“Public opinion made [Herbert Hoover] the villain of the Great Depression. In fact, the 31st president was a visionary — but a hopelessly inept politician… Until early 1931, midway through his presidency, Hoover had waged a vigorous offensive against the Depression. International events pushed him back onto the defensive. His overriding goals became damage control and even national economic self-preservation, as it became clear that the Depression was not just another cyclic valley, but an historic watershed. Hoover came to believe that the root cause of the Great Depression was the Great War.”
Don’t Blame Hoover Stanford Magazine David M. Kennedy Jan/Feb 1999
Watching the financial rescue legislation grind along to a conclusion reminds us that democracy is not meant to be efficient or pretty. The end result also makes us think of how our ancestors dealt with the Great Depression. We think not of FDR, who most Americans associate with the solution via the New Deal, but of President Herbert Hoover, a tragic figure but one of the greatest technocrats to ever hold the office of the presidency.
Hoover knew what was happening in the country in the early 1930s. He created many of the mechanisms that would be used to deal with it, including the Reconstruction Finance Corporation. But due to poor communications and other factors, Hoover could not marshal sufficient resources to act effectively. We’ve written about the attempts by Hoover to negotiate with Henry Ford in the days leading up to the collapse of the Detroit banks in early 1933 in a past issue of The IRA (“How’s My Bank or Why One Rating Just Isn’t Enough”), but by then Hoover had been fighting the Depression for over three years. He wrote in the third volume of his memoirs, The Great Depression:
“If we had possessed adequate banking laws and a sound financial system, we should never have needed the Reconstruction Finance Corporation, the Home Loan Banks, and the half dozen other government props to credit, which we were compelled to introduce later on… Our whole economic system naturally divides itself into production, distribution and finance. By finance I mean every phase of investment, banking and credit. And, at once I may say that the major fault in the system as it stands is in the financial system… In this system I am not referring to individual banks or financial institutions. Many of them have shown distinguished courage and ability. One the contrary, I am referring to the system itself, which is so organized, or so lacking in organization, that it fails the primary function of stable and steady service to the production and distribution system. In an emergency its very mechanism increases the jeopardy and paralyzes action of the community… That it has been necessary for the government, through emergency action to protect us (while holding a wealth of gold) from being taken off the gold standard, to erect gigantic credit institutions with the full pledge of government credit to save the nation from chaos through this failure of the financial system, that it is necessary for us to devise schemes of clearing-house protections and to install such temporary devices across the nation, is full proof of all that I have said. That is the big question. If we can solve this, then we can take in hand the faults of the production and distribution systems – and many problems in the social and political system. But this financial system simply must be made to function first.”
Today the US government has the means and the competence to act, and should do so quickly. Specifically, in the emergency economic stabilization legislation that has been enacted into law, the Secretary of the Treasury is given broad discretion as to what assets to purchase and how to manage these assets. BTW, don’t forget to read John Dizard in the FT on the bailout plan. Here’s our suggestion as to how to get the job done to maximum effect for financial institutions and the larger economy.
First, the Treasury should become a market maker in both the assets and equity of solvent financial institutions. By being prepared to purchase illiquid assets, guarantee same or buy preferred equity from solvent financial institutions, the Treasury can immediately put a floor under viable but liquidity constrained financial institutions that are being driven into default.
For example, preferred equity could be priced at the market for public institutions and on a negotiated basis for private institutions, and carry a small warrant that would remain with the Treasury as and when these preferred shares are either repurchased by the issuer or by a third party investor. The FDIC should be the final arbiter of solvency, which must be a precondition for participation in any aspect of this rescue program.
A dollar worth of new equity in a bank can absorb losses and support new leverage at a 10:1 ratio, thereby helping to restart the economy. Having the Treasury act as an equity market maker for banks is really going back to the future. As we have noted in previous comments, the use of double liability banks stock was popular in the US until the 1930s, when federal deposit insurance took over the primary role of safeguarding deposits. While the federal government did create numerous facilities in the 1930s to provide liquidity to banks, and the Fed retains enforcement power to force control parties to recapitalize an institution, the broad mandatory facility of double liability shares was lost and with it a means for banks to bolster their capital in times of market stress and illiquidity. By re-creating such a capital backstop, the Treasury can effectively end the run on the banks.
