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Strong Push for an RTC-Type Solution to the Crisis

September 22nd, 2008 8:52 AM by Lehel Szucs

Strong Push for an RTC-Type Solution to the Crisis

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 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 and Freddie Mac 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."

The savings and loan crisis of the 1980s and 1990s (commonly referred to as the S&L crisis) was the failure of 747 savings and loan associations (S&Ls) in the United States. The ultimate cost of the crisis is estimated to have totaled around USD$160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government—that is, the U.S. taxpayer, either directly or through charges on their savings and loan accounts which contributed to the large budget deficits of the early 1990s.
The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-1991 economic recession. Between 1986 and 1991, the number of new homes constructed per year dropped from 1.8 million to 1 million, the lowest rate since World War II
Savings and loan institutions (also known as S&Ls or thrifts) have existed since the 1800s. They originally served as community-based institutions for savings and mortgages. In the United States, S&Ls were tightly regulated until the late 1970s.[ For example, there was a ceiling on the interest rates they could offer to depositors.
In the 1970s, many banks, but particularly S&Ls, were experiencing a significant outflow from low-interest rate deposits, as interest rates were driven up by the high inflation rate of the late 1970s and as depositors moved their money to the new high-interest money-market funds. At the same time, the institutions had much of their money tied up in long-term mortgage loans at fixed interest rates, and with market rates rising, these were worth far less than face value. That is, to sell a 5% mortgage to pay requests from depositors for their funds in a market asking 10%, a savings and loan would have to discount its asking price on the mortgage. This meant that the value of these loans, which were the institution's assets, was less than the deposits used to make them, and the savings and loan's net worth was being eroded.
Under financial institution regulation, which had its roots in the Depression era, federally chartered S&Ls were only allowed to make a narrowly limited range of loan types. Late in the administration of President Jimmy Carter, caps were lifted on rates and the amounts insured per account to $100,000. In addition to raising the amounts covered by insurance, the amount of the accounts that would be repaid was increased from 70% to 100%. Increasing FSLIC coverage also permitted managers to take more risk to try to work their way out of insolvency so the government would not have to take over an institution.
Carter left office in January 1981, a year in which 3,300 out of 3,800 S&Ls lost money. In 1982, the combined tangible net capital of this industry was $4 billion. The chartering of federally regulated S&Ls accelerated rapidly with the Garn - St Germain Depository Institutions Act of 1982, which was designed to make S&Ls more competitive and more solvent. S&Ls could now pay higher market rates for deposits, borrow money from the Federal Reserve, make commercial loans, and issue credit cards. They were also allowed to take an ownership position in the real estate and other projects to which they made loans and they began to rely on brokered funds to a considerable extent. This was a departure from their original mission of providing savings and mortgages.
Although the deregulation of S&Ls gave them many of the capabilities of banks, it not only did not bring them under the same regulations as banks, the new legislation left them in a position to enter new lending businesses with very little oversight. First, thrifts could choose to be under either a state or a federal charter. Immediately after deregulation of the federally chartered thrifts, the state-chartered thrifts rushed to become federally chartered, because of the advantages associated with a federal charter. In response, states (notably, California and Texas) changed their regulations so they would be similar to the federal regulations. States changed their regulations because state regulators were paid by the thrifts they regulated, and they didn't want to lose that money.
Imprudent real estate lending
In an effort to take advantage of the real estate boom (outstanding US mortgage loans: 1976 $700 billion; 1980 $1.2 trillion) and high interest rates of the late 1970s and early 1980s, many S&Ls lent far more money than was prudent, and to risky ventures which many S&Ls were not qualified to assess. L. William Seidman, former chairman of both the FDIC and the Resolution Trust Corporation, stated, "The banking problems of the '80s and '90s came primarily, but not exclusively, from unsound real estate lending."
Keeping insolvent S&Ls open
Whereas insolvent banks in the United States were typically detected and shut down quickly by bank regulators, Congress sought to change regulatory rules so S&Ls would not have to acknowledge insolvency and the FHLBB would not have to close them down.
Brokered deposits
One of the most important contributors to the problem was deposit brokerage. Deposit brokers, somewhat like stockbrokers, are paid a commission by the customer to find the best certificate of deposit (CD) rates and place their customers' money in those CDs. These CDs, however, are usually short-term $100,000 CDs. Previously, banks and thrifts could only have five percent of their deposits be brokered deposits; the race to the bottom caused this limit to be lifted. A small one-branch thrift could then attract a large number of deposits simply by offering the highest rate. To make money off this expensive money, it had to lend at even higher rates, meaning that it had to make more, riskier investments. This system was made even more damaging when certain deposit brokers instituted a scam known as "linked financing." In "linked financing," a deposit broker would approach a thrift and say he would steer a large amount of deposits to that thrift if the thrift would lend certain people money (the people, however, were paid a fee to apply for the loans and told to give the loan proceeds to the deposit broker). This caused the thrifts to be tricked into taking on bad loans. Michael Milken of Drexel, Burnham and Lambert packaged brokered funds for several S&Ls on the condition that the institutions would invest in the junk bonds of his clients.
End of inflation
Another factor was the efforts of the federal government to wring inflation out of the economy, marked by Paul Volcker's speech of October 6, 1979, with a series of rises in short-term interest. This led to increases in the short-term cost of funding to be higher than the return on portfolios of mortgage loans, a large proportion of which may have been fixed rate mortgages (a problem that is known as an asset-liability mismatch). This effort failed and interest rates continued to skyrocket, placing even more pressure on S&Ls as the 1980s dawned and led to increased focus on high interest-rate transactions. Zvi Bodie, professor of finance and economics at Boston University School of Management, writing in the St. Louis Federal Reserve Review wrote, "asset-liability mismatch was a principal cause of the Savings and Loan Crisis"
