, the government split the bank’s assets into two parts: the “good” assets were continued within the bank while the “bad” non-performing loans were spun off into a separate legal entity called Securum, created in 1992. The spin-off into Securum was partly a response to Swedish banking regulations that prohibit banks from holding shares in the companies to which they lend money. Securum was not a bank, only an asset holding company and could, therefore, receive equity positions in the troubled companies when they defaulted on their bank debt.
A “bad bank” solution was also created for Gota Bank, the fourth largest commercial bank, when it failed in early 1992. This time, the bad assets were transferred to Retriva, the asset management company. The remaining good assets of Gota Bank were auctioned off and eventually purchased by Nordbanken in 1993 with no payment to Gota Bank’s shareholders.
Most of the troubled assets that Securum acquired from Nordbanken were in the form of loans to various financially distressed companies, with the remainder consisting largely of real estate holdings. Securum financed the purchase with the combination of a loan from Nordbanken and a government equity infusion. Securum’s mission was to liquidate in an orderly fashion the troubled assets so as to maximise recovery. The management company was dissolved in 1997 after successfully liquidating its assets.
Securum drove a hard but successful bargain with many of its troubled borrowers. Part of the loan mass was by small companies, and it was not uncommon for the company founder or entrepreneur to pledge his own common stockholding in the company as collateral for the company’s loan. If, however, the company failed to service the debt, Securum had the right to seize the pledged collateral, thus, in effect, acquiring control of the distressed company without the need for a formal bankruptcy procedure. In Sweden, the bankruptcy code mandates a quick auction sale of the bankrupt company (piecemeal or as a going concern).
Avoiding bankruptcy, Securum also avoided the auction time pressure, and instead proceeded to develop the troubled company in preparation for its sale as a going concern down the line. To support this strategy, Securum’s management team was deliberately chosen to have industrial management experience, which contributed to its success.
Unlike Norway, Sweden also issued (in the autumn of 1992) a blanket guarantee of all bank loans in the Swedish banking system, effective until July 1996. Naturally, this blanket guarantee greatly benefited existing bank shareholders. Moreover, the Swedish Central Bank provided liquidity by depositing large foreign currency reserves in troubled banks, and by allowing banks to borrow freely the Swedish currency (at no risk to the central bank, given the government blanket loan guarantee). Perhaps because of these additional moves, the Swedish government’s cash infusion to end the banking crisis was almost entirely limited to Nordbanken and Gota Bank.
In sum, both Sweden and Norway created bank restructuring agencies to oversee the government’s cash infusion in troubled banks. Existing shareholders were largely forced out of the failed banks. Both countries also established strict guidelines for companies receiving government support, including balance sheet restructuring targets, risk management and cost cuts. Moreover, both countries engineered a public takeover of the largest troubled commercial banks, and promoted private bank mergers. However, only Sweden implemented a “good bank/bad bank” model, and, perhaps most important, only Sweden issued a blanket creditor guarantee that greatly benefited existing bank shareholders. The end result was similar in both countries: a relatively speedy recovery and a return to robust economic growth. The macroeconomic impacts of these banking crises were relatively short-lived.
Lessons for the current downturn
When comparing Scandinavia with the US, what stands out is the role played by government ownership of the failed banks in Scandinavia. This role was (and still is) politically acceptable because the governments in Norway and Sweden have a long history of partnering with the private sector. Also, nepotism and outright corruption are minimal in these societies.
The US bail-out strategy up to the time of writing has been much less coherent, with a virtual case-by-case approach to the developing crisis. Thus, we have twice seen a specific loan guarantee to induce the takeover of a failed bank by a private party (JPMorgan’s purchase of Bear Sterns, conditional on a $29bn government guarantee of Bear Stearns’ debt; Bank of America’s acquisition of Merrill Lynch with an initial assistance of $10bn from the Troubled Asset Relief Program); a cash infusion in return for a controlling equity position ($80bn paid to AIG in return for an 80 per cent equity stake in the insurance giant); cash infusions without taking back equity ($200bn to Fannie Mae and Freddie Mac after the twin mortgage companies were placed into federal “conservatorship”; Tarp funds to nine banks, including $25bn to Citigroup); and auction purchases of non-performing loans from failing banks. As an extension of these policies, the US is also providing distressed loans to two industrial companies on the brink of bankruptcy (General Motors and Chrysler). Most recently, there is also talk about implementing a “bad bank” solution to Citigroup’s financial troubles, following the bank’s write-offs of more than $90bn over the past five quarters. The plan is to spin off Citigroup’s troubled businesses and assets into a separate entity (Citi Holdings) and gradually liquidate these over the next three years. This break-up plan comes after substantial cash infusions of Tarp funds.
In the US debate, government acquisition of controlling equity ownership positions in failed banks has proved to be controversial. Indeed, there remains a deeply rooted scepticism towards government ownership of private enterprise. However, as the Scandinavian experience suggests, the approach to this issue ought to be pragmatic. Since the objective is to maximise taxpayer returns from the bail-out, a greater commitment to government acquisition of equity stakes in troubled financial institutions ought to be considered. It is a zero-sum game: if the taxpayer does not insist on the best possible deal, some other party to the bail-out will reap benefits at the taxpayer’s expense.
A clear case in point is the $8 per share windfall to shareholders of Bear Sterns, when the government debt guarantee of that bank caused JPMorgan to raise its takeover bid from $2 to $10. This type of shareholder windfall, which we also saw in Sweden as the stock market responded to the government’s blanket debt guarantee, would have been avoided had the government taken an equity stake in the bailed-out bank.
B. Espen Eckbo is Tuck Centennial professor of finance and founding director of the Center for Corporate Governance at Tuck School of Business, Dartmouth College.