Second, the Treasury should display all of the assets held by the rescue fund in real time. Each day, the Treasury should conduct an auction for all of the assets in the fund. It is up to the discretion of the Treasury whether to accept or reject any bid, but the aggregate results of the daily auctions should also be published in real time, thereby creating an indicative market for pricing these assets. Likewise, any preferred equity sold to any financial institution participating in the program should be displayed in real time and put up for bid. As former Fed Chairman Alan Greenspan said of the GSEs several years ago, everything that can be sold should be sold – but at a price that suits the objectives of the Treasury.
Third, while the Treasury needs to run the market process, the FDIC should be given overall authority to manage the assets acquired or preferred equity purchased by the Treasury that is not immediately sold. The FDIC has the operational experience and personnel to act as general contractor for the Treasury, and in turn can direct the work of the tens of thousands of FDIC personnel, other regulators and contractors from the top accounting, consulting, forensic and IT services firms around the world who already are being marshaled behind the FDIC’s bank resolution efforts.
Because of its existing role conserving the assets of failed banks and even operating banks such as IndyMac, it makes sense to give FDIC overall responsibility for the great asset pile and then create a rational approach to organizing the vendors that is actually compliant with the Federal Acquisition Regs! There is no need to create the possibility of political cronyism by making exemptions to the FAR if Treasury and FDIC employ existing qualified vendors to perform the work.
Fourth, the whole point of this legislation is to use the credit of the US to buy time to resolve troubled assets, but the Treasury should not be shy about hitting a reasonable bid or making its fiscal operations aggressively transparent and inclusive. By letting the markets begin to operate under the aegis of the Treasury as market maker, it is possible to reverse the current deflation in asset values and public confidence.
In order to achieve this end, limitations on short selling against financial institutions need to be removed. The best way to discipline unsafe and unsound short selling activity is to enforce existing rules on capital and margin requirements, or tighten same, as with the proposal by the State of New York to begin regulating the sales of credit default swap protection against hedged positions starting January 1, 2009. Once the Treasury creates a capital backstop behind the major banks, the pressure from short-sellers will lessen.
For the continuous auction process to function, the Treasury and the participating institutions need to see both the longs and the shorts. Likewise, whatever compromise approach is used by the SEC to modify the accounting treatment of assets under the fair value accounting rule should be reflected in the Treasury’s auction process. That way we’re all on the same page, yes?
It may strike some of you as odd for The IRA to be urging the government to buy equity in private banks, but as we have argued in numerous venues over the past several weeks, the probable realized loss rates facing US banks in the next four quarters are well above 1989-1991 peak levels. The US government can get involved now, in a way that keeps the majority of assets in nominally private hands and encourages private capital to participate, or we can recapitalize these banks in a receivership at 100% public expense. We think the choice is obvious from a financial and public good perspective.
Offering a bank the opportunity to lose money and take a significant capital loss on an asset sale is far less attractive than raising new equity and only reinforces the deflationary tendencies in the economy. For some banks, however, selling an asset at a reasonable price may make more sense than selling new preferred shares to “the public.” But both banks will be helped merely by the fact of having a facility in place for solvent banks to raise capital. This facility could greatly calm frayed nerves in the interbank credit markets.
We have chewed up half a trillion dollars in financial services capital in the past 18 months, but the approaching wave in terms of realized losses on real estate and other loans means that the industry must have new capital to survive. Give solvent banks a capital backstop, and then let private markets resolve the issues of asset quality and falling home prices. Or to answer the question often asked as to when we will see evidence that the rescue legislation is working, our reply is simple: when the longs start pushing bank stocks higher and the insurgent shorts melt back into the jungle to wait to fight another day. That’s when the process of reflating bank balance sheets will begin.
As Hoover reflects in his memoirs, the problems facing the US financial system then and today are practical, not political. If the next President and the next Treasury Secretary want to fix the economy fast, make the asset purchase program favor the sale of new equity first, then asset guarantees, then finally the outright purchase of bad debt at significant haircuts. The amount of public expenditures under an equity-focused program will be less because instead of increasing the negative weight of collapsing leverage, we can again make leverage our friend and help expand bank balance sheets and the economy via new public and private equity infusions.
Originally published at The Institutional Risk Analyst and reproduced here with the author’s permission.