As in 1930s, Will Banks Lend Federal Bailout Dollars Until the Government Forces Them?

On 10/28 Houston Chronicle business columnist Loren Steffy said that in its bailout efforts to date, the U.S. Treasury Department has yet to jettison Alan Greenspan's benighted notion that banks will regulate themselves productively apart from government coercion.

The Treasury has given banks billions so that they can resume making loans and unfreeze the credit markets. Yet, Steffy notes, instead of lending the banks are hoarding the funds. Compounding the problem, some banks are using the money to buy up weaker ones.

Steffy says that's because the bailout law actually incents them to do that more than to make loans, "Who can blame them? A provision of the $700 billion bailout plan provides a tax deduction for bad assets when one bank buys another." Unfortunately, that only worsens the credit crunch: "That may remove some struggling players, but we’ll be left with fewer banks making fewer loans."

Steffy says the Treasury needs to do what it said it would do, and what European governments have already done: use the government's new ownership of preferred stock in the banks to demand seats on the banks' boards and to demand that the banks resume lending.

Yet history shows even that may not be enough. What Steffy fails to take into account was covered 10/18 in another Houston Chronicle column, this one an op-ed piece by Steven Fenberg, who has done documentaries and a biography of Jesse H. Jones, the Houston financier who headed the Reconstruction Finance Corporation (RFC) during FDR's New Deal.

The original RFC law, passed under Herbert Hoover in 1931, allowed the government to make loans to ailing banks and insurance companies; but that just put them deeper in debt and more employees out of work. Jones, an original member of the RFC board, was apparently the first to suggest that the government directly buy stocks in the banks. Right after his inauguration (3/4/33) FDR submitted an Emergency Banking Act that included that provision, and Congress passed it in less than seven hours.

Although initially the banks would not sell stocks to the federal government, it wasn't long before the government owned stock in half the nation's banks. Unfortunately, however, Jones experienced what Steffy is describing today: they hoarded the cash and would not lend.

Fenberg says the government had to take several additional actions to unfreeze credit. First, "After hounding them for more than a year to loosen up, the RFC finally stepped in and made government loans to consumers, businesses, cities, disaster victims, home owners, farmers and railroads. Jones safeguarded taxpayers by only making loans against marketable collateral."

That worked until 1937, when Roosevelt stopped the program, as part of a premature effort to balance the budget. The economy spiraled downward again. To fix that, in 1938 FDR asked Jones to "organize a national mortgage association in Washington and to provide it with management." It became the Federal National Mortgage Association, known today as Fannie Mae.

So based on the experience of the 1930s, even with owning preferred stock in banks and getting seats on bank boards, the government may still not be in a position powerful enough to force the banks to resume lending. It may again have to cajole the banks into lending by doing more lending of its own. That probably would have to be in conjunction with reforming Fannie Mae and Freddie Mac. But it certainly looks unavoidable.