Bringing Back the RTC

Brady, Ludwig, Volcker. Three pretty smart guys who have seen a lot in their careers and dealt with mind-boggling turmoil in the markets. Kind of like the turmoil we have today. They penned an editorial in today’s Wall Street Journal that essentially brings back the Good Bank/Bad Bank concept in a systematic way, not in the one-off, herky-jerky manner that has characterized Treasury Secretary Paulson’s handling of affairs. The crux of their arguments are similar to those I’ve made recently, with the creation of optionality through liquidity as the centerpiece of their plan. Further, the plan keeps us away from the moral hazard of pushing investment banks into commercial bank’s arms, leaving the FDIC to pick up the pieces of broken asset portfolios that were the making of their more lightly-regulated brethren. That is not supposed to be the way it works.

Four key reasons Brady/Ludwig/Volcker raise for bringing back the Resolution Trust Corporation (RTC) model are:

– First, by buying paper that otherwise is effectively not trading, it would help restore liquidity to the marketplace and help markets to function more fluidly again.

– Second, by warehousing the troubled paper for a longer period than, for instance, the Fed’s discount window typically should or could, it would allow for a more orderly liquidation of this paper, and the chance for much of it to recover a portion of its value.

– Third, by giving the agency the ability to manage mortgages with flexibility to keep people in their homes and businesses running, it should lessen the number of foreclosures. This, in turn, would help moderate the decline in real estate values and the deterioration of neighborhoods, thus supporting house prices that in fact lie at the heart of the crisis.

– Fourth, where necessary, like the RTC of the 1980s, this new mechanism can assist the Federal Deposit Insurance Corporation in resolving sick institutions that are so clogged with the troubled paper they cannot continue as independent entities. However, we would hope that purchasing the mortgage-related paper will minimize the need to provide emergency, short-term assistance to solvent banking institutions.

Private markets Good Bank/Bad Bank deals can happen when there is sufficient time to segregate the troubled assets, raise the capital necessary to support the Bad Bank and to implement the plan. This was the path Lehman was heading down before Dick Fuld’s stubbornness around valuation caused time to run out. Good Bank/Bad Bank was foisted upon them through the bankruptcy process. The thousands of regional and local banks that are in trouble due to both bad loans and bad investments will neither have the time nor the scale to implement private Good Bank/Bad Bank solutions. And even if their financial assets are poor, they generally have valuable core deposit bases and customer lists on which to build healthy, re-capitalized institutions or to become attractive sale candidates. It is these firms, as well as large banks, investment banks and insurance companies that find themselves in a liquidity crisis, that will sell troubled assets into the RTC pool. It is the RTC that will serve to mute the impact of massive asset liquidations in the short-run, while protecting value through the liquidity option for the U.S. taxpayer in the long run.

Will trillions of dollars be needed to properly capitalize the RTC in order for it to do all that it must? Yes. Will this burden fall squarely upon the shoulders of the U.S. taxpayer? Yes. But is it a better outcome than Treasury Secretary Paulson dealing with problems in onesies and twosies without a clear plan or strategy? Absolutely. Force transparency. Cement the fiduciary responsibilities of those running the RTC, whose sole purpose is operating the entity that protects and maximizes the interests of the U.S. taxpayer. Like Messrs. Brady, Ludwig and Volcker, I don’t see another way. Things have gone too far. Private Good Bank/Bad Bank deals are no longer a possibility in today’s highly uncertain environment. It is time to act quickly, decisively and in a transparent manner. Otherwise, the bottom of this crisis will keep moving farther and farther away.