Standard Operating Proceedure In a Credit Crisis

Ever heard of the Nordic Banking Crisis of 1992?  And, no, this isn't some lame economist joke. Sweden, Norway and Finland actually experienced a severe banking and economic crisis in the early 1990s because of a deflating real estate bubble.  The reason you've never heard of it is because the solution worked so well that it turned the country's economies around and averted even more serious economic downturn. 

Even though you've never heard of the Nordic Banking Crisis, you know the story.   In 1985, the government deregulated banks which caused a competitive frenzy for new loan growth.  The increase in credit availability created a real estate bubble as more individuals began speculating in real estate.  At the tail end of the five-year real estate bubble during which asset values increased by over 100%, banks became giddy with rising profits and loosened lending practices.  The economy boomed to the point where unemployment dropped to 1.4% in 1989. 

But then, in 1990, banks suddenly found themselves in dire straights as the bubble burst and asset prices began falling.   Three of the six major national banks were undercapitalized in 1991 because of the falling asset values backing the loans.  Several banks experienced "runs" on their deposits.  In the Fall of 1991, Gota Bank, one of Sweden's major banks declared bankruptcy.  The government stepped in and guaranteed the obligations of the bankrupt bank to avoid a market panic.  It then "bought" the bankrupt bank for 1 Krona.  The government bought the bank to rescue the financial system with a minimum of wealth transfer to the orginial shareholders, who were essentially wiped out.

Click on Image to Enlarge. Source:  Bloomberg and Contrahour

In addition, the government of Sweden created a government-owned institution, a "bad" bank, if you will, to liquidate the troubled mortgages and loans from two of the six national banks.  This bank, named Securum Bank, gave the government time to work out the troubled loans without being at the behest of the stock and credit markets.  In addition, the governemnt guaranteed that it would inject capital into any other bank that fell below the nine percent regulatory capital requirement.  In essenece, the government became both a buyer and investor of last resort. 

The "bad" bank worked out the troubled loans through asset sales, IPOs and restructurings.  The plan was a success.  While it could not avert a recession, the liquidity injections prevented the credit crunch from reaching more of the private sector.  Securum, the "bad" bank, was closed in 1997, just five years after the crisis reached its peak.  While the "bad" bank was capitalized with 65 billion kronas of government money to buy loans, it ended up not needing any additional capital and turned out to break even in the five years of operation.

Peter Englund describes the problems and solutions very well in his paper titled "The Swedish Banking Crisis: Roots and Consequences."   A copy of the paper should be on every Congressman and Regulators desks at this point. 

Download TheSwedishBankingCrisisRootsandConsequences.pdf

The Swedish model was a combination of models used in the United States Resolution Trust Corporation (RTC) to deal with the Savings and Loan crisis and the Reconstruction Finance Corporation (RFC), which was used in the Great Depression.

The Resolution Trust Corporation, formed by Congress in 1989, was not intended to "save" banks and thrifts by injecting liquidity into them before they failed.  Rather, it was used to liquidate real estate and financial assets which it inherited from failed Savings & Loans.  

During the late 1970s and early 1980s, thrifts faced numerous hardships caused by the rapid increase in interest rates.  Depositors essentially withdrew money from thrifts to put into higher interest rate bearing instruments because government regulation did not allow thrifts to pay market rates on savings accounts.  In 1980 and 1982, the government deregulated the industry and allowed thrifts to compete more freely with commercial banks. 

The deregulation, along with lax government oversight, caused thrifts to take on riskier real estate development loans, as well as other unsecured loans that were not in traditional near-by residential mortgage markets.  In 1984, Empire Savings went bankrupt, followed closely by numerous other thrift failures that eventually caused a "run" deposits of many S&Ls around the country.  By 1987, the Federal Savings & Loan Insurance Corporation (FSLIC) was technically insolvent because it had paid out so much money to depositors of failed S&Ls. 

In 1989, Congress re-regulated the industry and created the Resolution Trust Corporation to dispose of the assets held by failed thrifts. 

