Antonio Rivela. Professor. IE Business School
8 October 2008
One of the collateral effects of the crisis is a purge of the entire system as Darwin’s famous survival of the fittest kicks in. But should all species be left to fend for themselves?
What should the central banks do to combat the recession? That is the question asked constantly by investment banks, politicians, legislators and people on the street. Many players on the market will see a digital answer to the question.
Should they inject funds indiscriminately into the system from the public treasury to correct the upset caused by the investment banks? Or should they be allowed to fall in pure Darwinian survival-of-the-fittest style? On this particular occasion I happen to think that it depends on each case.
There are banks which, owing to their status, help the financial system on a structural scale. They can be compared with the age-old trees that form a basis for an ecosystem. Without them, no animal would be able to exist. The latest examples are the agencies that support the mortgage system in the United States, affectionately known as Freddie Mac and Fannie Mae, since their initials are unpronounceable, believe me. I think it is blatantly obvious that these institutions should be helped in order to avoid a potential collapse of the United States property market, which could have been comparable with the 1929 recession. In these two cases, the Fed was correct to inject $100 billion into each institution.
There are other banks which, although they are not quite so essential, would cause greater mayhem if they were to go bankrupt than the cost of the public aid needed to lend them a hand. They are like the foliage that surrounds the trees in the tropical jungle. Nobody speaks about them, but they play a vital role in the system. This group comprises the monoline financial insurers such as MBIA, Ambac, Security Capital Assurance, FGIC and CIFG.
For those who have read about the subject but have never understood what they do, briefly we can say that a monocline insurer guarantees the credit classification of a bond issue, bumping it up to AAA or AA levels. Accordingly, the issuer obtains cheap finance since the cost of the premiums is very competitive. An enterprise in the electricity sector with a credit classification of A would rise several steps up to the coveted AAA level thanks to the payment of a meagre 20 annual basic points (0.20%). I also think that it is of key importance for the central banks to help these institutions.
Finally, there is a third group of market players. In keeping with our Darwinian simile, they would be the jungle predators. They are important for the system but they have to be regulated by the right sense of "the survival of the fittest" and, in my modest opinion, they should not be helped by public funds. The reason is that these institutions should have a business model that can be sustained over time or, if the level of volatility does not allow said sustainability, they should save when times are good for when times are not so good. This is precisely what investment banks and building companies have failed to do. They have both taken a directional view based on the property market, which, as we all know, is cyclical.
In this third group, we have heard news that is comparable (if we apply the biological simile) to the disappearance of a protected species: the disaster of the Lehman Brothers investment bank, which has resorted to the useful option of chapter 11 before the bankruptcy court of Manhattan.
In United States bankruptcy legislation, chapter 11 is the option taken by firms attempting to reorganise their balance sheets to cope with their liabilities and continue their business. In contrast, chapter 7 enables the process for liquidating assets and is for firms that have no intention of continuing their operations. Whatever the case, it is a bankruptcy in the purest sense of the word that results in bonds selling at residual value, that some market players estimate stands at around 60%. Lehman had a debt totalling $613 billion.
After the failed attempt by its potential buyers Bank of America, Barclays , and "daddy" Fed to finance Lehman’s losses in its associated assets, mainly residential and commercial property risks, the North American Federal Reserve, quite correctly in my humble opinion told them, to their shame, to go take a running jump.
One last example: the well-known insurer AIG is asking for $40 billion for losses that have been estimated to stand at $30 billion at least. I think my position is clear with regard to enterprises in this third group and, if you are in any doubt, just ask Charles Darwin.