Congress enacted the Emergency Economic Stabilization Act (EESA) on October 3, 2008, and President Bush signed it into law later that day. The EESA is a bailout package for the financial services industry. The initial bailout effort focused on giving the Treasury Secretary authority to purchase assets that are so good that taxpayers cannot possibly lose very much money but that are so bad that financial institutions are desperate to get rid of them. Within days, this approach proved to be a non-starter, at least when judged by its failure to get credit markets functioning again.

In the grab-bag of rationales for the bailout proposal, the underlying problems of the financial system were generally ignored until after passage of the bill by Congress. The basic problem was a lack of solvency or capital in the financial system, not a lack of liquidity. Thanks to the Federal Reserve’s activism over the last year, liquidity now is sloshing around the financial system. The principal measure of abundant liquidity, reserve balances at Federal Reserve Banks, reached $171 billion on October 1, 2008. The normal or baseline measure for that statistic is about $8 to $10 billion. 

 

Instead, as people soon realized when the October 3 law failed to strengthen the financial markets, the central problem was a lack of bank capital.  Once Britain's Gordon Brown came up with measures for direct capital infusion to that nation's banks in mid-October, there was a sudden change of opinion on this side of the pond about how to shore up U.S. banks. Lo and behold, it was said, what American banks really need is more capital.

 

In similar circumstances in 1932-1933, in the waning days of the Hoover Administration, Congress created the Reconstruction Finance Corporation (RFC). It purchased preferred stock from assisted institutions, with warrants convertible into common voting equity. This provided the needed capital relief. Assisted institutions had incentives to repay the government within the 10-year maturity of the preferred stock. The government’s equity position gave taxpayers a stake in the future success of assisted enterprises. The RFC then became the main vehicle for federal assistance to private enterprise in the 1930s.

 

Judging by classic free-market principles, it is best not to engage in direct state assistance to enterprise. Instead, “Bankruptcy is the answer,” as Harvard University economist Jeffrey Miron puts it. 

    

But if a society is bent on government assistance to enterprise, the minimum standards that should be applied for the protection of taxpayers can be seen in the RFC plan. In particular, Treasury Secretary Paulson seems to make sense when he says that the infusion of capital into participating banks may not cost taxpayers a dime.

 

Why? The Treasury provides capital to the banks by purchasing preferred stock that pays 5 percent dividends for the first 5 years, and 9 percent thereafter (an inducement for the banks to buy back the stock quickly). In addition, the Treasury receives 10-year warrants (options to buy more stock, it it rises) that could also repay the Treasury--and the taxpayers.  All this assumes, of course, that none of the big banks so helped will now go bankrupt.

 

Judging by the reaction of the financial markets to this new (or old) wrinkle, the feds have finally stutter-stepped around to a plan that restores confidence and trust to the financial markets. Time will tell. 

 

For further information on the history and structures of the original RFC, see Walker F. Todd, “History of and Rationales for the Reconstruction Finance Corporation,” Economic Review, 4Q1992, Federal Reserve Bank of Cleveland. A useful summary of the RFC is on pp. 6-7 of the PDF version of the article.