During the Great Recession of 2008 and 2009, the US and UK economies had a lot in common. Both had large, over-leveraged financial sectors with interlinkages that often weren’t visible to regulators. Both saw sharp declines in business and consumer confidence as the crisis took hold, particularly in the aftermath of Lehman Brothers’ collapse in late 2008. Both governments eventually took the decision to prop up their financial titans by directly injecting capital and guaranteeing debt.
When the decision to pump money directly into the banks was taken – first by Gordon Brown – there were many who objected. David Cameron and George Osborne, at the time, opposed the bank bailouts as a waste of public funds. But the reason that so many governments acted in this way – not just the US and the UK, but a host of other Western countries as well – is that there was simply no other choice. Letting RBS fail would have crippled the UK’s financial infrastructure, and probably plunged the economy into outright Depression. This meant that even if a government thought the entity it was supporting would still fail, they might have to grin and bear it. Northern Rock is the poster child here in the UK; and in the US, it was American International Group (AIG), the large insurance firm that was tied into thousands of contracts. In the jargon, AIG was ‘systemically important’ – like RBS, letting it fail could have brought down the entire financial sector.
At the height of the crisis, AIG’s balance sheet was bigger than $1trn, and it was heavily exposed to derivatives. Most insurance companies like to balance long-term, boring and safe returns (normally government bonds) against exposure to equities that can being higher yields. AIG invested its funds in sub-prime mortgages, and at the same time wrote insurance against those risky securities. Just as home insurance can pay for a new carpet if the fire burns a hole in it, AIG’s insurance policies would pay out to investors if the risky securities went belly up. In other words, it had lots of contingent liabilities tied to the sub-prime market; but a large chunk of its assets were invested there as well. To make matters worse, AIG was also involved in retirement accounts and ordinary insurance, so its failure would have been felt in the real economy straight away.
In total, the US poured $182bn into AIG. The company spent $85bn of that within two months. At the time, the US administration all but admitted that it might not get its money back.
After seizing control, the priority for the government was to assess the securities and exposures that AIG had on its balance sheet, and slowly write them down, package them up, and sell them off. In order to do this, the US used a version of the so-called ‘bad bank’ approach, where the government set up new entities to buy bad assets from AIG (and other institutions). These bad banks – known as Maiden Lane II and III – were financed with public loans, buying time for the government and its advisors to sift through the debris.
Ultimately, the US government could not stop AIG losing money on these loans and securities – they were still likely to be sold off for less than AIG first paid for them or valued them at. But, because the government ‘bought’ AIG at a relatively low price, there was a chance that taxpayers could even make money on the assets.
This is because of the one critical commodity that governments (and central banks) can buy: time. Fiscal policy cannot remove losses per se – the best it can do is socialise them. But one of the key strengths of fiscal policy is that countries are infinitely lived – governments can borrow money at (usually) low interest rates and support companies or projects over long horizons. If conditions improved, and prices started to rise, then the US government could even sell bad assets for more than they bought them, and make money.
This is what happened with AIG. The Fed thinks that it might have made about $8bn profit, overall, from sales of AIG assets. Together with the interest and fees for public support, the US is well on course to make money, overall, from its financial sector interventions.
Compared with the UK, the critical difference is to do with the divergence in economic performance since the bailout of AIG. The US recession was relatively shallow, and the economy has bounced back to positive, if recently soft, growth. The UK recession was the deepest since the 1930s, and the recovery has been even worse than after the Great Depression. Fiscal policy has undoubtedly exacerbated these differences; while Americans are rightly concerned about their budget deficit, it has at the same time helped to support activity.
This economic divergence matters because, in the end, bank losses are endogenous – they depend on the state of the economy. The US has made money on AIG because its economy has performed better. Of course, continued central bank support has helped financial markets, but we have similar structures in place here in Britain. What we don’t have is a growing economy. Unfortunately, unless the UK government can finally pull its finger out and generate some decent growth, British taxpayers could end up losing money on the UK bailouts. This would be yet another public policy failure: as the US experience shows, bailouts don’t have to cost money.