Bailout Nation

by Barry Ritholtz

  Beyond the telegraph and railroads, this boom-and-bust cycle has been repeated across all industries. The same pattern has played out in all new technologies: radio, steel, automobiles, television, aviation, electronics, computers, and, more recently, Internet companies. The boom-and-bust cycle in subprime mortgage originators, mortgage brokers, and even real estate agents is no different than prior cycles. And we can expect the same cycle to occur during the next few decades in solar power companies, gene therapy research, electric car manufacturers (again), nanotechnology, stem cell medicine, and all manner of alternative energy production.

  Believe it or not, there was a time when this great nation of ours actually believed in allowing consumers in the marketplace to choose the winners and losers of an industry. History has repeatedly shown us that this is a more efficient allocator of capital than representative governments or dictatorial central planners. Alas, it is a lesson easily forgotten.

  There is a temptation to compare the present-day Bailout Nation—an era of big government bailouts and bigger corporate rescues—to the Great Depression and the New Deal. But there are many obvious differences between the two periods: In the 1930s, the United States was an industrial powerhouse. Steel, manufacturing, railroads, and coal were the dominant industries. Stocks were not that widely owned, so the market crash was initially seen as affecting only the wealthy. The modern era is diametrically different.

  There are some similarities between the government’s response to the current crisis and Franklin Delano Roosevelt’s New Deal, particularly the seemingly endless array of new programs with acronyms like TARP and TAFFY. But massive government response to a crisis is the effect. What is truly different between the two eras is the cause of the crisis, who got bailed out, and why.

  The 1929 stock market crash eventually led to a worldwide depression. It was particularly acute in the United States, where unemployment rose to 25 percent, and nearly one in five homeowners faced foreclosure. Through no fault of their own, the vast majority of Americans were in economic distress. The recipients of government aid had not gotten into these difficult situations by virtue of their own recklessness, speculation, or outright stupidity. Rather, they were the victims of a broad economic collapse, and not its architects. The Great Gatsby era certainly had its fair share of excesses; however, the average citizen was not, as Citigroup’s Former CEO Chuck Prince once stated, “compelled to dance so long as the music played.”

  Viewed in this light, it’s hard to see the current crop of big corporate bailouts as somehow similar to the government’s response to the Great Depression. It is simply not an apt comparison in terms of causes and culpability.

  It is true, however, that the 1929 crash and ensuing era led to a vast smorgasbord of government programs. The population demanded action from their government in response to the widespread economic distress. It was intervention into the economy that they wanted; and it was intervention into the economy that they got.

  Compare that with the reaction to the bailouts in 2008. It is hard to find many people who supported Secretary of Treasury Henry Paulson’s initial plan to spend $750 billion buying troubled assets from banks and brokers. As originally conceived, the Troubled Asset Relief Program (TARP) was intensely disliked by the country (and people didn’t exactly embrace it as it evolved). Calls to members of Congress ran 10 to 1 against the enormous spending package. Perhaps that is why it was voted down on the first attempt in the House of Representatives. The citizenry opposed the idea of casino capitalism, a system where privatized profits stayed in the hands of fair-weather capitalists, but all the risks were borne by the public. There was minor outrage over bailing out the very firms that had caused such widespread economic distress.

  In the 1930s, there was very little in the way of objections from the public. In fact, the biggest applause line in FDR’s 1933 inaugural address was not “We have nothing to fear but fear itself” but his repeated calls for action: “This nation asks for action, and action now.”3

  Here is a neat reversal of roles: Business leaders in the 1930s strongly objected to the government oversight and regulation that came with taxpayer largesse. In the modern era, it is the taxpayers who are objecting, while business leaders take private jets to Congress to go on bended knee and request bailout bucks.

  Consider the steel industry, long a symbol of American might, as an example of economic distress that led to a major government intervention. From its precrash peak in 1929, the steel industry had fallen into utter disarray just three years later. Production had all but collapsed, cascading from more than 63 million net tons of ingot iron produced in 1929 to barely 15 million tons produced in 1932. This more than 75 percent drop in manufacturing output took production to the lowest levels since 1901, more than a third of a century earlier. Bethlehem Steel, which had been running at 90 percent of capacity before the crash, was operating at 13 percent of capacity by 1932.

  Steel was emblematic of the rest of the U.S. economy: It had ground to a virtual standstill after the crash. The extreme economic conditions led to extreme responses. The government’s focus was not on rescuing a single company or industry, but rather on resuscitating a once-great economy. As such, it’s hard to think of these actions as bailouts—at least in the same way we view modern-day corporate bailouts. A look at the details reveals why.

  From its 1929 peak to the ultimate low in 1932, the Dow Jones Industrial Average fell some 89 percent. The 1929 market crash was far broader than the technology crash in 2000. The broad indexes in 1929 lost more than three-quarters of their value. Most of the losses in the 2000-2002 crash were concentrated in technology and telecommunications and the new dot-com stocks. The benchmark Standard & Poor’s 500 index lost only 50 percent, while the Dow Industrials fell a mere 38 percent.

