The Mother Of All Interventions
In Long History of U.S. Actions, None Posed Such Costs, Risks

By Steven Mufson
Washington Post Staff Writer
Wednesday, September 24, 2008

A big bank stumbles under an avalanche of bad loans. Rumors of its impending failure spark a run by investors and depositors. In vain, the Federal Reserve pumps in money. Finally, the president, a Republican committed to free markets, blesses a government takeover, moving billions of dollars of bad assets onto the government books and firing the bank's top executives.

The scene resembles the current financial crisis, but it actually took place 24 years ago under President Reagan. The bank was Continental Illinois, then the nation's seventh-largest bank, and the rescue gave rise to the phrase "too big to fail."

Today's financial rescue package -- a mixture of bailout and nationalization -- has many precedents in U.S. history, from a bank bailout engineered by Alexander Hamilton during the panic of 1792 to the bailout of automaker Chrysler in 1979, from the nationalization of the Penn Central in 1971 to the takeover of about half of the nation's savings and loan institutions in the late '80s and early '90s.

The federal government has also chosen to run businesses deemed vital to national interests, starting with postal service. In World War I, it took over the nation's railroads, then reprivatized them. During the Great Depression, it launched the Tennessee Valley Authority. After the Sept. 11 attacks, private airport security services were moved to the federal Transportation Security Administration.

The episodes of financial rescue most closely echo today's crisis. In each case, the U.S. government stepped far beyond its normal boundaries to prevent a corporate collapse from hurting auto workers, commuters, ordinary depositors or the economy at large. Budget costs, ultimately borne by taxpayers, ranged from nearly nothing to about $125 billion.

Yet the current $700 billion proposal for cleaning up the crisis in the financial system carries risks as well as costs much greater than those earlier government interventions in the market system. And there is no guarantee that the executives who made the mess will be held responsible.

"The intellectual damage to American finance -- the damage to the structure of ideas that sustains free markets -- is going to be much more extensive and long-lasting than the dollars involved, and that is extensive already," said James Grant, commentator and editor of Grant's Interest Rate Observer. "And all this happening under the Republican banner."

Practical issues loom large, too. The Bush administration has compared a new proposed bailout agency to the Resolution Trust Corp., which took control of hundreds of savings and loan institutions and sold off assets from golf clubs to office buildings. Today the RTC is viewed as a relative success. Insolvent S&Ls, hurt by bad real estate loans, were taken over by the Federal Deposit Insurance Corp. and turned over to the RTC. The government ended up losing about $125 billion, and sold $458.5 billion in assets in just six years.

But L. William Seidman, who was head of the RTC, warns that the new entity will have "at least twice as hard a job" as the RTC, which itself required a staff of 10,000 people.

"It's very different in that the RTC got the assets from failed institutions whereas this [entity] is going to have to buy them," Seidman said. "You have to decide who you are going to buy from and figure out a fair price and what actions you're going to require of the seller," such as guarantees that information about the assets is correct or agreements to cut executive pay.

"The history of government institutions that have tried this is not one of great success," he said.

Benjamin Friedman, an economics professor at Harvard University, is also worried about how much the federal government will pay big banks for troubled assets. In calculating the cost of this rescue plan, he said, "a lot depends on how much they get snookered overpaying."

Some overpaying is inevitable, he warns. Friedman says that it is hard to figure out the value of the troubled assets of financial institutions. "If all they're doing is paying market price, they're not doing anything," he said. "Banks can already do that. The whole notion of rescuing the banking system is that they are paying more than the market price."

To many advocates of government intervention, the Chrysler bailout -- a revival plan based on federal loan guarantees rather than takeover -- is another model. Executives at the company took deep pay cuts; the chief executive Lee Iacocca cut his salary to $1 a year. And the company repaid $1.2 billion in federal loan guarantees after just four years. The cost to taxpayers was essentially nil.

But a Heritage Foundation paper written in 1983 noted that during the bailout, 60,000 Chrysler workers were laid off and creditors were forced to accept as little as 30 cents on the dollar for loans to the company just as they would have if the carmaker had been allowed to bankrupt. Meanwhile, shareholders, who would have been wiped out in bankruptcy, were rescued and executive salaries were restored, in some cases retroactively, in 1981. Iacocca got a recruitment bonus and $360,000 in salary supplements, the Heritage report noted.

Most companies nationalized in the United States, unlike those nationalized in Europe, have been sold back to private interests. Luigi Zingales, a University of Chicago finance professor from Italy, said, "We nationalized the banking sector and part of industry in 1930 and it took us 65 years to privatize them." A 2002 study by Paola Sapienza in the Journal of Financial Economics showed that Italian state-owned banks gave more loans and at cheaper rates to people an firms in regions controlled by country's strongest political parties.

European governments still own big chunks of large enterprises such as the Italian oil giant Eni, the French utility Electricite de France and Norway's petroleum company Statoil.

In the United States, by contrast, Continental Illinois was quickly sold to bigger banks. The RTC sold off troubled real estate and stronger banks bought the remnants of the bankrupt S&Ls; the agency closed its doors in 1995, a year ahead of schedule. Conrail, formed in 1976 from several major northeast railroads, lasted longer, but has returned to private hands.

One company that remains under government control is Amtrak, the intercity railroad that continues to rely on federal subsidies.

"By and large the government does badly operating businesses," said Michael Mussa, a senior fellow at the Peterson Institute and former chief economist at the International Monetary Fund. "And what we've seen over the years, not so much in United States but where other countries owned a lot more businesses because of socialist or quasi-socialist ideology, is that they've gotten out of those businesses."

View all comments that have been posted about this article.

© 2008 The Washington Post Company