Reconstruction Finance Corporation II: Lessons from the Great Depression. Part XXV: Understanding what we own, Financial History, and the Dangers of Price Floors.
One good thing about the new information age is there is no lack of ideas on how to go about solving our current economic crisis. Yet I am a bit dismayed how some people have suddenly found economic religion yet sat by when the Federal Reserve expanded powers to unprecedented levels and cheered on the first cut of the $350 billion in TARP funds. It is a sort of reverse version of eat the rich where we eat the poor for the ills of our market. Some people are latching on to an idea with iron claws that poor people (aka subprime borrowers) somehow caused this entire global collapse. What is disturbing about this argument is the lack of math and analysis behind it. The amount of subprime loans pales in comparison to the amount of overall mortgage debt, corporate debt, consumer debt, credit default swaps, and other more exotic forms of financial engineered credit products. But some people love a good rallying cry and saying “subprime borrowers caused this problem” is an easy target since most subprime borrowers don’t have access to a public podium.
The argument during the bubble, if you can remember the mania, was that subprime was a tiny niche of the overall mortgage market so there was no need to worry about any market contagion. Subprime was contained and if any problems did occur, it was such a small portion of overall mortgage debt that it was isolated on an economic deserted island. Ironically, most of these people are now arguing that subprime caused all or the vast majority of the market problems. Keep in mind that $7 trillion has been wiped off from the S&P 500 and the United States real estate market has seen $8 trillion wiped away from the peak. Just with the S&P 500 and the U.S. residential market we have seen $15 trillion in wealth evaporate. You mean to tell me that roughly $1 trillion in subprime loans has caused $15 trillion in wealth to disappear? Is it any wonder why so many in our population don’t even understand the basics of Algebra but know who the last American Idol is?
Another interesting thing is occurring and this is more in the social trends department. I’ve talked about a few radio shows here in Southern California that pumped up the real estate market like a used car salesman. These shows normally occurred during the weekend. Well for the last couple of weeks, this regular programming has been replaced with Beyonce and Ludacris. Not sure if this is temporary but many that listened to the show realize how wrong these people were. They not only were wrong they were major cheerleaders for the real estate market for years. They were the real estate carnival promoters. Radio is in it for the money. And I am certain that many in Southern California got sick of hearing people so wrong about the market and probably tuned out.
What I want to discuss in today’s article is the Reconstruction Finance Corporation and panic moves during the Great Depression. During the Great Depression, President Hoover recommended the formation of a big governmental credit agency that would then lend money to banks, railroads, and insurance companies. This might sound very familiar but it would seem that people have forgotten many of the lessons from the Great Depression. It is important that we focus on what worked and what didn’t instead of demonizing one side or the other. This is high stakes poker here and decisions that we make today will last for years. The Reconstructions Finance Corporation (RFC) was chartered in 1932 during the last year of the Hoover administration. The RFC was disbanded in 1954.
This is part XXV in our Lessons from the Great Depression series:
21. The Big Change
So why did the RFC come to be? I’ll refer to Frederick Lewis Allen here:
“Again Hoover acted, and again his action was financial. Something must be done to save the American banking system, and the bankers were not doing it; the spirit of the day was sauve qui peut. Hoover called fifteen of the overlords of the banking world to a secret evening meeting with him and his financial aides at Secretary Mellon’s apartment in Washington, and proposed to them that the strong banks of the country form a credit pool to help the weak ones. When it became clear that this would not suffice-for the strong banks were taking no chances and this pool, the National Credit Corporation, lent almost no money at all-Hoover recommended the formation of a big governmental credit agency, the Reconstruction Finance Corporation, with two billion dollars to lend to banks, railroads, insurance companies.”
It would seem that we are following similar patterns here. Yet the problem in our situation is that the big banks don’t even have any capital to lend – in fact, we are injecting capital into them. Last week we broke below the November market lows since two of the nation’s largest banks were pummeled under fears of nationalization. This is another fascinating part about consumer behavior. We already own Fannie Mae and Freddie Mac, two institutions that guarantee or own $5 trillion in mortgage debt yet people fear temporary nationalization? We own AIG, an institution with over $1 trillion in assets yet people still don’t think the government is involved? We are massively involved already. And the problem that we now confront is do we keep lending money to zombie banks or do we nationalize a select few on a temporary basis, clean them up, and set them back to the private market. Heck, even Alan Greenspan has recommended this course!
