The U.S. once purged bad S&Ls for $85 billion. How much would it cost to clean up a much bigger financial crisis? No one seems to know
As Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke met on the evening of Sept. 18 with congressional leaders, momentum was building for a new Resolution Trust Corp.-style entity. The vehicle would be set up to stem the slide in the markets and halt the erosion of the financial sector.
Just two days earlier, Treasury officials had said no broader entity was needed. But rather than easing market woes, the $85 billion federal bailout of insurer American International Group (AIG) sent new waves of fear through the market, as investors tried to assess what other corporations might suddenly turn up insolvent. With the markets down through midday Sept. 18, and lending among institutions all but grinding to a halt, regulators and lawmakers decided a more systematic approach was needed to keep more institutions from buckling under the strain.
At the hastily called Capitol Hill meeting, Paulson and Bernanke met with House and Senate Republicans and Democrats to discuss current market conditions. Paulson and Bernanke "began a discussion with them on a comprehensive approach to address the illiquid assets on bank balance sheets that are the underlying source of the current stresses in our financial institutions and financial markets," said Treasury spokeswoman Brookly McLaughlin in a statement. "They are exploring all options, legislative and administrative, and expect to work through the weekend with congressional leaders to finalize a way forward."
A Chorus of Demands
With the policy measures taken by Washington so far unable to stop the slide, there had been growing calls in recent days for a more systematic approach modeled on the RTC, which was set up in the late 1980s to restructure the underwater mortgages held by nearly 750 insolvent savings and loan institutions. "Lesson No. 1 from that era is: Move quickly. Troubled assets don't become more valuable over time; they become less valuable," said Richard Breeden, the RTC's architect and a former Securities & Exchange Commission chairman.
The idea has drawn powerful supporters: ex-Treasury Secretary Lawrence Summers and former Federal Reserve chairmen Alan Greenspan and Paul Volcker have recently backed it, while lawmakers ranging from Representative Barney Frank (D-Mass.), the influential head of the House Financial Services Committee, to Senator Richard Shelby (R-Ala.), the top Republican on the Senate Banking Committee, said early in the week that a new RTC should be considered.
Both Presidential contenders have also said such an approach was needed. "I am calling for the creation of the Mortgage & Financial Institutions Trust—the MFI," Senator John McCain (R-Ariz.) said Sept. 18. "The priorities of this trust will be to work with the private sector and regulators to identify institutions that are weak and take remedies to strengthen them before they become insolvent. For troubled institutions, this will provide an orderly process through which to identify bad loans and eventually sell them." Senator Barack Obama's (D-Ill.) rhetoric was similar: "I'll call for the passage of a Homeowner & Financial Support Act that would establish a more stable and permanent solution than the daily improvisations that have characterized policymaking over the last year."
How would an RTC-like entity help? The original RTC sold off the restructured loans as the market improved, rather than in a quick-fire sale, thus lessening the cost of the savings and loan crisis to the economy and to taxpayers.
An Undercapitalized System?
One key difference between the 1980s S&L affair and today's financial crisis is that the government had already taken over the insolvent banks by the time it created the RTC. In effect, Uncle Sam already owned the assets and set the agency up to facilitate a smooth liquidation. That's not the case today: The goal now would be to buy up bad mortgage-related assets from banks and other institutions to prevent a further wave of insolvencies.
But the basic idea remains the same. The deepening housing crisis has forced banks and other institutions to write down repeatedly the value of the mortgage-related assets they hold, be they mortgage-backed securities or more complicated derivatives. The markdowns have eroded capital, pushing many toward insolvency. And as those firms try to get rid of their toxic assets, the fire sales put further downward pressure on prices, weakening their capital further—and forcing more sales. With no end to that vicious spiral in sight, private buyers are scarce, as Lehman Brothers and AIG discovered. "The worry is that the system as a whole may be undercapitalized," says Brad Setser, a former Treasury official now with the Council on Foreign Relations. "There may not be enough capital to absorb the losses caused by the ferocity of the downward spiral."
That's where a new entity would come in. The government fund would serve as a buyer of last resort. It could acquire the bad mortgages or related debt from the banks directly, at a heavily discounted price or in exchange for equity. That would shift some of the bad assets off the institutions' balance sheets, stop the downward price spiral, and help the banks remain solvent. Or, if troubled institutions were too far gone to save, the government might allow them to get bought up or go bust, and then step in to manage the liquidation of those assets in a more orderly fashion.
Breeden: New RTC May Be Unnecessary
Like the old RTC, the new entity would not face a short-term need to sell. "Rather than seeing forced sales to vulture investors for 10¢ on the dollar, the government could take its time and get, say, 40¢ on the dollar," says Lawrence J. White, an economics professor at New York University.
As of the night of Sept. 18, it was unclear exactly what form the new entity might take. Breeden noted that the federal government may already have the tools it needs to buy problem assets out of the marketplace. By taking over Fannie Mae (FNM) and Freddie Mac (FRE), the government took control of their massive portfolios of mortgage securities. The Administration also won approval from Congress to buy more such securities from other holders. "That may be your RTC," Breeden said. "You don't need to go out and create something new; Treasury probably already has the structure that will work fine."
Indeed, at the same time it put the government-sponsored enterprises into conservatorship, Treasury announced it would wade into the market to buy mortgage-backed securities. At the time, government officials said Treasury had no target amount it planned to purchase, but would start with a $5 billion purchase soon after the takeover.
Take Your Mortgage to Court?
Others would go even further. On the afternoon of Sept. 18, Senator Chuck Schumer (D-N.Y.), chairman of the Joint Economic Committee, proposed another variation: He argued that the RTC model, by taking distressed assets off the books of troubled institutions, would shift the risks and costs of the bad assets to Uncle Sam while doing little to address the underlying problems of homeowners struggling under mortgages they can no longer afford.
Schumer contends that, in addition to providing capital to troubled financial institutions in exchange for equity, further measures must be included to help homeowners. He recommended allowing homeowners to renegotiate their mortgages in bankruptcy court. Such proposals have been before Congress for months, but banks and other financial institutions have fought hard against them. Schumer argues that this additional step would spur far greater efforts to modify loans, helping to avoid the defaults and foreclosures that have been at the root of the crisis. "If the federal government is going to continue to support the economy, its new formal lending program with the banks must address both the need for restoring stability and confidence in the U.S. financial system and the need to set a floor in our plummeting housing markets," Schumer said.
Whatever form it takes, however, a move to shift bad mortgage assets from the balance sheets of private institutions and onto that of Uncle Sam raises plenty of questions—not least, how much such a bailout would cost. The original RTC took on some $225 billion in junky S&L assets and eventually sold them for $140 billion, so the hit to taxpayers was $85 billion. No one knows how much bad debt a new RTC would have to take on, or what the burden might ultimately be worth, but the price tag could be far higher. Restructuring the complex mortgage-backed securities and derivatives at the heart of the crisis will also be much tougher than what the RTC faced in restructuring portfolios of mostly plain-vanilla home loans. "Doing this would be an admission we are in deep, deep trouble," says Setser. But, he adds, "if the situation doesn't stabilize, we have relatively few policy options left."