Banking Law

James Thompson, financial economist for the Federal Reserve Bank of Cleveland, proposed today that the federal government set up the second coming of the Resolution Trust Corporation, which he would call the Resolution Management Corporation, to handle a future crisis like the one we faced in the fall of 2008, in which financial institutions are loaded up with toxic assets with no place to offload them. Although the Housing Wire article does not reveal a lot of details about how the RMC would work, the theory is that in the case of such a crisis where the volume of distressed assets exceeds the FDIC's capacity to manage them, the RMC would become the toxic waste dump into which these assets could be dumped, and the RMC would be funded and staffed by the federal government (apparently, Thompson proposes the US Treasury) with more bad asset managers than you could find in a hive of IndyMacs.

Thomson said troubled assets ? such as toxic mortgage loans ? are "like a carton of eggs in a supermarket. They might appear to be fine eggs, but if shoppers suspect they might be tainted on the inside, the eggs might not sell at any price."

This is the dilemma that paralyzed financial institutions holding toxic mortgages during the 2008 crisis, he said.

Thomson believes a quick cutting away of bad assets in times of market volatility will free up financial institutions, allowing them to move forward with lending and other business activity.

"The logic of stripping away toxic assets from their current owners is the same as ripping off a bandage ? it hurts, but it?s best to get it over with quickly," Thompson said. "Otherwise, you only prolong the pain."

While Thompson is quite correct about the nature of the dilemma that paralyzed financial institutions in 2008, readers should also remember that when TARP was enacted in 2008, Thompson's scheme was essentially its initial game plan. Ben Bernanke was even quoted at the time as saying that the federal government was the entity best able to fund the bad assets of banks and hold them until values recovered. That ship ran aground on the shoals of asset valuation. Banks didn't want to transfer bad assets at less than book value (or with a haircut substantially less than would be required by a mark-to-market valuation) because they didn't want to take the hit to capital that would ensue. From a political standpoint, the federal government was worried that if they bought the assets at too high a value, then a firestorm would erupt about "socializing losses while privatizing gains" and creating a moral hazard by bailing out broken banks. Instead, the government decided to force big banks to take capital injections from the government so the banks could retain the assets on their balance sheets and take the necessary capital hits to work them out and/or dispose of them over time. Of course, that also caused a firestorm of criticism that the federal government was "socializing losses and privatizing profits" and creating a moral hazard.

The valuation and moral hazard issues are not discussed by Mr. Thompson, although he does discuss that the fast realization of losses is the fastest way to recovery. The tricky question to answer is "who takes the losses?" If he's talking about an entity that replaces the FDIC in managing and disposing of bad assets of failed financial institutions, then he's discussing a true RTC-type of entity and the moral hazard and capital impact issues are not in play. If he's discussing an entity that would deal with assets of solvent banks that intend to remain solvent, the problems become much thornier.

While it's an intriguing idea that deserves some serious dispassionate discussion, there are important potholes in its road to realization that must be filled, or that buggy's going to bust an axle before it travels too far.