These fears of nationalization are nothing new:
“Already the pressure of events had pushed the apostle of rugged individualism much further toward state socialism than any previous president had gone in time of peace. Hoover’s Reconstruction Finance Corporation had put the government deeply into business. But it was state socialism of a very limited and special sort. What was happening may perhaps be summed up in this was:
Hoover had tried to keep hands off the economic machinery of the country, to permit a supposedly flexible system to make its own adjustments of supply and demand. At two points he had intervened, to be sure: he had tried to hold up the price of wheat and cotton, unsuccessfully, and he had tried to hold up wage-rates, with partial and temporary success; but otherwise he had mainly stood aside to let prices and profits and wages follow their natural course. But no natural adjustment could be reached unless the burdens of debt could also be naturally reduced through bankruptcies.
And in America, as in other parts of the world, the economic system had now become so complex and interdependent that the possible consequences of widespread bankruptcy-to the banks, the insurance companies, the great holding-company systems, and the multitudes of people dependent upon them-had become too appalling to contemplate. The theoretically necessary adjustment became a practically unbearable adjustment. Therefore Hoover was driven to the point of intervening to protect the debt structure-first by easing temporarily the pressure of international debts without canceling them, and second by buttressing the banks and big corporations with Federal funds.”
It is a curious coincidence that under two of the most supposedly free market administrations have we seen two of the most direct market interventionist emerge. Take a look at Henry Paulson and his $700 billion TARP plan and weekend bank parties with Bear Stearns, Lehman Brothers, and Merrill Lynch. I think what we have witnessed is strict ideologues inflexible to common sense notions. It is great to say the free market knows best but what use is it saying that if you can’t live by those ideals when times are tough? Now I’m not a strict believer in quick taglines because I realize some people are greedy and economically lustful and many will spend more than they should if they can get away with it. And that is what happened. It is sensible to have some common checks and balances to prevent outright orgies in financial markets but we flew to the other side of the equation.
And that is why with the RFC, Hoover had to suck it up and do what he totally believed against. That is, charter an entity that would do the lending that the free market could not. That is, socialize lending. Now during the first year in 1932, the RFC dispersed $1.5 billion and $1.8 billion in 1933. Another $1.8 billion in 1934. It is hard to simply lay these numbers out with no context. For that, let us look at GNP from the Great Depression:
The first stunning thing you will notice is that GNP fell from $103 billion in 1929 to $55 billion in 1933, a near 50% fall. To put that in today’s numbers, this would mean losing $7 trillion in GDP in the next few years. So let us run some numbers here:
1933 GNP: $55 billion
RFC 1933: $1.8 billion
3.2% of GNP
2008 GDP: $14 trillion
3.2% of current GDP: $448 billion
So already we know that we are spending much more than what was spent during the Great Depression. First, we have allocated $700 billion through the TARP program. Next, we have passed nearly $800 billion in a fiscal stimulus program. Next, we nationalized the major mortgage lenders Fannie Mae and Freddie Mac and also one of the countries largest insurers through AIG.
We are much more active than during the Great Depression yet things still are deteriorating at a quick pace. What gives? As I highlighted above, we are stunting the market process of finding a true bottom by propping up home prices or trying to save select banks. All this will do is prolong the shaking out and will certainly give us a lost decade similar to Japan. As things play out, I am more convinced we will face something similar to Japan. Unless we temporarily nationalize banks and clean them out, this is going to be an extremely long crisis. I don’t think any of us likes the options presented to us but we must choose the best course forward. Otherwise, we will keep sinking billions into banks that are already insolvent.
The RFC in a way was like the good bank idea that was being proposed. Create an entity that will loan to the market burden free of toxic loans. Yet how can we with a good conscience now create another institution with $448 billion to loan out to small businesses and the public? It is incredible how much money is being put at risk now. I understand the frustration of many and don’t kid yourself, we are going to be dealing with the fall out for years no matter what course we take. The RFC which was going to be temporary lasted over 20 years and morphed into all sorts of things. Take a look at some of the lending numbers:
For a time the RFC merged with the FDIC. RFC lending increased dramatically during World War II. So to think that any programs established will be fast is nonsense. Think of the first $350 billion in TARP injections. That is taxpayer loans to the banks. Want to take a wild guess when we’ll be paid back?
I also find it interesting how some people don’t even know what we have done. For example, part of the recent housing plan comes straight from money allocated from the TARP and of our nationalization of Fannie Mae and Freddie Mac. That is, we have already committed this money! I almost fell off my chair when I saw some moronic Congress person hoping that Fannie Mae and Freddie Mac collapses. We now own these agencies! It would behoove us if we make smart and prudent moves with them. We are now shareholders whether we like it or not. If anything, the recent plan although painful for most prudent borrowers to stomach, could have been a lot worse. One thing I like is that most option ARM folks in California and Florida are not going to get one cent. I like that. The fact that it is capped at 105% rules out many of the bubble states. That was my main concern. Frankly, if you can get someone in a $150,000 home to pay $200 less a month by increasing the term of their mortgage and dropping the rate by 1 percent, I find this more reasonable than injecting $350 billion into irresponsible banks and praying they do the right thing.
