Bankruptcy

Some Curious Parallels with the 1930s

By Adam Levitin

There are lots and lots of differences in the financial institutions situation of the Depression and today. And yet there are some remarkable parallels in the problems and government responses. We shouldn't overread parallels as predictive matters. But some of them are pretty astounding:

Banks in the early 1930s found themselves undercapitalized after profligate lending in the 1920s. Banks reacted by carefully hoarding their remaining capital and not lending (not that there were many creditworthy borrowers available). The result were frozen credit markets, just like today.

The Hoover administration first tried to fix the problem without involving the government directly. Instead, the government merely facilitated the formation of the National Credit Corporation, a private central lending institution. Sound familiar? Remember the MLEF (Master Liquidity Enhancement Fund), a SIV of SIVs that Treasury tried to coordinate back in the fall of 2007, only to have the banks refuse to pitch in.

Next, the Hoover administration (a lot of New Deal institutions were Hoover inventions) attempted to bolster bank capital through direct government loans through a government agency called the Reconstruction Finance Corporation. The loans didn't do the trick though. We tried some direct government lending support for faltering institutions: AIG, discount window lending to investment banks, government support for JPM purchase of Bear Stearns, FDIC guarantee of Citi's planned purchase of Wachovia. While this lending support might have helped prevent a worse crisis, it did not solve the current one.

The Roosevelt administration then pushed through the Emergency Banking Act (cf. Emergency Economic Stabilization Act) that expanded the RFC's powers to include government purchase of preferred stock from banks. Banks didn't want to sell preferred to the RFC. It took RFC chair Jesse Jones telling the American Bankers Association that if they didn't get with the program and start lending again, the government would go into the direct loan business itself. The banks sold preferred to the RFC. I can only imagine what Secretary Paulson told the 9 bank CEOs would happen if they didn't sell to Treasury.

In the end, the RFC bought lots and lots of preferred stock from banks. By 1935, nearly 1/3 of bank stock value was held by the RFC. The dividend on the preferred stock? Then, as in the current deal, it was 5%.

The recapitalization of banks alone was not enough to get them to start lending, however. They didn't have enough credit-worthy borrowers. Government had to get into direct lending itself. Compare this with Secretary Paulson's declaration that the banks that received the forced equity injection from the Treasury had to deploy it. But also notice, that we've moved in the direction of government direct lending anyhow: the Fed is buying commercial paper (using a special deposit from the Treasury to do so) and FHA-insured refinancings as part of the hapless HOPE for Homeowners Act are equivalent to mortgage lending.

In the 1930s, the government had another major lever, however, to get credit markets going again in the 1930s. RFC preferred stock, unlike the preferred shares that Treasury is going to buy today, came with equal voting rights to common. The RFC exercised this to put its own managers in place at major financial institutions. The result was a distinctive type of state-capitalism. Arguably, Treasury might have done better to take preferred stock that would give it stronger control over bank management.

There is a vigorous academic debate about the efficacy of the RFC and New Deal statist-capitalism. But you can read an interesting paper by Federal Reserve Governor Randall Kroszner on the subject here.

Full post as published by Credit Slips on October 17, 2008 (boomark / email).