Rewarding Dishonesty

The Problem of ‘Toxic Assets’

"Our job is to fix the problem in the financial sector at the least risk to the taxpayer," said U.S. Treasury Secretary Timothy Geithner 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," according to the Fact Sheet of the Public-Private-Investment Program of the U.S. Treasury, which confirms what has been rumoured since early March.

According to the new bailout strategy, the U.S. government will spend yet another staggering $75-100 billion in order to help raise $1 trillion to stimulate the economy and ‘flush’ the U.S. financial system of the ‘toxic assets.’

Geithner admitted that this plan was fuelling public anger as Wall Street seemed to benefit at times where average Americans were suffering. The financial sector has indeed been a major beneficiary of previous support. As an example, the Troubled Assets Relief Program (TARP) worth more than $700 billion, included $25 billion packages each for Citigroup, J.P. Morgan Chase and Wells Fargo, the largest amounts ever given to any bank.

"The (public) anger and outrage is perfectly understandable." He firmly added, "we have to make sure our assistance is not going to award failures."

The bailout strategy for the banks is symptomatic of how the United States plans to combat a self-inflicted economic crisis: Enabling banks to lend money freely with a federal interest rate 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 – hopefully – facilitate increased public and private spending.

In the short-term, the U.S. strategy might help stimulate economic activity, given how 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 this global economy, the recession greatly impacted a significant number of countries as well as business sectors that had, however, little or no benefit from the aggressive increase of the market share, including dramatic increases in Return-On-Investment (ROI) from U.S. banks.

Banks in Austria, a paragon for most Western European counterparts, usually follow a conservative substance-oriented strategy of financing private houses and apartments, as well as financing investment portfolios with low contingent liability and comparatively small surcharges on reference interest rates, resulting in fewer earnings for the banks compared to those in the U.S.

However, when the financial crisis spread 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 in government subsidies in case of equity capital shortages, currently with 9.3 % interest. At the time of writing, EUR 2.8 billion was spent, and among the banks that applied for support were some of 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 to the 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 Democrat Chancellor Werner Faymann of Mar. 10, EUR10 billion were so far approved by the government, though he was quick to assure that Austria’s Bank Rescue Package contained "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 in supporting Austrian banks through the financial crisis would be sufficient. In an interview with the Austrian daily Kurier on Mar. 12, Nowotny claimed optimistically that "the (Bank Rescue) package would not be fully capitalized."

The Effects of Subprime

Austrian banks are less affected than by the international financial crisis than other European banks, pending the economic development in Central and Eastern European countries. However, the U.S. financial institutions are central. Their method of financing reflects short-term consumer-oriented policies far exceeding earnings risks.

Subprme lending by American banks was anything but fair to private house owners, or to national economies. Those responsible knew, or should have known, of the immense contingency risks, estimated by the IMF in Jan. 2009 at $2.2 billion contingent liabilities for the U.S. economy.

To approve a mortgage in Austria, banks need to verify two conditions: Firstly, the borrower has to be able to afford the repayment terms, based on an assessment of monthly expenses. Secondly, the mortgage must not exceed 60-80% of the estimated market value of the property. This approach is crisis-resistant, and, among others, responsible for stable overall real estate prices in Austria.

In the United States, it was customary for lenders to approve mortgages for borrowers unable or unwilling to meet their payment schedule. Those bundled subprime packages were then sold to third parties, ensuring that their own mortgages would be taken out. At the same time, the banks and mortgage companies earned a commission on the new mortgages.

Yet, it was not just for the sheer number of new mortgages. Those were based on up to 300% of the property value, already deliberately overrated by the banks and mortgage companies, in order to take even higher earnings 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.

Clearly, national U.S. politics has its share of responsibility in this crisis: the authorities – the Federal Reserve in particular – knew about outsourcing and the sales of non-performing mortgages, for example. However, the danger of setting the world economy back as in the 1920s caused by the collapse of the financial sector is an unacceptable risk. One only needs to think of the ensuing mass unemployment, political riots and the rise of extremes on the political left and right.

Nevertheless, that does not remove the political responsibility of taking the right decision. Either we follow the United States in its attempt to give everyone a slice of the cake so that as much money as possible is pumped into the economy; or Europeans pursue the approach of selective support based on evaluation of individual measures, like the continued emergency financial support for Hungary in an attempt to stabilize its forint.

From current perspectives, Europe has a better chance of overcoming and gaining 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 in the United States, the economic developments are severe: As for Austria, the two primary economic research institutes, the Institut für Höhere Studien (HIS) and Wirtschaftsforschungsinstitut (Wifo), estimate a drop in GDP of 2.2 to 2.7% (EU-27 estimates of -3%) for 2009; the OECD estimates for the U.S. a decrease of 2.7%. The recovery is predicted for 2010 for the U.S. with an increase of 0.5% –as in Austria with 0.4 to 0.5% -- while 0% projected for the EU-27 in 2010.

Given those economic indications, the only pragmatic course is to subsidize the troubled financial institutions to avoid a long-time depression. And for the United States, Geithner sees the bailout as the answer for Europe as for 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 efficacy of the ‘toxic assets’ bailout program remains to be seen, European countries have not chosen to ‘reward’ those who contributed to the crisis with large subsidies.

While former BAWAG manager Helmut Elsner or CPB boss Karl Petrikovits in Austria have found themselves under criminal investigatio, a wider criminal investigation into the dealings of the U.S bank managers is still outstanding. This will be essential to prevent future financial dealings that endanger the global financial sector.

 

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