The major causes of Savings and Loan crisis according to United States League of Savings Institutions
The following is a detailed summary of the major causes for losses that hurt the savings and loan business in the 1980s:
Lack of net worth for many institutions as they entered the 1980s, and a wholly inadequate net worth regulation.
Decline in the effectiveness of Regulation Q in preserving the spread between the cost of money and the rate of return on assets, basically stemming from inflation and the accompanying increase in market interest rates.
Absence of an ability to vary the return on assets with increases in the rate of interest required to be paid for deposits.
Increased competition on the deposit gathering and mortgage origination sides of the business, with a sudden burst of new technology making possible a whole new way of conducting financial institutions generally and the mortgage business specifically.
A rapid increase in investment powers of associations with passage of the Depository Institutions Deregulation and Monetary Control Act (the Garn-St Germain Act), and, more important, through state legislative enactments in a number of important and rapidly growing states. These introduced new risks and speculative opportunities which were difficult to administer. In many instances management lacked the ability or experience to evaluate them, or to administer large volumes of nonresidential construction loans.
Elimination of regulations initially designed to prevent lending excesses and minimize failures. Regulatory relaxation permitted lending, directly and through participations, in distant loan markets on the promise of high returns. Lenders, however, were not familiar with these distant markets. It also permitted associations to participate extensively in speculative construction activities with builders and developers who had little or no financial stake in the projects.
Fraud and insider transaction abuses were the principal cause for some 20% of savings and loan failures the past three years and a greater percentage of the dollar losses borne by the Federal Savings and Loan Insurance Corporation (FSLIC).
A new type and generation of opportunistic savings and loan executives and owners—some of whom operated in a fraudulent manner — whose takeover of many institutions was facilitated by a change in FSLIC rules reducing the minimum number of stockholders of an insured association from 400 to one.
Dereliction of duty on the part of the board of directors of some savings associations. This permitted management to make uncontrolled use of some new operating authority, while directors failed to control expenses and prohibit obvious conflict of interest situations.
A virtual end of inflation in the American economy, together with overbuilding in multifamily, condominium type residences and in commercial real estate in many cities. In addition, real estate values collapsed in the energy states — Texas, Louisiana, Oklahoma particularly due to falling oil prices — and weakness occurred in the mining and agricultural sectors of the economy.
Pressures felt by the management of many associations to restore net worth ratios. Anxious to improve earnings, they departed from their traditional lending practices into credits and markets involving higher risks, but with which they had little experience.
The lack of appropriate, accurate, and effective evaluations of the savings and loan business by public accounting firms, security analysts, and the financial community.
Organizational structure and supervisory laws, adequate for policing and controlling the business in the protected environment of the 1960s and 1970s, resulted in fatal delays and indecision in the examination/supervision process in the 1980s.
Federal and state examination and supervisory staffs insufficient in number, experience, or ability to deal with the new world of savings and loan operations.
The inability or unwillingness of the Bank Board and its legal and supervisory staff to deal with problem institutions in a timely manner. Many institutions, which ultimately closed with big losses, were known problem cases for a year or more. Often, it appeared, political considerations delayed necessary supervisory action.
The United States Congress granted all thrifts in 1980, including savings and loan associations, the power to make consumer and commercial loans and to issue transaction accounts. Designed to help the thrift industry retain its deposit base and to improve its profitability, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 allowed thrifts to make consumer loans up to 20 percent of their assets, issue credit cards, accept negotiable order of withdrawal (NOW) accounts from individuals and nonprofit organizations, and invest up to 20 percent of their assets in commercial real estate loans.
The damage to S&L operations led Congress to act, passing a bill in September 1981 allowing S&Ls to sell their mortgage loans and use the cash generated to seek better returns; the losses created by the sales were to be amortized over the life of the loan, and any losses could also be offset against taxes paid over the preceding 10 years. This all made S&Ls eager to sell their loans. The buyers - major Wall Street firms - were quick to take advantage of the S&Ls' lack of expertise, buying at 60%-90% of value and then transforming the loans by bundling them as, effectively, government-backed bonds (by virtue of Ginnie Mae, Freddie Mac, or Fannie Mae guarantees). S&Ls were one group buying these bonds, holding $150 billion by 1986, and being charged substantial fees for the transactions.
In 1982, the Garn-St Germain Depository Institutions Act was passed and increased the proportion of assets that thrifts could hold in consumer and commercial real estate loans and allowed thrifts to invest 5 percent of their assets in commercial loans until January 1, 1984, when this percentage increased to 10 percent.
A large number of S&L customers' defaults and bankruptcies ensued, and the S&Ls that had overextended themselves were forced into insolvency proceedings themselves.
The U.S. government agency Federal Savings and Loan Insurance Corporation (FSLIC), which at the time insured S&L accounts in the same way the Federal Deposit Insurance Corporation insures commercial bank accounts, then had to repay all the depositors whose money was lost. From 1986 to 1989, FSLIC closed or otherwise resolved 296 institutions with total assets of $125 billion. An even more traumatic period followed, with the creation of the Resolution Trust Corporation in 1989 and that agency’s resolution by mid-1995 of an additional 747 thrifts.

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Posted by Lehel Szucs on September 22nd, 2008 8:52 AM



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