I understand the frustration that most feel. It is absurd. But keep in mind we have already committed this damn money and the time for anger was years and months ago when the bills passed or bad ideas germinated. Frankly, this is probably the best they could do. My fear was that we were going to get a plan that allocated funds to bailing out California or Florida home speculators that jumped into option ARMs. That would have lit a fire under me. It doesn’t look like that has happened and we better hope it does not because that would be a tragedy to our economy. Here is an interesting take on the RFC:
“In addition to the empirical evidence indicating that in general the RFC loan guaranty program has exerted a destabilizing force upon the economy, there are a priori reasons why one would expect this to be true in the future as in the past. A loan guaranty system operating with fixed rules such as eligibility requirements and a constant rate of interest would be expected to result in an excess demand for funds during periods of price rises and increasing marginal efficiency of capital. Since the quantity of funds demanded at the fixed rate of interest would increase during inflation, this would create the impression that the “shortage” of private funds was increasing.”
This is from a paper written in 1952 and some of the same conditions work in today’s market. For example, much of the bubble was caused by artificially low rates that actually did not factor in the true underlying risk of the credit products. Now, we have outside forces trying to stabilize prices while the market is actually trying to increase rates because we are now understanding the true risk of the products that were sold. The longer we blunt this price discovery, the deeper the recession will be. That is why those calling for suspending mark to market are delusional crony capitalist that are basically saying, “let us suspend reality until we can sell out our crap at bubble prices we paid.” Artificial price bottoms do not work. They never have and never will.
It is difficult to say how much the RFC helped but it did have an impact with the numerous programs pushed by the government during the Great Depression:
Without a doubt, there was an impact by the fiscal spending done by the government. Take a look at the above chart. It is interesting to note that our current true unemployment rate is now at 13.9% which puts us in line with the 1935 unemployment rate which counts emergency government workers. That is, our current unemployment rate is now at Great Depression levels. People will argue otherwise because they focus on the headline 7.6% rate but does it really feel like that? Of course not because it isn’t true. You mean to tell me that having 7 out of 100 workers unemployed is causing all these problems? Of course not. Currently we have 11.6 million people unemployed in the U.S. At the height of the Great Depression we had 12.8 million people unemployed. I know that we have to factor in the fact that we now have 3 times the population but just take a look at those humbling statistics and you’ll understand why we are doing such historical moves to solve the current crisis.
I’m not exactly sure how to solve the current crisis. Yet I do know what won’t work:
(a) Price floors: Trying to put any price bottom on home prices will only prolong the misery. It is hard to even come up with any good examples of artificial market floors working.
(b) Capital injections into banks: The first $350 billion in TARP did nothing. In fact, we are now below the November market lows. Most of this money was never lent to the public. Why are we suppose to inject more money to institutions who were the root cause of this problem? If we want to lend the money let us do it ourselves through a good bank model.
(c) Avoiding foreclosure: Fortunately in the U.S. we have a healthy rental market. People can rent a home if they can’t afford their current home. Is this all that bad? We should actually be encouraging these kinds of programs. In fact, there are many investors and lenders willing to buy homes and to rent them out at fair market rates. Yet few will buy if there are artificial floors being put in place. The notion that everyone should own a home is absurd. You should own a home if you are prudent and can afford it. That is why the 20 percent down payment made sense for many years. It showed that you had the financial discipline to own a home.
(d) Trusting Wall Street: I still don’t get why we haven’t seen any high profiled people go to prison. We need to see a fleet of FBI agents stroll into Wall Street and take away many of the engineers of this crisis. Many homeowners have paid for gambling. They have lost their homes. Many Wall Street executives have received bonuses for their part in crushing the global financial system for a quick gain.
So as we go along with this crisis, we can expect stronger oversight on Wall Street. This is a long battle. We haven’t even started tackling the dark world of the hedge fund industry which you can rest assured will come up. If it isn’t apparent already, no one has a clean answer to this crisis. Yet we can at least avoid making the obvious mistakes from the past. The California housing market is off 50% and guess what? Home sales are increasing. We should avoid trying to make errors from the past that we already know will not work. That is one thing that we should at least strive for.
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