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Ron Trecker

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Member Since: Oct, 2008

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Deja Vu, Itís the Reconstruction Finance Corporation - Again
by Ron Trecker   
Rated "PG13" by the Author.
Last edited: Wednesday, October 15, 2008
Posted: Wednesday, October 15, 2008

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It was deja vu in a truly high stakes, high drama meeting yesterday. It was reminiscent of a depression era Reconstruction Finance Corporation meeting of seventy-five years ago. Yesterday nine large bank CEOís were told by U.S. Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and FDIC Chairman Sheila Bair that it was in their own best interest to agree to the partial nationalization of their banks by the U.S. Treasury Department. When the meeting was over the CEOís had agreed to a $125 billion stake by the U.S. Government in their firms. They had no choice and history was made Ė again.

t was deja vu in a truly high stakes, high drama meeting yesterday.  It was reminiscent of a depression era Reconstruction Finance Corporation meeting of seventy-five years ago.

Yesterday nine large bank CEO’s were told by U.S. Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and FDIC Chairman Sheila Bair that it was in their own best interest to agree to the partial nationalization of their banks by the U.S. Treasury Department. When the meeting was over the CEO’s had agreed to a $125 billion stake by the U.S. Government in their firms. They had no choice and history was made – again.

The Reconstruction Finance Corporation was originally legislation from the Hoover Administration. By 1932 when FDR was elected, the RFC was a minor player in the banking industry. FDR was quick to realize the value of the RFC as a mechanism to combat the depression banking crisis.  Because the RFC was an agency with the ability to obtain funding through the Treasury Department outside of the normal slow legislative process.  FDR found the independence and flexibility of the RFC to be a useful mechanism to provide capital to failing banks in a timely manner, and thus prevent their failure.  

On March 9, 1933, the Emergency Banking Act was approved as law.  This legislation and a later amendment improved the RFC's ability to assist banks by giving it the authority to purchase bank preferred stock, capital notes and debentures (bonds), and to make loans using bank preferred stock as collateral.  The RFC encouraged banks to issue preferred stock with voting rights for it to purchase. The government then barred the banks from paying dividends until they had bought out the government's stake. This transfusion of capital funds to banks strengthened the financial position of many depression era banks.  Banks could use the new funds to expand their lending, and did not have to pledge their best assets as collateral. 

The RFC purchased $782 million of bank preferred stock from 4,202 individual banks between 1933 and 1935. In total, the RFC assisted almost 6,800 banks. In the years following 1933, bank failures, which at that time were common events, declined to very low levels. The RFC provides the model for the partial nationalization of the banking industry Monday.  When the partial bank nationalization was announced, Barney Frank commented, “we can buy the toxic assets later when we figure out how to do it.”  It won’t happen anytime soon. As part of their penance for their greed, avarice and amazingly poor judgment, the banks holding mortgage backed securities will have to unwind them themselves and take the losses that will occur.

On September 18th in a meeting with members of congress, 25 days prior to the meeting mentioned above, Paulson refused a plan to take a direct investment in banks similar to the RFC model and instead pursued his own plan to directly buy up distressed mortgage backed securities (the so-called toxic assets).  He refused to see the writing on the wall, and the financial crisis deepened. The former Goldman Sachs CEO and the Bush Administration quickly found that Congress has financial expertise of it’s own. Congress could not agree on a suitable way for the Treasury Department to directly buy these toxic assets. As a result, the House of Representatives rejected Paulson’s original financial bailout plan knowing full well that the proven and much cleaner RFC option was available. In-fact, Warren Buffett has called buying-up mortgage backed securities “like carrying a cat by the tail and suffering multiple scratches” because of the difficulty in unwinding the complicated multiple mortgage securities. No one has surfaced a plan to buy these assets in a way that provides the oversight and protection for the taxpayer that Congress and good sense demands.
 

The Treasury Department will also invest another $125 billion over the next 30 days in smaller banks and thrifts across the country. The $250 billion total investment by the Treasury will amount to 25% to 30% of the market capitalization for publicly traded banks.

Moreover, the FDIC will temporarily insure the senior debt of all FDIC-insured institutions and their holding companies. Analysts believe such guarantees are necessary to get banks lending again, since they are hoarding capital and no longer trust that other institutions will be able to repay their loans if the credit squeeze continues.
The Federal Reserve meanwhile, announced it will begin buying massive amounts of short-term debt or commercial paper, which is crucial short-term funding that many companies rely on to pay their workers and buy supplies. Last week the Fed said it intended to take the action but didn't specify when.

 The decision to invest simultaneously in nine of the largest banks was necessary to eliminate any stigma attached toTreasury’s partial nationalization program. If any one bank agreed to the plan it would signal that it knew it couldn't survive and had no hope of attracting private capital. Even weak banks would have resisted Paulson for fear of greater pressure on their already battered shares. 

This meeting follows by two days, action by the European Union led by Britain’s Gordon Brown, to lift insurance limits on bank deposits and to guarantee lending between banks. Britain and other nations have also moved to take equity stakes in their own banks. This action forced Paulson’s hand and the U.S. had little choice but to follow suit or see a flood of money move into foreign banks.

Before we give Henry Paulson, Ben Bernanke, and Sheila Bair too much credit, recall that the Reconstruction Finance Corporation is the model that members of congress and financial leaders like Paul Volker and Warren Buffet seized upon as a proven alternative to directly buying the complex ‘toxic assets’ that Paulson was convinced was the solution to the credit crisis. The real hero of the current solution to the credit crisis, if there is any, is the FDR Administration. Paulson and the Bush Administration are the problem, not the solution, and history repeated itself.

 



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