Legislative Idiocy - Its Like Deja Vu All Over Again

Turnaround/Vulture investor Wilbur Ross recently predicted that 1000 banks will be forced to close within the next year or so (and he has raised a fund to buy a bunch of assets). History suggests that his claim is modest. In its existence, the Fed has closed 3,286 banks. 82% of these, or roughly 2600, were closed in 1990-1992, the last time the government stepped in to help us out of a financial mess with an imbecilic strategy. The centerpiece of that strategy was the Resolution Trust Corporation, or the RTC as it became known.

In that sterling example of clouded thinking, our government legislated against banks making leveraged loans (Highly Leveraged Transactions or HLTs) which limited borrowers' ability to refinance. The government then forced the closure of the Drexel Burnham (basically because some guy named Milken made $410 million one year), a firm that at the time controlled over 80% of the leveraged bond market. In two seemingly unrelated actions our government utterly closed the refinancing market. Corporate borrowers therefore defaulted, and the prices of bonds fell from par to roughly 33% of par. Nice job.

Why did the government do that? LBOs and their companion junk bonds had gotten lots of bad press as Uncle Wally and Aunt Millie lost their jobs to corporate restructuring. Junk bonds and LBOs were deemed "bad", and the government in its infinite wisdom wasn't going to stand around and let it continue willy-nilly.

The problem? Lots of insurance companies and savings & loans held these bonds as assets. So the value of their holdings fell, wiping out their equity to the extent that they no longer had the required regulatory capital. The Fed stepped in, took over a bunch of banks and S&Ls, and handed their assets over to the RTC. With the closure of banks and S&L's and coincident recession these actions caused, the housing market had little liquidity, causing a downdraft in real estate prices, leading to real estate loan defaults, which led to more bank and S&L failures.

The RTC proceeded to hold an unprecedented gi-normous and hasty liquidation. California did its part - foreclosing on three huge insurance companies (Executive Life anyone?) and itself hosting a bulk sale of their assets. Predictably, asset prices were low; real low. Buyers of these assets made out like bandits (within twelve months the buyers of the Executive Life bond portfolio tripled their money); the American taxpayers, including Uncle Wally and Aunt Millie, were stuck with a $1 trillion bill.

Notice any parallels with our situation today? We have to a degree a government induced reduction of liquidity (sub prime loans, like junk bonds, are "bad"). We have a huge government agency acting to take on lots of illiquid assets. We have structural weakness in our financial institutions, and we have lots of cash waiting on the sidelines (Buffet/Goldman, Wilbur Ross and others) to take advantage of illogical pricing to make a fortune. And we have the American taxpayer who is resigned to picking up the tab once again.

At least in 1991 the surviving financial institutions were in a position to get back to the business of moving money around. That's because largely the commercial banks (if you ignore Bank of New England) and the investment banks (excluding Kidder Peabody) had not been caught up in holding these assets, and the talent from Drexel became disbursed across Wall Street to create a vibrant bond market - renamed from "Junk Bonds" to the more politically acceptable "High Yield" bonds.

Just as importantly, in 1991 the US was on the cusp an 8 year increase productivity, led by the widespread adoption of the PC in the work place, the lowering of interest rates, and some would argue to the revival of the LBO. These productivity gains drove our economy to unprecedented heights.

Today, virtually all of our financial institutions are tainted by our financial mess, and our economy has not seen material productivity gains since 2001. One year after 1991 the US began an eight year period of expansion. Unfortunately, current conditions do not suggest a repeat of that history.