Bailouts by the Federal Government Have a Long Precedent

by MB on September 20, 2008

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What a week!

We a truly living in interesting (financial) times.

The US Treasury and The Federal Reserve Bank took massive actions this week in order to stabilize the US financial system. Congress is expected to pass a bill next week which would allow for further, more radical intervention.

Interestingly enough, this is not without precedent. In today’s Wall Street Journal, there is an article titled: Government Bailouts: A U.S. Tradition Dating to Hamilton, which discusses various interventions the US government has taken over the years to end financial panics.

Two stand out as being especially relevant to our current situation:

First in 1792, Alexander Hamilton engineered the first financial bailout in US history. It started when the federal government assumed the revolutionary war debts of several individual states. This was part of a deal the eventually made Washington the capital. In order to assume the debt, the federal government issued 6% bonds, known as Sixes. Financial speculators attempted to corner the market in Sixes, and also to weaken the Bank of New York in order to take it over. The plot ran the price of the Sixes up for a time, but then crashed 25% in two weeks. In order to stop a wider panic, Hamilton did something extraordinary:

Working without a historical blueprint, Hamilton engineered an innovative response. The Treasury borrowed money from the banks and used it to buy government bonds, lifting the market price. He also told banks to accept bonds as collateral for loans to securities brokers, with the government guaranteeing the collateral.

The financial system stabilized, and no banks failed until 1809.

Another government bailout which I think has significance to the current situation occurred in 1933, during The Great Depression. By that time, 1,000 Americans per day were losing their homes to foreclosure. President Roosevelt and Congress created the Home Owners’ Loan Corp., which bought defaulted mortgages from banks and then refinanced them at a lower rate.

Ultimately, the agency issued mortgages, averaging $3,039 apiece, to some one million homeowners. About one in 10 Americans with nonfarm, owner-occupied dwellings secured aid from the agency, according to a 1951 paper by C. Lowell Harriss of Columbia University.

The current mortgage crisis involves securities backed by subprime home loans. But during the 1930s, there was no secondary market for securitized mortgages. So the agency had to hold the mortgages for the full terms. It finally closed up shop in 1951, with about 80% of borrowers having paid their loans off on time or early.

The agency earned the government a small profit.

Did you get that? They saved 80% of the people from foreclosure and earned a profit!

I find this second example to be very interesting, and hope that the folks designing our most current bailout look to it as a model.

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