RTC repeat may not end the drama

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So now it is Back to the Future. That, at least, is the message emanating from Washington. Over the past week the financial system has staggered from drama to crisis, with every new plot twist getting worse.

But just when investors were cowering beneath their seats, yet another narrative surprise has occurred: on Thursday it emerged via leaks to cable television (where else?) that Washington policymakers were mulling the creation of a new state-backed entity to purchase toxic debt.

Cue the sound of wild applause from investors around the world. After all, every analyst worth their salt knows the Resolution Trust Corporation helped drag America out of the Savings and Loans crisis almost two decades ago, while the Home Owners Loan Corporation performed a similar service in the 1930s. Hopes are thus riding high that the latest venture will deliver a rerun.

Will it? In reality – and notwithstanding the stock market euphoria – that remains a finely balanced bet. The good news is that last week’s events have removed the last vestige of self-denial in Washington about the scale of the banking mess. Better still, this shock is prodding politicians to produce some truly proactive policies.

Of course, it is a pretty damning indictment of our system that it has taken a full-blown crisis to achieve this turnabout. But the US is, at least, acting faster than Japan did during its banking crisis a decade ago. (There the political gridlock lasted so long that financial bureaucrats used to pray for a “Goldilocks bank collapse” – one big enough to shock politicians into action but not big enough to blow everything up.)

Better still, the current Washington debate on an RTC rerun suggests
that policymakers have recognised the key problem behind this week’s crisis: that investors simply do not believe western banks have enough capital to cope with credit losses.

In some respects, that lack of trust might look extraordinary. After all, western financial companies are estimated to have written down $500bn-odd of credit assets in the past year – and raised between $200bn (€139bn, £109bn) and $360bn new capital to plug the gap. And it is still not clear that the tangible economic losses will even reach the scale of current writedowns. One factor pushing down credit prices, aside from defaults, is investor panic. The system is trapped, in other words, in a vicious spiral where it is impossible to judge credit losses.

But what is clear is that investors are unwilling to give 21st-century finance the benefit of the doubt: not only are they are scared that banks are short of capital, they also fear banks will be unable to raise it from private sources any more. Thus, Washington appears to have concluded it must plug that gap itself, by putting more capital into the banks or taking duff assets from them.

It is still unclear which of these two options will be followed. However, opinion appears to be leaning towards the latter, not least because there is tangible evidence that when the RTC bought duff S&L assets 15 years ago, this did help to get markets moving.

Before anybody starts thinking the magic of the RTC could be replicated easily, several key conditions must be met. First, nobody should pretend that the creation of an RTC will make the cost of losses disappear: that must be paid, by private banks or taxpayers – and if that truth is concealed, any scheme will backfire.

Second, a new RTC will restore long-term investor confidence only if it is clearly committed to selling assets at a future date in a transparent manner. After all, investors are unlikely to return to the market until they are confident they know the clearing price for dodgy assets – and that can only be discovered when assets start to trade rather than being placed in an institutional deep freeze.

But third, any new RTC will only work if it is established in a credible manner. That might sound obvious, but it is not: when the Treasury floated the idea of a so-called Super-SIV last autumn to acquire distressed assets held by investment vehicles, that floundered partly because it was poorly conceived (and most bankers seemed to hope it would simply act as a freezer for bad assets).

There is no guarantee this problem will not occur; after all, in an election year there are plenty of politicians who would like to hide toxic assets in a freezer. But if Washington policymakers can learn the right lessons from history – a big “if” – we could be at a turning point. Just don’t expect to see the closing credits soon: I fear this great 21st-century drama still has a few more twists.

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