History Lesson in Bank Failures
Over the weekend, the government released information regarding its new plan to restart the economy. While details remain vague, the plan will likely authorize the government to purchase around $700 billion dollars worth of distressed debt at a steep discount from banks and other financial institutions. In the short-run, this will give banks and financial institutions liquidity and enable them to loan money again, freeing up the credit markets. In the long run, as the debt comes to maturity, the government will be able to resell the debt to investors, reducing the cost to the taxpayer.
A model of the plan would look like the Resolution Trust Corporation, which bought and sold hundreds of billions of dollars in Real Estate from Savings and Loan Companies in the late 1980’s. Saving and Loan Companies, also known as Thrifts, were financial institutions that specialized in accepting federal and state insured deposits and making mortgage loans. Thrifts sprung up following the Federal Home Loan Bank Act of 1932, which assisted banks in funding long-term fixed rate mortgages.
In the 1980’s, to combat inflation, the Federal Reserve Board enacted a series of rises in short-term interest rates. This led the cost of borrowing short term to outperform the thrifts portfolio of long-term fixed rate mortgages. Though the government eventually began to deregulate the industry by allowing the companies to expand into consumer and commercial lending, this only caused further declines as banks began to make poor speculative loans in real estate and distressed debt.
By 1983, the situation was dire as 35% of thrifts were unprofitable and as many as 9% were technically bankrupt. As more banks went under, the State and Federal insurance government agencies began to run out of the money needed to refund depositors. Despite this, S&L’s kept remained open, making bad loans, and the losses kept mounting.
Finally, in 1989, congress passed the Financial Institutions Reform, Recovery, and Enforcement Act, which provided $50 billion to close failed banks and stop further losses. It also set up the Resolution Trust Company, which took the debt off the failed companies’ balance sheets to resell to investors in order to pay back depositors of the banks.
Today, the government seems to look to do the same with the mortgage-backed securities currently on the balance sheets of hedge funds, investment banks and other financial institutions. As the government steps in to take over bad debt, it should help lift the uncertainty, encouraging banks to lend again. Whether or not it will work, is a problem that will be determined by the reaction of investors. What we have seen so far is extremely positive, as the Dow jumped over 800 points in two days, buoyed by the discussion of this plan.
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