Bank investment plan is more Depression deja vu

[October 15, 2008]  SAN FRANCISCO (AP) -- The U.S. plan to ease the credit crisis by investing in banks retraces steps taken during the Depression by an agency that accomplished its mission -- but became a sprawling bureaucracy that dissolved amid fraud and corruption allegations.

The Reconstruction Finance Corp., formed in 1932, proved that making the government a shareholder in thousands of banks can restore order during periods of financial chaos.

Another heartening outcome: The RFC was repaid the roughly $1.1 billion it invested in nearly 6,800 banks. That suggests the same could happen this time, as the government invests $250 billion, or about $1.6 billion in 1933 dollars.

"I believe the government has a fair chance of making its money back because it is buying when smart investors should be buying -- when everyone else is terrified," said Alex Pollock, a resident fellow with the American Enterprise Institute.

Banking lawyer H. Rodgin Cohen, chairman of the firm Sullivan & Cromwell, is also optimistic, partly because "the banks aren't in as bad a shape" as they were during the Depression.

But the RFC's history also provides a critical lesson about the unintended consequences of taking such an extraordinary step.

Initially conceived as a stopgap agency, the RFC wound up spending about $50 billion before shutting down in 1957. Its tentacles extended far beyond banks as it subsidized farmers, helped the U.S. effort in World War II, invested directly in other U.S. businesses and even intervened in the gold market.

This time around, the government has committed only to investing in banks. But opening such a Pandora's box is bound to increase the pressure to save other failing companies, said Robert Bruner, dean of the University of Virginia's Darden School of Business, who has studied past financial crises.

"That is part of this deal with the devil," Bruner said. "My gravest concern is where do you stop? There are number of industries in free fall, like autos, airlines and newspapers."

To guard against an expansion of the bank program into other areas, Pollock said it would be important to set provisions requiring it to disband after it achieves its goals. He thinks that might take up to five years.

The government hasn't spelled out how long this investment initiative will last, but has indicated that it may be collecting dividends from the participating banks for more than five years.

Originally, the RFC was designed only to make loans to banks as they sunk into deeper trouble during the first few years of the Depression. After he was elected, President Franklin Roosevelt authorized the RFC to make direct investments in banks.

But it didn't take long for RFC to branch into other areas of the economy. It spawned the Commodity Credit Corp. to help farmers during the Depression. Later, it loaned directly to businesses, leading to the creation of the Small Business Administration in the 1950s when Congress decided to make dismantle the RFC.

And at Roosevelt's behest, the RFC established the Federal National Mortgage Association, or Fannie Mae, in 1938 -- an agency that would eventually go private and become one of the big names of this generation's financial crisis.

Facing charges of political favoritism and other abuses, the RFC was ordered to stop making loans in 1953 and finally closed in 1957 by Congress.

Much of the RFC's influence flowed from its strong-willed leader, a Texas entrepreneur named Jesse Jones who later became U.S. Secretary of Commerce. While he ran the RFC, he wielded tremendous power over banks -- in particular, dictating the terms of executive pay and prohibiting the payment of common stock dividends until the government got its money back from its investment.

This time, the government isn't stopping banks from paying dividends to other shareholders, but is imposing limits on executive pay.

Cornelius Hurley, director of Boston University's Morin Center for Banking and Financial Law, said the government today must try to balance protecting the value of its bank investments and avoiding political meddling that could gum up the free market.

"You don't want rank political interference, but we also need to shepherd our investment like any other shareholder," Hurley said. "We are going to be on a bit of high wire here."

The RFC's heavy-handed approach may have actually hurt the economy by making bankers so leery they turned away many creditworthy borrowers, said University of Delaware economics professor James Butkiewicz, who has studied the RFC's history.

"When the government is scrutinizing what you are doing, you tend to be very careful," Butkiewicz said.

In a sign that it intends to be a passive investor, the government is accepting nonvoting shares in banks. Treasury Secretary Henry Paulson emphasized Tuesday he hopes the banks will take advantage of the government infusion to make more loans.

The process of investing in banks also figures to be a delicate proposition because those who accept the government's money could be seen as endangered institutions -- a perception that could trigger a backlash among investors and depositors.

"The weakest institutions will be reluctant to participate because there will be a taint to it," said banking consultant Bert Ely. "It will become like a scarlet letter."

The government is trying to remove any possible stigma by making its first round of investments -- a total of $125 billion -- in nine of the nation's biggest and healthiest banks.

"Hopefully, depositors will stop and think about implications of what is happening and realize that it is a reassuring thing for the government to get involved," Bruner said.

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On The Net:

A history of the Reconstruction Finance Corp.

[Associated Press; By MICHAEL LIEDTKE]

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