It’s tough to date the beginning of the financial crisis. As a convenient starting point, I use April 7, 2007 — the day that New Century Financial filed bankruptcy. It wasn’t the first of the subprime mortgage lender collapses, but it was the biggest to date and caught the market’s attention.
By that reckoning, we’re now over four years into the Great Deleveraging and the market that led us down — housing — is still flatlining. At the same time, lending to small businesses remains anemic with tragic consequences for our unemployed. What’s to be done? Increasingly, knowledgeable voices are waxing nostalgic for a Resolution Trust Corp. (RTC)-style solution.
Recently a reporter sent me a link to new research out of the Cleveland Fed describing how to establish a federal bad bank to hold and resolve problem real estate loans. In an article entitled “How to Build a Bad Bank — for the Greater Good,” James Thomson listed the benefits and objectives of a liquidation authority.
This was followed by TARP Inspector General Neil Barofsky’s blistering assessment of TARP’s lapses. The U.S. Chamber of Commerce’s Tom Bell also recently weighed in at a small business lending forum sponsored by the FDIC. He wondered aloud about the velocity of economic progress had an RTC authority been in place.
A careful reader of Inspector General and Congressional Oversight Panel reports on TARP will realize that among TARP’s three objectives, it accomplished one: It kept the financial system out of the ditch. The other two goals — home retention and expanded bank lending — are out of sight.
Purging could be helpful
There’s a legitimate political controversy as to whether government policy should try to intervene as opposed to letting the market sort itself out. But whether due to a policy failure or market reaction to lending excesses, it’s clear to me that systematically purging problem real estate loans from banks — as happened in the early 1990s — could still ignite a more robust economic recovery.
It’s important to note the significant structural differences between these two eras. The thrift crisis resulted largely from speculative commercial construction and a rapid expansion in thrift charters and their balance sheets. The crux of today’s crisis is the overbuilding and overleveraging of residential real estate.
Over the life of the RTC, more than 1,400 institutions were closed, most of them with good cause. Since 2008, approximately 350 institutions have closed, but the number of FDIC-insured institutions at the beginning of the RTC (over 16,000) was more than double the number of today’s institutions (7,600). We are not overbanked, but overleveraged.
Many remaining institutions — including a number deemed problem banks — deserve to stay open and serve their communities. The plug that prevents many banks from resuming their core banking function of allocating credit to deserving borrowers and projects is the continued overhang of overleveraged loans on real property.
At great direct and indirect cost, we can continue to disrupt communities by closing banks and auctioning off loans at deep discounts and at the significant expense of the FDIC and affected local markets.
Solution to closures?
Alternatively, we can look to a more creative model powered by Keynes’s “animal spirits” of the private sector.
First, transfer ownership of problem loans, partially or completely, to third-party managers and investors. Second and simultaneously, authorize the FDIC to co-invest in deserving banks through open bank assistance when matched by private investors.
Moving these problem assets out of banks would be matched by a simultaneous capital raise in order to offset losses brought on by discounted asset sales and loan resolutions. As an additional spur to moving problem assets, loans could be transferred at the net carrying value on the books of the transferee bank and losses only recognized as third party asset managers resolve the loans through economic modifications or, failing that, foreclosure and liquidation.
Compensation arrangements and incentives would be structured to encourage a reasonable and orderly resolution through the establishment of net present value analyses as used in structured finance agreements.
As we enter the next presidential cycle, the politics of a mechanism to encourage the cleansing of the banking system becomes irresistible. We know the well-worn maxim that small businesses create jobs. We know further truths as well: Community and regional banks lend disproportionately to small businesses.
Dearth of loans
Lending has shrunken without relief at these banks for the past 12 quarters. Some of this results from a real or perceived fear that regulators will criticize bankers for new and existing loans and lack of adequate liquidity.
This regulatory pressure causes a movement out of loans and into cash and investments. Many of our banks are becoming money market mutual funds.
This credit paralysis will endure as long as these banks carry the weight of mortgage loans criticized by regulators. The slow jobs recovery will continue unless banks purge themselves and raise capital in order to stoke new lending. The housing malaise will persist as long as these banks lock up years of shadow housing stock.
If you accept these premises — and I do — removing this credit blockage allows bankers to resume lending to deserving borrowers, encouraging American small business to grow and accelerating a jobs recovery. Purging problem real estate assets also lays a foundation for stabilized housing values.
Proper, healthy lending trumps any benefit from the Fed’s quantitative easing. The Fed’s securities purchase program may inject additional liquidity into the system. But it’s up to the banks to allocate that liquidity through prudent lending.
It may be too late and probably inappropriate to resurrect the RTC. A free-market solution that moves problem real estate loans into the hands of active managers while preserving worthwhile banking charters provides all the solution with little of the bureaucracy. America needs our community and regional banks healthy and open for business.
Brian Olasov is a managing director in the Atlanta and Washington offices of McKenna Long & Aldridge LLP where he focuses on banking and real estate capital markets issues. The views expressed herein are Mr. Olasov’s and do not necessarily reflect the views of McKenna Long & Aldridge.