turmoil and fear in American and other financial markets have
triggered equally extraordinary policy actions and proposals in
Washington and New York City. Markets have appeared on the brink of
collapse, with substantial and harmful impacts on consumers,
workers, investors, and businesses both large and small. And there
is a great deal about the exact nature of the situation in
financial markets that is unknown. Even those in government charged
with addressing the crisis-such as Treasury Secretary Paulson, Fed
Chairman Bernanke, and New York Fed President Geithner-lack full
What we know is
that the nation faces a fast-spreading financial contagion and that
the risk of that contagion to the broader economy warrants bold,
comprehensive, and decisive actions that would otherwise not be
contemplated. Under these circumstances, and given the serious
threat to the financial fabric of the economy and the economic
security of Americans outside the financial industry, it appears
that decisive actions are warranted and appropriate. However, many
important details remain to be settled, and taxpayer protections
must be included.
breadth of the four measures announced by the Administration
between Thursday, September 18, and Friday, September 19, indicates
the extent of the concern. Perhaps the most important and most
controversial measure is the suggestion that Congress create an
entity similar to the Resolution Trust Corporation (RTC). Congress
created the original RTC following the savings and loan debacle of
the late 1980s and early 1990s. Creating another one requires
action by Congress.
The three other
measures did not require congressional approval and have already
been put into place. These three are themselves extraordinary and
raise important policy issues. They are:
Insurance for money market accounts. The Treasury has
offered, for a fee, to insure private money market accounts held at
qualifying institutions. This insurance is similar in nature to the
insurance provided for checking and savings deposits at commercial
banks, savings and loans, and credit unions.
was necessary to restore confidence to money markets that have
almost seized up entirely in recent days. However, to avoid
distorting markets further and to protect the taxpayer, it is
important that the Treasury sets the fee at a level that will
properly price the insurance, which means in part that it reflects
the level of risk of the fund's assets.
Temporary suspension of all short selling in certain
equities. Short selling is a common activity that under normal
circumstances creates another avenue by which markets set prices.
However, short selling tends to lead to enhanced volatility. Under
normal circumstances, volatility is neither good nor bad. However,
in the current environment volatility arising from short selling
has added to the turmoil by distorting market corrections.
Therefore, the Securities and Exchange Commission has properly
suspended all short selling in the shares of over 800 financial
service firms for at least 10 days and up to 40 days. It is
important, however, that short selling be permitted again as soon
market conditions allow.
Significant expansion of Treasury and Fannie Mae and Freddie Mac
purchases. The Treasury placed Fannie Mae and Freddie Mac in
conservatorship some days ago because of their financial weakness.
The Treasury has now expanded their capital so they can begin
purchasing billions of dollars of securities at market prices to
help other financial institutions correct their own portfolios. In
addition, the Treasury will expand its purchases of mortgage-backed
securities on its own account.
As a rule,
the federal government should not buy up private assets as though
it were a private investor, either directly or through Fannie Mae
and Freddie Mac. However, if the market for mortgage-backed
securities seizes up, as it has done in recent days, then direct
federal intervention is warranted to help restore normal market
conditions. But such interventions should occur only in the event
of a market breakdown and should continue only as long as the
market continues to struggle to clear.
What Was the
Created in 1989,
RTC sold the bad assets of failed savings and loans and other
thrift institutions ("thrifts") that had been taken over by their
deposit insurance fund. For the most part, these assets were made
up of real estate and securities that were difficult to move in the
tight markets of the early 1990s. Good assets such as the thrift's
deposits, offices, and easily sold assets were not given to RTC as
they were usually sold to another financial institution at the time
the original thrift failed. Between 1989 and its 1995 absorption
into the FDIC, the RTC dealt with 747 thrifts with assets of about
$394 billion. Overall, the cost to the taxpayers was estimated at
$124 billion in 1995 dollars.
A key feature of
the RTC was its use of equity partnerships under which pools of
assets were partially bought by a private investor, who then
liquidated the pool and split the profits with the RTC. Because the
RTC's assets were sold gradually instead of being dumped on the
market all at once, the total cost to the taxpayers was
significantly lower than early estimates that losses could reach
several hundred billion dollars.
whether the new RTC is structured as a part of the Treasury
Department or as a free-standing temporary agency, there would be
similarities to the original RTC. While the original RTC liquidated
mainly real estate that was left over from failed thrifts, the new
RTC would be dealing with financial instruments based upon
mortgage-backed securities. Some of these could be so exotic and
complex that it would be difficult to give them any realistic
value. However, despite the differences in investments, both
entities would be dedicated to reducing the cost to taxpayers by
orderly selling large pools of investments over time rather than
allowing them to be dumped into the markets and sold at distressed
Principles to Guide
a New RTC
Congress and the
Administration should follow key principles in structuring any new
RTC-like entity in order to meet the goal of stabilizing the market
with the least danger to the taxpayer:
agency should have a limited scope and lifespan. Legislation
authorizing the new agency should delineate its duties in as much
detail as possible to prevent "mission creep" into other types of
financial activity such as financing low-income housing, promoting
infrastructure development, or anything other than dealing with the
current financial crisis. While some flexibility will be required
in a time of so much financial uncertainty, any substantial change
in the agency's mission should require additional congressional
action and should be resisted. In addition, the enacting
legislation should be clear that the new entity will have a
strictly limited lifespan, after which it will be dissolved. This
entity should exist only as long as it takes to orderly liquidate
the assets it receives and not become a permanent part of
government. The original RTC lasted for six years and was dissolved
once its work was completed. Hopefully, the new RTC could complete
its mission within three years and then be similarly
agency should not take an ownership stake in financial
institutions. While the new agency may exchange assets with
private financial institutions, it should not own stock in
profits should go to the taxpayers. Over time, a substantial
proportion of the assets held by any new RTC will likely be sold at
a higher price than what the agency paid for them. In such a case,
profits should go to the taxpayers to reduce the overall cost of
the bailout. Under no circumstances should any profits be used to
finance other public policy objectives.
Companies should pay for this assistance. Any assets
acquired by the new RTC as part of the process of taking these
investments off the balance sheets of financial institutions should
be purchased at a discount to their true worth. Alternately,
companies using the new RTC could pay a significant fee for those
services. Under no circumstances should companies receive these
services for free or an inadequate price.
agency should operate using private entities wherever possible.
The purpose of the new RTC should be limited to purchasing and
holding poor quality assets, with sales being handled through
private entities through either equity partnership or on a
legislation should be kept clean. Congress should not attach
legislation on other subjects to the bill creating the new RTC.
These include such items as increasing unemployment insurance,
changing capital gains taxation, allowing bankruptcy courts to
alter the terms of mortgages, or anything similar. This bill is the
response to a major crisis and not an excuse for legislators to
advance their pet projects.
C. John is Senior Research Fellow in Retirement Security
and Financial Institutions and J. D.
Foster, Ph.D., is Norman B. Ture Senior Fellow in the Economics
of Fiscal Policy in the Thomas A. Roe Institute for Economic Policy
Studies at The Heritage Foundation.