The RTC or the RFC: Taxpayers as Involuntary Equity Investors

Do we need a “new RTC” as the U.S. Treasury is proposing—or something else? We believe that an alternative framework is needed. Its key elements should be two: recognition of systemic risk embedded in the illiquidity of mortgage-backed securities and capture of the upside of a rescue for taxpayers, not for banks and (former) investment banks that created the bubble.

Let’s set some context. The United States now presents a striking case of the recurring debate about governments using public money to offset the losses of financial firms in the name of financial and social stability. The debate goes back at least to 1802, when Henry Thornton (The Nature and Effects of the Paper Credit of Great Britain) clearly discussed the “moral hazard” and “systemic risk,” as we now call them, so prominently involved. At the end of the last big U.S. bust, in 1989-91, Americans seemed relieved to have the government “resolve” things by presenting the bill for the cost of its deposit guarantees to the taxpayers. The Japanese in the 1990s developed the same attitude, as have many others before and since.

Financial systems involve an uncomfortable combination of the public’s desire to have short-term assets, including deposits, which are effectively riskless. But these instruments fund businesses which are inherently quite risky and subject to recurring losses greater than anyone ever imagines. The combination of riskless funding with risky businesses is in fact impossible. Governments are therefore periodically put in the position of desperately wanting to transfer losses from the banks to the public—as once again today.

These transfers effectively make the taxpayers into involuntary equity investors. How do we give them fair treatment as investors?

The Treasury’s proposal to Congress to allow the purchase of mortgage-backed securities directly from banks, investment banks, and insurance companies will not give taxpayers a stake in the systemic benefits that will result from a solution to the banks’ unique, incipient solvency problem. Currently, “private label” mortgage securities are challenging, if not impossible, to value. Their holders refuse to sell them at offer prices that would clear the market because such prices would raise questions about the solvency of many financial institutions that own much of the $15 trillion of U.S. residential and commercial mortgages outstanding. The liquidity problems faced by the financial sector create an incipient solvency problem because if all holders of mortgage-backed securities need to sell/liquefy them, their value would collapse and create an explicit solvency problem. But, electing to hold on to mortgage securities in the hope of receiving a better price in the future requires financing the holdings. With house prices continuing to fall, the cost of financing has risen sharply and, in some cases, has become unavailable at any price. The result has been acute distress and, in some instances, outright failure—as in the case of Lehman Brothers—or the need for a firm to sell itself to a large bank—as in the case of Merrill Lynch’s absorption by the Bank of America. As the plight of these institutions threatened Morgan Stanley and Goldman Sachs, systemic panic set in, and Paulson and Bernanke had to go hat-in-hand, up to Capitol Hill for some real money—upwards of $700 billion.

Moving ahead, if the Treasury offers too much for the distressed mortgage-backed securities—MBS—owned by banks and others, the cost of the bailout will skyrocket. It could become counterproductive if the prospect of another $700 billion-plus in Treasury borrowing pushes interest rates higher. If offer prices are too low—far below current optimistic values being placed on MBS by their owners—solvency risks will remain.

A better model for a fair solution to the incipient solvency problem is the Reconstruction Finance Corporation, or RFC, of the 1930s. This was one of the most powerful and effective of the agencies created to cope with the greatest U.S. financial crisis ever. When financial losses have been so great as to run through bank capital, when waiting and hoping have not succeeded, when uncertainty is extreme and risk premia therefore elevated, what the firms involved need is not more debt, but more equity capital.

Consider the approaches available to a government to address a financial crisis. First, there is delay in recognizing losses while issuing assurances (e.g. “the subprime problems are contained”). Then there is the central bank as liquidity provider or lender of last resort, which however freely lending, is by definition providing short-term debt, not equity. There is an RTC, a master liquidator. But when the capital is gone, something different is needed: an emergency provider of new equity capital, as was the RFC.

