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Is US response to financial crisis strong enough?

Government action to save major financial firms has yet to show clear, positive results.

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This fits with the history of past crises around the globe, in which nations often find that cost estimates keep rising, partly because banking problems get worse when unaddressed or partly addressed.

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One reason: When a banking system is under stress, real economic activity typically suffers. That, in turn, affects the value of bank collateral such as real estate and the performance of bank loans, and the crisis deepens.

As to who bears the losses, the choices boil down mainly to investors, taxpayers, or some mix.

In his annual letter to shareholders of Berkshire Hathaway, released over the weekend, billionaire Warren Buffett said rescues have been necessary, but he warned of the rising federal tab.

“Major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests,” he said.

A skeptical US public

The public shares this concern about the toll of rising federal deficits and is skeptical of aiding troubled corporations. In a USA Today/Gallup survey late last month, 39 percent of Americans supported aiding financial firms that are in danger of failing and 59 percent were opposed.

That may be one reason Timothy Geithner, Mr. Obama’s Treasury secretary, is not moving yet to ask for extra money beyond the initial $700 billion fund Congress created last fall.

But Mr. Geithner also appears reluctant to impose high costs on investors who own the bonds or stocks issued by the banks. He has said he hopes to avoid outright nationalization of troubled banks by wiping out shareholders, for example.

He has proposed an alternative plan, but it’s not clear how successful it will be.

The Treasury’s planned course is to assess how healthy the major banks are – and then inject new capital as needed. It would come in the form of preferred shares that may be converted to common shares in the future, if needed by the banks themselves.

The banks would pay dividends back to the Treasury on the preferred shares. By trying to avoid taking common shares, the government hopes to sidestep the need to acquire a large ownership stake in the banks.

Geithner and other officials worry that the more entangled in banks the government becomes, the harder it will be to restore them to normal functioning.

Taxpayers versus investors

Critics respond that government ownership, though difficult, is the logical way out for the most troubled banks – and that to avoid it is to subsidize investors at taxpayers’ expense.

It’s possible the government is headed that way with Citigroup. The rescue announced Friday involves swapping $25 billion in preferred stock for common shares. The deal, which depends on other preferred shareholders agreeing to do the same, could make the Treasury a 36 percent owner of Citi – by far the largest shareholder.

The deal confirms that the government will be in a position to call many shots as the bank moves forward. The restructured federal aid puts Citi in a stronger position, because the amount of total common stock is now viewed by investors as the litmus test of a bank’s health. The new common shares give the bank a larger buffer against potential losses. Its existing shareholders take a large loss, because their stake is diluted in the deal.