  The current downturn is one for the record books, at least in terms of speed: From their October 2007 all-time highs, the Dow and the S&P 500 were cut in half barely a year later. This was one of the steepest falls and fastest drops in market history. This downturn has seen major wealth destruction—but the effects in the overall economy have yet to reach the same damage as in the Great Depression. Perhaps it is the safety nets that are in place; maybe the 1970s prepped us for this downturn. It may simply be that we have yet to plumb the full depths of this downturn.

  Regardless, the impact of the 1929 market crash was far worse than anything we’ve seen since. The ensuing economic contraction was a uniquely devastating event in modern history. During the Great Depression, the U.S. economy simply collapsed into shambles. Lenders faced heavy investment losses, communities were unable to collect property taxes, the construction industry was all but frozen. Unemployment rates ran over 25 percent. Industrial capacity plummeted. Municipalities were badly in need of funds. The automobile industry ground to a full halt. During the worst of the Depression, one in five homes was in danger of foreclosure.

  Even the worst of the complex difficulties of the 2008-2009 credit crunch and housing recession were mere sun showers compared to the financial hurricane of the Depression era: Banks have failed, but the FDIC’s guarantees have prevented widespread panic. Unemployment has risen, but far below the worst levels of the 1930s. And the two million or so foreclosures over recent years are far less, on a percentage basis, than the nearly 20 percent foreclosure rate in the 1930s. In short, while the broad economy circa early 2009 is ugly, it remains far healthier than during the Great Depression.

  President Roosevelt’s response to the economic crisis has become known as the New Deal. It involved spending programs, aid to industry, new job creation, public works programs, and lending assistance to homeowners. Significant new legislation attempted to restore faith in the American banking system and credit markets, in the equity markets, and in the U.S. economy. It was the single most comprehensive and far-reaching set of legislative programs in American history.

  The housing sector was a key part of the economy devastated by the Depression. It may be ins
tructive to examine how homeowners benefited from intelligent government-sponsored lending.

  When considering whether this was a bailout, one needs to consider the context of this massive intervention. The market for financing homes was quite different in the 1920s and 1930s than it is today. There were no such things as 30-year, fixed-rate mortgages. Instead, the typical mortgage was an interest-only loan for a period ranging from three to five years. These nonamortizing mortgages called for a balloon payment upon maturity. Most were renewed without much fuss—assuming the borrowers had maintained their jobs and payment histories.

  As the 1930s economy went from bad to worse, this cozy home financing arrangement ran into trouble. Home prices entered into a steep decline. A cash-strapped populace, suffering from massive job losses, was frequently unable to meet its mortgage payments. In History and Policies of the Home Owner’s Loan Corporation, C. L. Harriss writes, “What had generally been regarded as a reasonably sound arrangement by all parties concerned proved to be very weak when a set of interrelated forces combined to bring on a severe depression after 1929 and to disrupt seriously the structure of home-ownership finance.”4

  At its worst, mortgages were being foreclosed at the rate of 1,000 per day.5 Moreover, as demands for cash increased from depositors, many lending institutions were faced with the issue of their own insolvency. Some lacked the capital to roll over mortgages. Others saw their credit lines disappear. Real estate assets were sold off of their books as many banks went bankrupt and had their assets seized by creditors.

  All in all, the housing finance system was breaking down.

  The Home Owners’ Loan Act of 1933 (HOLA) was President Roosevelt’s response to the wave of foreclosures. It directed the Federal Home Loan Bank Board to create the Home Owners’ Loan Corporation (HOLC) with $200 million in Treasury funds, and authorized the HOLC to issue not more than $2 billion in bonds for the purchase of mortgage bonds. Ultimately, this amount was more than doubled to $4.75 billion. Loans were limited to distressed homeowners of units of one- to four-family residences. Homes valued at less than $20,000 were eligible, so long as the mortgage was recorded prior to HOLA (June 13, 1933).

  By just about any conceivable measure, the Home Owners’ Loan Corporation was a wild success. When the HOLC was liquidated on March 31, 1951, it did so at a slight profit, returning to the Treasury an accrued surplus of $14 million.6 The rest of its performance was just as impressive:• From June 1933 to June 1935, the HOLC received 1,886,491 applications for $6.2 billion of home mortgage refinancing, an average of $3,272 per application.7

  • Seventy-five percent of loans were for less than $4,000, and amounted to about 69 percent of the HOLC appraised value of the property.8

  • The HOLC made more than one million loans, lending more than $3.5 billion and refinancing 20 percent of the mortgaged homes in the country.

  • At one point in time, one in five mortgages in the United States was owned by the HOLC.

  • The total lending amounted to 5 percent of GDP.9

  As part of the effort to revive the economy as a whole, the HOLC rescued the American housing sector. And it did so with little cost to the taxpayer. It is hard to think of this program as a true bailout, especially in comparison to modern bailouts. Homeowners who ran into trouble did so through no fault of their own. They hadn’t purchased homes they could not afford. Home buyers of the day did not dabble with exotic mortgages, but instead used conservative financing to make their purchases. They did not engage in flipping, spec building, or other forms of speculation. There were no liar loans back then. The homeowners of the 1930s who were rescued by the HOLC did not contribute in any appreciable way to the economic mess of the time. Because of these many factors, the term bailout is not the correct title for this act; rescue is the more appropriate term.