It is little realized today what a huge operation the RFC was. Its total investments in American companies, mostly financial institutions, were $50 billion. Adjusted for the change in the CPI since 1933, this is about $800 billion; adjusted for the growth in nominal GDP, it would be about $12 trillion. The most important element of RFC operations to address the nationwide banking collapse was the ability of the RFC to invest in equity capital in the form of preferred stock. More than 6,000 financial institutions, including many of the principal banks of the day, were the recipients of RFC investments.

The basic pattern of RFC operations, as described by its head, Jesse Jones, in his instructive memoirs, Fifty Billion Dollars: My Thirteen Years With the RFC, consisted of four principal steps:

1. 1. Write down the bad assets to realistic economic values, and consequently write off book equity.

2. 2. Make a judgment about the character and capacity of management and make any appropriate management changes.

3. 3. Based on realistic asset values and capable management, have the RFC buy new equity in the bank in the form of redeemable, dividend-paying preferred stock.

4. 4. Receive dividends and ultimately the par value of the preferred stock back, as the bank returns to profitability and recapitalizes in the private market over time.

In fact, this proved to be a successful crisis model. On the RFC model, the public, instead of only providing subsidies, makes equity investments which have an expected return. Indeed, one important improvement on the RFC model should be that the public deserves greater equity upside potential. The government’s preferred stock should be combined with warrants on the common shares of the recapitalized firms, as in Chrysler bailout, which resulted in significant profit to the government. This structure might provide attractive outcomes for the taxpayer-investors, as the crisis passes and growth in time resumes.

The economic historian Charles Kindleberger observed that over the last four centuries, banking crises occur on average about once every ten years. Some can be bridged by provision of central bank liquidity, but the worst cases involve severe asset deflation and destruction of financial system capital. They need something different: the emergency provision of new equity as a bridge to private recapitalization when normal financial functioning is restored—in other words, the RFC strategy. This is entirely different from the RTC concept.

Congress should consider the RFC, not the RTC, as the most relevant model for our current exigencies.

8 Responses to "The RTC or the RFC: Taxpayers as Involuntary Equity Investors"

  1. Paulann Sheets Groton Town Councilor   September 30, 2008 at 10:57 am

    Sounds like a PLAN!!! Has the heft of successful history behind it, and sound grasp of the MAGNITUDE of our crisis. How about also infusing proposed RFC with proceeds from a securities turn-over exchange tax (.0025) such as partially financed all our wars since the Civil War, until we inexplicably abandoned it in 1966? Keynes liked it a lot–necessary to mitigate “the dominance of speculation over enterprise.” Also has the potential virtue in this case, of taxing the culprits and banksters as they speculate their way through the “blood in the streets.”

  2. spoonful   September 30, 2008 at 12:46 pm

    OK – sounds like a nice remedy for the short term – However, I have one fundamental question: Why are we here in the first place, i.e., why has housing collapsed? I suggest the answer largely stems from the 50% decline in the dollar during the reign of GWB. An economy ridden by the $20bb/month war machine can only get talked up so much before its true colors start to show in the falling dollar. This nonsense expenditure must be addressed and terminated in order for any plan – RFC, RTD or THC – to succeed. Reminds me of the margarine ad, “you can’t fool mother nature.” In this case, however, you can’t fool “daddy greenbacks.”

  3. DJC   September 30, 2008 at 1:55 pm

    Economist Marc Faber Says U.S. Taxpayer Bailout Won’t Workhttp://www.bloomberg.com/apps/news?pid=20601080&sid=alvjAlfEBU1s&refer=asiaSept. 30 (Bloomberg) — Investor Marc Faber said any proposal to rescue the U.S. financial system will fail to avert a recession in the world’s largest economy.A stock rally in the event that a package is approved will be temporary and should be used as “an opportunity” to sell, said Faber, who predicted the so-called Black Monday crash in 1987. U.S. lawmakers voted yesterday to reject a $700 billion plan worked out by congressional leaders and the administration of President George W. Bush.“The rejection of the package is good because it shows that some people in the U.S. are still sane,” Faber said in a phone interview. “A bailout will not buy the U.S. a way out. The government is less powerful than markets in fixing this mess.”

