Bank to the Future

What’s the difference between the “Bad Bank” now being so actively discussed as the next stage of political finance and the original description of the TARP plan (call it “TARP I”), namely issuing government debt to buy distressed financial assets? No difference.

They both have the same two fundamental problems:

(1) Since we have illiquid markets without clear prices for these assets, at what price are you going to buy them? Fire-sale prices? Generous prices, which are effective subsidies to the sellers? Government-mandated prices? Who will do the mandating?

(2) If you do acquire a trillion dollars or so of troubled assets of highly uncertain value, what do you do with them? Have a fire sale, as the Resolution Trust Corporation (RTC) did with the assets of failed thrifts in the early 1990s? Drive the markets further down with these sales? Hold on and hope for the best? How does this compare to the approach TARP switched to (call it “TARP II”), namely recapitalizing financial firms with government funds, thus allowing them to hold on, fingers-crossed?

Although the comparison is often made, the proposed Bad Bank (“TARP III”) would not be the same as the RTC. The RTC was a liquidator. It did not purchase assets, troubled or otherwise—it just got them when the institutions failed. It did not have to agonize about what price to pay.

Perhaps a different past program might make a more fruitful comparison to TARP: the Reconstruction Finance Corporation (RFC)—specifically, the RFC of the 1930s financial crisis (not the war finance RFC of the 1940s).

Established under President Hoover, and expanded by President Franklin D. Roosevelt, this was one of the most important and powerful of the agencies created to cope with the greatest ever U.S. financial crisis. It made investments in more than 6,000 banks in its day. And it was run for most of the time by a forceful character named Jesse Jones, a successful entrepreneur from Texas whose formal schooling had ended in the eighth grade.

The RFC was set up as a separate corporation, wholly owned by the government, so that all its assets, liabilities, income, and expenses could be accounted for. The lack of such clarity in financial reporting is a major problem with all versions of TARP so far—I, II, or proposed III.

Government Risk

Let’s set some wider context. The United States and many other countries are having the recurring historical debate about governments using public money to offset the losses of financial firms in the name of economic and social stability. The debate goes back at least to 1802, when Henry Thornton, in An Enquiry Into The Nature and Effects of the Paper Credit of Great Britain, discussed the “moral hazard” and “systemic risk,” as we now call them, involved in financial rescues.

At the end of the last truly big U.S. depository institution bust, from 1989 to 1992, Americans seemed relieved to have the government present the bill for the cost of its deposit guarantees to the taxpayers. As the RTC liquidated the failed thrifts and helped the commercial banks by selling them cheap assets and deposits, the thrift depositors were paid off with funds from the Resolution Funding Corporation (Refcorp). Refcorp sold 30- and 40-year non-callable bonds on the Treasury’s credit, with some coupons of over 9 percent, to get the money. The Japanese in the 1990s (and many other countries before and since) have experienced similar government bailouts of financial institutions.

Why should this be? It reflects an unresolvable tension in financial systems between the public’s desire to have riskless deposits, combined with the banking business, which is inherently quite risky. Indeed, banking is subject to recurring losses which turn out to be greater than anyone imagined possible—just like now.

The combination of riskless funding with a risky business is, in fact, impossible: the risk simply goes to the government guarantor. Governments are therefore periodically put in the position of transferring losses from the banks to the public, and money from the public to the banks—as, once again, today.

Taxpayers as Investors

These transfers make the taxpayers into involuntary investors: either investors in distressed assets (TARP I or III), or investors in bank equity (TARP II), or both. How can these involuntary investors get fair treatment as investors?

The basic pattern of RFC equity investing operations suggests an answer. As described by Jesse Jones, in his instructive memoirs, Fifty Billion Dollars: My Thirteen Years With the RFC, there were four principal steps:

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

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

(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) 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.

This summarizes a sensible and tough-minded program. It’s easier said than done well, but it’s a logical crisis model.

Note a key difference from the recent equity investments of TARP II in Jones’ rule: first the write-downs, only then the recapitalization. TARP II did not impose this order. If it is followed, a Bad Bank looks unnecessary.

The eminent economic historian, Charles Kindleberger, observed that banking crises occur on average about once every ten years. Some can be bridged by provision of central banks loans, but the worst cases involve severe asset deflation and destruction of bank capital. They need emergency provision of new equity as a bridge to private recapitalization while normal market functioning is restored. But first the write-downs, only then the capital.

And another thing: find a new Jesse Jones to run the operation.

Originally published at The American and reproduced here with the author’s permission.