TARP on a Businesslike Basis

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Madam Chairman and Members of the Oversight Panel, thank you for the opportunity to be here today. I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views. Prior to joining AEI five years ago, I spent 35 years in banking, including twelve years as President and CEO of the Federal Home Loan Bank of Chicago. I have both experienced a number of financial crises and studied the instructive history of recurring bubbles and busts.

TARP in Historical Context

I believe the closest historical analogue to TARP is the Reconstruction Finance Corporation (RFC) of the 1930s. Like TARP, the RFC was created under a Republican administration, and expanded under the succeeding Democratic one (in the RFC case, the Hoover and Roosevelt administrations) as an emergency response to financial crisis. In both cases, the original liquidity idea--loans for the RFC, troubled mortgage assets purchases for TARP-- developed into a solvency idea: providing additional equity to banks in the form of preferred stock.

Consider the approaches available to a government to address a financial crisis. First, there is delay in recognizing losses while issuing assurances (for example: "the subprime problems are contained"). Then there are central bank lending operations, providing liquidity. But however freely the central bank lends, it is by definition providing debt, not equity. No matter how much it lends to entities with negative capital, the capital is still negative. When the capital is gone, new capital, not just liquidity, is needed.

The RFC made preferred stock investments in banks to offset the capital which had been lost. Its goal was to have a modest overall positive return on the taxpayers' money and redemption of the preferred stock at par when growth resumed and the firms were refinanced in the private market. By and large, this strategy appears to have succeeded.

In September, 2008, when considering the original "Paulson Plan" to buy mortgage assets, I expressed the view that something along the lines of the RFC's preferred stock investments would be a better idea. Of course, this is how TARP then turned out, and it is still my opinion that this is the least-bad approach.

TARP has made equity investments in almost 700 financial companies. The RFC made investments in over 6,000 banks, including such major banks of the day as National City Bank of New York, Chase National Bank, Manufacturers Trust Company, National Bank of Detroit and Continental Illinois. The vast majority of these were retired in full, after paying dividends along the way. The RFC also assisted over 1,000 savings and loans. Counting by the number of financial institutions involved, the RFC was about ten times as big as TARP.

The RFC's bank equity investments totaled about $1.3 billion--scaled to nominal GDP of 1933 vs. 2008, this would be the equivalent of about $325 billion today--comparable to TARP, which has a few gigantic investment positions. The RFC was also involved in numerous other areas, with a total of $10 billion spent fighting the Depression, which would be the GDP-scaled equivalent of about $2.5 trillion.

The RFC, like TARP, got involved in transportation companies. In the RFC's case, this was financing for railroads, said to have been the worst paying of its major investments. This seems likely to be true of TARP's automobile company investments, as well.

Alex J. Pollock is a Resident fellow at AEI.

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