  The specifics of the HOLC were the secret to its success. HOLC loans were for as much as 80 percent of the appraised property value, but no greater than $14,000 under any circumstances. The HOLC exchanged Treasury bonds (4 percent interest rate) for mortgages. The Treasuries were triple tax free (exempt from local, state, and federal income taxes). The homeowner was charged a 5 percent interest rate over a 15-year loan term. At the time, prevailing rates were above 6 percent, so the HOLC terms were a substantial discount from what might otherwise be available. In some cases mortgages were interest only for the first three years, followed by the 15-year amortization period.

  It was the mortgage issuers who absorbed the loss between the value of the refinancing and their interest in the distressed loans. This was a preferable outcome to the certain loss a foreclosure was sure to cause in the very difficult real estate and credit markets of the time. The guaranteed HOLC bonds, and their tax-free status, encouraged the acceptance of HOLC bonds by mortgage issuers. Banks in receivership also were able to exchange mortgage holdings for HOLC bonds.

  But the HOLC was not a giveaway program. The program took over more than 200,000 houses by foreclosure.10 In some states the HOLC foreclosure rate was quite significant. In New York and Massachusetts, over 40 percent of the government loans made were foreclosed.

  In 1932, President Herbert Hoover called for the creation of the Reconstruction Finance Corporation (RFC) in a State of the Union address. In its first year, the RFC primarily made loans to banks and financial institutions. Later, its role was dramatically expanded to include loans to railroads, agriculture, and the steel industry. The RFC was initially created with $500 million of capital from the Treasury (the RFC was eventually authorized to borrow $1.5 billion more). During its years of existence, the RFC borrowed $51.3 billion from the Treasury and $3.1 billion from the public.11

  Under Roosevelt, the government’s response was greatly expanded. The New Deal was a bevy of legislation and government funding, including the National Industrial Recovery Act (NIRA), the Home Owners’ Loan Act of 1933 (HOLA), and the Defense Plant Corporation (DPC). (See Table 3.1.) The NIRA “provided a legal framework under which both government and business acted together to raise prices without fear of anti-trust punishment.”12

  The creation of the FDIC in 1933 and the expansion of FDIC insurance in 2008 served similar purposes. Then, as now, the financial system was prone to panics and bank runs. By establishing deposit insurance for all banking deposits, the government sought to alleviate the fear of loss that potential bank failures were causing. Panics were all too frequently developing. Bank runs became self-fulfilling prophecies, ultimately leading to institutions failing. Many of the banks held railroad bonds, and as the railroads succumbed to the economic contraction, the banks suffered also.

  Table 3.1 New Deal Programs

  SOURCE: Greg D. Feldmeth, www.polytechnic.org/faculty/UShistory

  Unlike the current crisis, the Great Depression was not primarily located in any one sector; it was endemic to every corner of the economy. The government tried to reinvigorate the broader economy and to recapitalize the financial sector. It provided funding and a mechanism to allow homeowners who could afford to rework their mortgages to do so. The focus of the many government programs was to shore up the financial institutions. Once that was accomplished through government guarantees—insurance for deposits, credit availability for banks—only then did the population start developing faith in these institutions.

  Yet, there are a few parallels between today and the 1930s. Rampant speculation among Wall Street players set up the initial market crash in both eras. In both cases, the primary vehicle for leverage was unregulated credit or derivatives. Leverage added fuel on the way up, and it caught fire on the way down. Once all this liquidity began to dry up, the leverage led to a myriad of interconnected problems throughout the economy. Growth rapidly contracted. The initial government reaction was tepid, with key players mostly in denial about the extent of the economic damage. As the damage became increasingly difficult to ignore, the governmental response became broader, with major corporate bankruptcies spurring action. Then came a presidential ele
ction and new administration promising significant change.

  One of the government’s early responses to the crisis of the 1930s was to provide loans for railroads. The goal was to maintain the value of their bonds and therefore indirectly strengthen the banks’ balance sheets. In the current era, loans to banks and brokerage firms—initially to keep them liquid, but ultimately to keep them solvent—has been one of the early Federal Reserve responses.

  Here’s a fun trick: Take any Depression-era railroad lending legislation, and place it into a document. Now do a “find & replace,” substituting the words “home mortgages” for “railroad bonds.” You very nearly end up with what became known as the Emergency Economic Stabilization Act, also known as the Troubled Assets Relief Program (TARP) passed on an emergency basis on October 3, 2008.

  Current Fed chairman Ben Bernanke is a renowned student of the Great Depression, so perhaps similarities in the legislation are a bit of an homage. But Bernanke may have missed the biggest lessons of when and why massive government intervention is warranted—or at least may have turned them on their head, as we’ll see in ensuing chapters.