The Resolution Trust Corporation came up with a very clever solution to liquidate the illiquid assets of the failed thrifts.  Rather than sell assets in bulk and dumping them on the market, the RTC partnered with private companies who had expertise in liquidating real estate.  The RTC set up partnerships and trusts into which it would convey a portfolio of bad mortgage loans.  Pre-qualified investors would bid for a 49% interest in the trusts, payable to the RTC.  This 49% interest was then managed by an asset manager with expedience in liquidating distressed real estate assets.  A portion of the proceeds from recovered assets was paid back to the RTC.  In addition, the Resolution Trust Corporation created separate programs for the management of land other assets.  A more thorough discussion can be found at wikipedia and EH.net if you are interested.

All in all, the Resolution Trust Corporation closed 747 thrifts with assets of $394 billion. While it didn't "save" thrifts from going bankrupt, it provided an efficient model for liquidating troubled assets. 

Unlike the Resolution Trust Corporation, the model created in the Great Depression did try to inject liquidity into companies before they went bankrupt.  In 1932, the Reconstruction Finance Corporation (RFC) was created to make loans to troubled banks.  The Treasury authorized the RFC to borrow $2 billion ($2.8 trillion in todays dollars!) to make loans to banks, railroads and farmers.  

Initially, the RFC was a horrible failure because it required disclosure of which banks were borrowing from the RFC.  In addition, in exchange for the loans, the RFC required banks to pledge their best collateral.  Banks were obviously reluctant to do either because it could mean a destabilizing run on the bank.  In addition, the disclosure of which bank borrowed from the RFC caused politics to enter the picture, eventually leading to the failure of Union Guardian Trust in Michigan, and creating a nation-wide run on banks. 

This caused newly elected President Roosevelt to declare a nationwide bank holiday (that's right, no access to your money for a week!  Now you know why grandpa keeps cash under his mattress).  President Roosevelt revised the RFC to allow it to inject capital straight into banks through the Emergency Banking Act of 1993.  The RFC essentially bought preferred stock from banks to increase liquidity and stem the banking crisis.  The plan worked and banking failures declined significantly from 1933 onward.  

The RFC did dramatically expand the power of government to finance the "public" interest.  The RFC morphed into a gargantuan government financial entity that spun off such programs as the Federal Housing Administration (FHA), the Federal National Mortgage Association (FNM), and the Commodity Credit Corporation (CCC).  In addition, the RFC was used to finance war loans during World War II.  Despite the wide reaching investments of the RTC, the majority of loans made during the initial life of the RFC.  A more thorough discussion can be found on EH.net

Click on Image to Enlarge. Source:  Bloomberg and Contrahour

Over the past two weeks, I've seen red blooded capitalists on the floor of the Chicago Board of Trade (I'm talking about you Rick Santelli of CNBC) practically weep at the thought of the capitalist system dying.  I've also heard populists on the other side of the capitalist spectrum call for the end of bailouts for fat cat investment bankers and traders.  Neither extreme is correct.  As I've highlighted, the government can and has, on numerous occasions, intervened in the capital markets to prevent crisis from spreading.  It does so to serve the greater public good.  And it doesn't mean that life as we know it in America will come to an end.

This crisis was created by most everyone in America – from consumers using their houses as ATMs, to Wall Street traders who greedily sold products they knew little about, to investors who rapaciously bought products they knew little about, to Alan Greenspan who left rates too low for too long, to Ben Bernake who left rates too high too long, to Republicans who forgot why regulations needed enforcing, to Democrats who wanted everyone in America to live the dream and own a house. 

It's now time to clean up the mess using a well thought-out plan that borrows from the lessons learned from previous credit crisis, allowing government to provide much needed liquity to the market but also limiting its powers from over-reaching into other areas.  The Swedish model of creating a "bad" bank to buy troubled assets makes sense as long as the assets are purchased at level where a work out results in a proft for the government.  The Resolution Trust model of liquidating the assets with the help of private investors makes sense in creating the most value from the assets.  And the Reconstruction Finance model of intervening before the crisis deepens by injecting equity into troubled institutions makes sense to keep good companies afloat.  Implementing a solution that borrows a little from each model could avert a more serious financial crisis, while also making the government whole once the crisis passes.