Thursday, September 18, 2008

What would a New Government Entity Look Like?

by Calculated Risk on 9/18/2008 09:24:00 PM

It appears Paulson and Bernanke are promising to work through the weekend on a comprehensive crisis plan. And the NY Times reports that lawmakers hope to complete the legislation by the end of next week.

But what will the plan look like?

First, the goal of the plan is to help recapitalize the banks and keep them lending. Once again the credit markets are frozen, and all indicators of stress are at or near record levels (like the TED spread). It appears even credit worthy borrowers are having difficulties obtaining loans.

A number of observers have been comparing the new entity to the Resolution Trust Corporation (RTC). As an example, from the CNBC story that broke the news:

Such a facility would be similar to the Resolution Trust Corporation, which was set up in 1989 to take on all the failed thrift assets during the savings and loan crisis, sources told CNBC.
And Volcker, et. al, titled their opinion piece yesterday in the WSJ: Resurrect the Resolution Trust Corp.

However this new entity would be very different from the RTC in a number of ways. The RTC was created to dispose of assets accumulated from failed Savings & Loans.

The new entity, according to the WSJ, would purchase illiquid assets "at a steep discount from solvent financial institutions and then eventually sell them back into the market".

With the RTC, the government already had direct responsibility for the assets since they acquired them from insured S&Ls that had failed. The role of the RTC was to liquidate certain of these assets.

In the current situation, the government has no financial responsibility for the assets, except for a few exceptions like the assets of Fannie and Freddie, and the NY Fed's assets acquired in the JPMorgan / Bear Stearns deal. The new entity will both buy assets "at a steep discount" and eventually sell the assets. So unlike the RTC, this new entity puts the taxpayers at risk.

Details of how this will work aren't available yet. But one of the key problems - in addition to the risk to the taxpayer - is that this program will actually reduce regulatory capital as losses are realized. The opposite of the goal!

Another previous entity mentioned today was the Reconstruction Finance Corporation (RFC) that was created in 1932 by Hoover. A key purpose of the RFC was to purchase preferred stock in banks to increase their capital positions and expand their landing capacity. This might also be part of Paulson and Bernanke's "comprehensive plan".

A new RFC might help certain FDIC insured banks, especially banks with significant losses associated with Freddie and Fannie preferred shares.

But since the first part of the plan - buying impaired assets at a steep discount - appears to reduce regulatory capital, a RFC preferred investment might be included to help boost regulatory capital. We will know more soon.