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.