Khanna asks, 'Did bailout inadvertently freeze credit markets?'

Publish Date: Monday, October 20, 2008

Broad School Professor Naveen Khanna, the A. J. Pasant Endowed Chair Professor in Finance, wrote a three-part commentary on the 2008 financial crisis. According to Khanna, "The crisis we are now facing is no longer due to the excesses in the housing market, but because of the excesses by our government in dealing with the problem."

The biggest bailout in U.S. history, which is now unfolding, was expected to stabilize the markets. Instead, the markets have lost nearly 20 percent of their value since the bailout was signed into law, leaving many experts and the government perplexed. In spite of injection of huge amounts of funds into the markets, why are the credit markets still frozen and businesses still starved for funds? In spite of the bailout's direct intention of helping banks become healthier, why are bank stocks swooning?

I argue that the crisis we are now facing is no longer due to the excesses in the housing market, but because of the excesses by our government in dealing with the problem.

Let us not forget that originally the subprime loans amounted to only about 12 percent of the banks' assets. Since not all of these mortgages were likely to go bad, this should have been a manageable problem for the banks without government 'help.'

However, by intervening, and doing so in an unexpectedly heavy-handed way, the government has violated fundamental free market principles. The rules under which banks operate are suddenly very different. The Secretary of the Treasury now decides who lives and who dies. The penalty for a bank in financial distress is now draconian (potential takeover without compensation), inducing banks to hoard large amounts of money in an effort to establish a cushion against 'inviting' government intervention. This has caused the credit markets to remain frozen (or become even more frozen) in spite of the unimaginable amounts of liquidity being pumped into the system.

By expropriating most/all shareholder value of the institutions it 'helped,' the government has made investing in bank stocks extraordinarily risky. Who would want to invest knowing tomorrow the government, for potentially opaque reasons, may decide to expropriate all/most shareholder value? This has led investors to demand a huge 'intervention premia' for investing in bank stocks' thus reducing stock price and making banks even weaker.

The large bailout amount of $700 billion with very few constraints on how the treasury may use it, serves only to make government's hand in determining any bank's future infinitely stronger. It is like we have unintentionally let loose a 700-pound gorilla which, in its desire to help out, is scaring off already nervous investors and making share prices tank. The very well-intentioned offer to help banks creates so much fear for the investors that they cannot wait to sell their bank stock. This sell-side pressure can become strong enough that even a previously healthy bank now needs to be helped. This is playing out like a tragic self-fulfilling prophesy with no end in sight.

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