Explaining the Swedish bailout model

Explaining the Swedish banking model

There’s a been a lot of talk of the Swedish bail-out models by the economic big-wigs lately.  Here are some facts to get you up to snuff.

What brought it on?

In the early 90s, Sweden suffered from an economic crunch brought on by the property bubble.  From 91 to 93, the economy went into the reverse gear.

According to the Swedish central bank, “a tidal wave of bankruptcies” between 1990 and 1994 left Sweden’s seven largest banks, which accounted for 90 percent of the market, with loan losses totaling the equivalent of 12 percent of Sweden’s annual gross domestic product.

The Swedish bailout

Sweden set up an agency to recapitalize the banks.  Contrary to what the US is proposing – taking over the bad debts of the near-insolvent banks, the Swedish government became owners of those banks in exchange for help.

Step 1:

Provide blanket guarantee on all bank liabilities.

Outcome: Restore depositor and creditor confidence, prevent run on banks that would’ve made restructuring impossible.

Step 2:

Parliament passes emergency legislation to take over and nationalize any bank on the verge of failing.

Outcome: Good enough banks would gain enough time and credibility from the blanket guarantee that no take-out/nationalization is needed.

The threat of government control scared most banks away from seeking bail-outs.  Most of the large institutions found ways to get through the problems without any government help.

For example, large Swedish banks such as SEB and Swedbank obtained new capital from private investors, and established their own bad banks with the help of outside investors.

Step 3:

Liquidity test on banks.  If the model indicates the bank  can become profitable again in the near term, then it is given support to survive.  If the model indicates the bank will never become profitable again, then it is closed or merged.

Outcome: Avoids the Japanese problem, where illiquid or semi-liquid banks were given a lifeline despite its profit outlook.

Step 4:

Nationalize insolvent banks once they write down their losses.

Outcome: In the end, Sweden only had to nationalize two – Nordbanken and Gota Bank, that were on the verge of failure.

Step 5:

Set up a bad bank for each new nationalized bank to dispose of bad loans.

Outcome: Removing bad assets allows management team to resume its rightful role as a lender.  A separate entity is better equipped to dispose of the loans or underlying collateral since it is its mandate to do so.

Furthermore, no more write-offs to undermine the morale and confidence of the banking sector.

Step 6:

Price assets of bad banks to reflect market value with help of outside consultants.

Outcome: Government gets accurate assessment on the amount put into the banks.  It then waits for market to rebound.   As an equity investor, it’s able to recoup its original investment plus potential gains.

The bad bank – Securum closed after only four years.  The Federal Reserve of Cleveland found (PDF)that more than half of taxpayers’ money had been recovered.

Economists and investors loves it, here’s why

Who loves this solution?  Count in Jim Rogers, Nouriel Roubini and Nassem Taleb.

1. The strategy held banks responsible for their actions, and turned the government into an equity owner.  When distressed assets were sold, the profits flowed to the tax payers, and the government could later recoup its investment by selling shares into the companies.

The extraction of bad assets from the bank meant that the investors would bleed and pay for their investments into the banks, but the taxpayers were not on the hook.

Market observers liked the Swedish model in steep contrast to what they see lacking in the current US rescue plan.

The US version provides the banks capital with “no strings attached” financing, whereas the Swedes took control of the struggling banks in exchange for aid.  This gives the investors an upside once the market picks up, and the assets become valuable again.

2. The measures were designed to minimize costs for the government and reduce the risk of moral hazard.

The stockholders were not covered by the plan, and lost their equity investments in order for the government to come in.  This crucial litmus test ensured that owners would not apply for state support unless absolutely necessary.

Instead of having the bond and stockholders bearing the cost of their failed investments, the US bailout plan has the taxpayers paying for assets which values are unclear.

picture source: ~maq4ka

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  • http://creditreportscrub.blogspot.com/ The Scrub

    Thank you for writing this. I linked to it in an article I wrote in support of this model. You saved me about 3 hours of writing.

  • http://creditreportscrub.blogspot.com/ The Scrub

    Thank you for writing this. I linked to it in an article I wrote in support of this model. You saved me about 3 hours of writing.

  • http://investoralist.com Dana

    Thanks for visiting, glad to be of help!

  • http://investoralist.com Dana

    Thanks for visiting, glad to be of help!