The financial press’ coverage of the “bailouts” on Wall Street by foreign and other investors has left out a critical component—namely what if the bailouts hadn’t happened?
Several business news outlets hint at, but never explain, dire scenarios these bailouts apparently averted.
The Wall Street Journal recently led its front page with a banner headline declaring “World Rides to Street’s Rescue.” The Financial Times headlined its page-one article “US banks get Dollars 21bn foreign bail-out.” The New York Times said “Citigroup’s Big Loss Fuels Anxiety and Depresses Stocks.” None give us the background necessary to really understand the implications of the bailouts.
The WSJ says that “Citigroup needed fresh cash to keep its capital levels from dipping into dangerously low territory.” So what would have happened if Singapore, Prince Alwaleed bin Talal, and the like hadn’t forked over the cash? Could Citigroup’s earnings be wounded for a few years? Or something worse? We’re not told.
The FT’s story says little about why the story mattered beyond the fact that the move was “to shore up balance sheets devastated by the subprime mortgage crisis.” And if the balance sheets weren’t shored up? No comment.
The Times was no better.
The Washington Post, in an otherwise pedestrian story, gives readers a hint of the background necessary to understand how raising capital can boost the banks themselves and the economy as a whole:
The moves to raise more capital are particularly important if financial institutions are to play their normal role of cushioning the blow to the economy amid a slowdown. In a typical slowdown, banks stand ready to lend money to businesses and consumers, helping mitigate the damage. But in this financial crisis, banks are finding themselves with a shortage of capital. That, economists worry, may make them exaggerate the downturn rather than cushion it.
But how are readers to know what happens when these giant losses hit the balance sheet? How do they affect a bank’s reserves, capital ratios, and ability to lend? What impact do the losses have on the bank’s future earnings?
Readers need a quick lesson in banking. A bank must keep a small amount of capital in reserve for every dollar it lends (roughly $1 of capital for every $10 to $12 lent at many banks, though it can be less). When a bank writes down its assets, its capital decreases and it can’t lend as much. That hurts the economy as a whole, which depends on credit as its lifeblood, and it hurts the bank’s future earnings since it doesn’t earn interest on loans it otherwise could have made.
To ease a capital crunch, banks can raise money by issuing new stock, as they’ve recently done. That causes its own problems because it dilutes the value of existing shares. But the big purchases of bank stocks also boost confidence in the banks’ future and provide the cushion for future (hopefully) profitable loans.
Even with the recent capital infusions, banks’ ability to lend has been severelydamaged. The Globe and Mail gave its readers a nice explanation of how the impact of the writedowns get amplified:
The U.S. subprime mortgage disaster has dried up liquidity, sucking an estimated $1-trillion (U.S.) from the amount that banks have for lending [The crisis] has cost many of the world’s biggest financial institutions roughly $180-billion (U.S.) worth of writedowns and credit losses thus far, although those have been somewhat offset by about $80-billion in cash infusions, largely from foreign government funds, analysts at Desjardins Securities Research said in a note yesterday. “Still, the contraction of $100-billion (U.S.) in balance sheet equity means that there is about $1-trillion (U.S.) less to lend, assuming a 10-per-cent reserve ratio,” the note said.