When Throwing Good Money After Bad Can Be Good

In 1989, we were in a savings and loan crisis – these relatively unregulated “banks” had taken advantage of reduced regulation (sound familiar?) to plough vast fortunes into a real estate market that “could not stop rising” in value. They were wrong. These S.&L.s (“thrifts”) began collapsing in droves, and the failed real estate assets and loans on their books were threatening to drag the whole system down. Déjà vu all over again?

The federal government knew something had to be done fast, so Congress and the President (the senior Bush) decided to create a public corporation, the Resolution Trust Corporation (RTC), to take over these failed institutions and their underlying assets.

The January 17 New York Times: “Resolution Trust closed or reorganized 747 institutions holding assets of nearly $400 billion. It did so by seizing the assets of troubled savings and loans and then reselling them to bargain-seeking investors. At the peak in early 1990 there were 350 failed savings and loan institutions under the agency's control. … By 1995, the S.& L. crisis abated and the agency was folded into the Federal Deposit Insurance Corporation, which Congress created during the Great Depression to regulate banks and protect the accounts of customers when they fail. The total cost to taxpayers was later estimated at $124 billion.”

There are no simple solutions to our current meltdown; the government must engage in parallel tracks, layering in solutions as time and circumstances change. I’ve already suggested that the government must step in and at least temporarily guarantee interbank lending, restarting the mainstream bank syndication structures that fuel corporate growth and survival. We have just watched Circuit City announce that will liquidate, closing its doors forever, because there is no lending capacity to allow what would have been a pretty ordinary “loan out of a reorganization-style bankruptcy” (one that would have keep the company operating) just a year ago.

Banks are risk averse; in a world of job loss and declining assets, few are will to step up to the plate where the meltdown has destroyed the meaning of “creditworthy.” The January 17^th New York Times illustrates the point: “At the Palm Beach Ritz-Carlton last November, John C. Hope III, the chairman of Whitney National Bank in New Orleans, stood before a ballroom full of Wall Street analysts and explained how his bank intended to use its $300 million in federal bailout money… Skip to next paragraph ‘Make more loans?’ Mr. Hope said. ‘We’re not going to change our business model or our credit policies to accommodate the needs of the public sector as they see it to have us make more loans.’ ” Fear (they’ve already messed up enough in their eyes). That’s why TARP did not unfreeze the credit markets. These financial institutions are preparing their businesses for lending only after they know we have bottomed out. So we need to find that bottom as soon as we can.

But is there a lesson in the past from our experience with the RTC more than a decade ago? Joe Nocera, writing for the January 16 New York Times observed: “As it turns out, [F.D.I.C. chief Sheila] Bair — who, thankfully, will remain the head of the F.D.I.C. in the new administration — has been thinking along the same lines [as the past RTC effort]. She, [Federal Reserve Chairman Ben] Bernanke and Treasury officials have begun talking about a new kind of bank, one that would be created and capitalized by the federal government, and whose sole purpose would be to buy up bad assets. Instead of ring-fencing bad assets one bank at a time, it would warehouse them in one place, much the same way the Resolution Trust Corporation did for real estate assets during the savings and loan crisis.

“Would the sale of these assets cause further write-downs? Of course. That is why you would need to throw more capital into the banks as part of a systemic solution. But at least you would finally know how deep the hole is. ‘You would have to mark the assets at the price they were selling for,’ Ms. Bair told me. ‘I think that is an advantage.’ At long last, there would be some certainty. Private capital won’t return to the banking system until that happens.”

There are lots of problems: how do you figure out what stuff is really worth to “buy” bad assets and move them into a new governmental bank-like structure? What is this going to cost? $1 trillion? More? A lot more? At least we are dealing with assets that can ultimately be sold by the government, so these staggering raw numbers will not be the actual ultimate cost to taxpayers… but it still needs to be paid. The government would be in the banking business in a very big way – adding further capital to the surviving banks and buying up troubled assets from these lenders (wasn’t this the original vision for the TARP bailout?), only to dispose of them, over time, back into the markets. But at least we’ve gone down this road before, and it seemed to work.

There is some receptivity in Congress to this concept once the answers to the questions can be determined, but we are still on a largely uncharted course. We need to look at all of the alternatives as we try and stop this massive tanker of an economy from heading farther south and begin to turn it around. It’s just nice to know that we have had some experience with some of the same negative variables in our recent history. Day two of the Obama administration, and this concept needs to move to the top of the priority list for his economic advisors.

I’m Peter Dekom, and I thought you might like to know.