September 19, 2008 | WebMemo on Economy
The extraordinary 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 information.
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.
The stunning 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:
This measure 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.
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 Original RTC?
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.
Regardless of 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 prices.
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:
David 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.