State-owned banks simply do not allocate capital to the most efficient and profitable enterprises
Fannie Mae and Freddie Mac are United States government-sponsored mortgage firms. Often seen as the originators of the subprime mortgage crisis in the US, these two quasi-governmental organisations need more money. They have requested an additional $1.8 billion from the US government, which brings the total to $148.3 billion since the financial crisis began.
How did a staid, quiet, boring government-related financial institution get into this mess? The answer is simple. Government banks simply don't work. The economic purpose of banks in a market economy is to help investors or depositors allocate capital to the most efficient and profitable enterprises. In a recession, their job is to eliminate as quickly as possible inefficient or failed businesses for the least amount of loss.
State-owned banks and other state financial institutions simply cannot do this. It is bad enough that politicians allow public funds to follow political power. It is far worse that politicians force banks to allocate depositor money to the politically connected rather than the financially successful.
The problem is not just in the US. It is everywhere. There is hardly a country where a state-owned bank either has or will create a financial crisis. It is not a question of culture or the ability of a legal system to regulate the financial industry. Politicians are the legal system. They make the laws. They create the regulations. They control the regulators. If they want public or depositor money to go to a particular segment of the economy, it goes to that segment regardless of its economic potential.
Fannie and Freddie were able to bend the rules because of their close relationship with Congress. The extent of their interrelationships was exposed as far back as 2007 when they were fined a record $3.8 million for using corporate resources to support the campaigns of 85 members of Congress. The fine did not even slow their path to ruin and political clout insured no supervision.
One would think that the tidy Germans could manage to sustain strong banks, but the system of Landesbanken, independent state banks jointly owned by the state governments and the savings banks, have been a constant sore. As far back as 1987 they set up a 'bad bank' to deal with troubled loans. They went through major restructuring in 2002 and 2005 attempting to get rid of billions of euros in bad loans. Protected by state guarantees they happily gobbled up subprime mortgage products and created off-balance sheet vehicles. Of course two of the Landesbanken were among the few banks to fail the recent European stress tests and others refused to disclose details.
It is not just the developed countries. In Brazil, the country's state-owned development bank, BNDES, has been called "the best bank in the world". The reality is quite different. Like China, Brazil's government used the public banks to pump money into the Brazilian economy. In 2009 private bank lending grew only 10% while loans from public banks rose by 50% and most of that was from BNDES. Like China the loans from BNDES do not go to efficient smaller enterprises, who hire the most people. Instead they go to the largest and best-connected firms. Four-fifths of its loans go to large companies. Often these are state-owned firms like Brazil's oil giant Petrobras. BNDES is subsidised, which makes it difficult for private banks to compete. Considering the amount of new lending and the potential for political interference, there is no doubt that bad debts will mount.
Finally the worst of the worst is China. We discovered recently that Wall Street is not the only place that specialises in off-balance sheet securitised loans. Last year Chinese state-owned banks lent an incredible 9.6 trillion yuan ($1.4 trillion). The Chinese are trying to slow the lending down. Their target for 2010 is 'only' 7.5 trillion ($1.1 trillion). The estimate of lending in the first half of the year is $4.6 trillion yuan ($680 billion).
Under the regulations lending by Chinese banks is limited to their capital ratios. But the banks found a way around the regulations. Like banks on Wall Street, Chinese banks securitised the loans and sold them to Chinese trust companies and so removed the loans from their books and from the credit ratios. The result is that the level of Chinese loans for 2010 is 1.3 trillion yuan ($192 billion) higher than realised.
The extra money not only exacerbated the real-estate bubble and inflation, but will no doubt lead to a massive amount of new bad loans. Worse, in order to avoid inflation, the Chinese authorities may have to try harder to tighten an out-of-control money supply. Whatever the reaction, the result will not be pretty. Also like Wall Street, China's financial problems will not stay at home.
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