  4. Guest   October 1, 2008 at 3:37 am

    For all the good will that is expressed by helpful ideas on the websites. Does eveyone realize that TARP was audaciously proposed without any oversight whatsoever? Can you imagine if that stance still prevails at this point? Asking for 700 billion stipulating no disturbance, no jurisdiction, just hand over a blank check? We’re talking about the Teasurer and FRB chairman not two petty gangsters.To me as well as many others such arrogance can only be interpreted that the FRB is a government within the U.S. government and must have an agenda of its own.This should be of grave concern to all.

  5. Guest   October 1, 2008 at 5:33 am

    The families that own the FRB take in a trillion dollars a year tax free. They were suppost to be monitoring the situation. Let them pay for the bailout.

  6. Guest   October 1, 2008 at 8:07 pm

    Obviously you’re right, Mr. Pollock and Mr. Makin. Now can you convince our idiot Congress of this? Obviously Bush is a lost cause, but the idiot Congress is still acting like Bush’s plan is the only plan!

  7. Jawdog   October 5, 2008 at 7:04 am

    The RFC won’t work this time because of one key difference. Back then, the credit crisis was because of losses on share values, in the face of an anticipated slowdown. This time the crisis is because of overinflated real estate values. Back then, taxpayers could afford to invest in banks. This time, tax payers are already in debt through their mortgages.Over a period of years the tax payer paid to get the American economy out of the Depression. They can’t afford it this time.Maybe the solution involves looking outside of the emerged markets for someone to help with the costs of recapitalising this time?

  8. Richard E. Kaplan   February 4, 2009 at 12:12 pm

    In January of 1932 Herbert Hoover established the Reconstruction Finance Corporation (RFC) that he hoped would bailout the banks and their major asset (railroad bonds). This strategy did not work and did not prevent widespread bank closings even though Hoover threw 1.62 billion dollars to the banks. Hoover failed to envision the use of this corporation as a National Bank similar to Alexander Hamilton’s First National Bank to be the primary lending bank for recovery. Alexander Hamilton had used his National Bank towards lending America the means to make America a Manufacturing Giant. When FDR came into office, his administration expanded the use of the RFC. The key was private entrepreneurs did not own any part of the RFC. It was entirely owned by the United States Government. Hoover had created a Stradivarius Violin but had no idea how to play it. When Franklin Roosevelt began his Presidency, he unlike Hoover, played the instrument like a virtuoso. As envisioned by Alexander Hamilton, FDR utilized the bank to make direct cheap loans for manufacturing and infrastructure development. Between 1933 and 1945, $33 billion dollars was loaned by the RFC that in today’s money is over a trillion dollars. That money was repaid over time. Contrast this successful program with the haphazard loaning of $350 billion to the Banks by Bush and the misguided attempt by Obama to send the rest of the $350 billion to private banks with or without conditions. Let alone now wanting to send over $800 billion to the states for their boondoggles. This is not recovery but a feeding frenzy of local politicians. The New Deal presided over the reorganization of the banking system and a system of infrastructure improvement and development that set the economy on the road to recovery and prosperity. Hoover had thought that if he simply threw money at the banks, the public’s confidence in banks would be restored. However, as is the case today, this simply allows the private banks to spend the money for their own purposes. Hoover was rather naive to believe human nature would change in the course of a few months. Today by virtue of FDIC insurance the public has been patient watching the experts funnel money to private concerns. The politicians have feigned outrage knowing full well if the banks gave out large bonuses, state politicians would not be able to share at the trough. When FDR came into office he did not go to Congress for more funds. The RFC issued debentures to private industry after the RFC Act was amended. During the New Deal FDR used the RFC to restore the economy by direct federal control. Who does Congress represent the national interest or state politicians? If President Obama would use the RFC like Roosevelt the federal government can stimulate recovery far cheaper than as presently proposed.