In Finance, Connections Are What Matter Today
The September 15, 1944, issue of the Finance Section of the Chicago Daily Tribune noted in the lead column that the "old RFC-Dawes" loan had been finally repaid - with interest. The loan, as the prominent place in the paper suggests, was of high public interest going all the way back to its first initiation. The repayment of the loan itself was also very contentious, as the same Daily Tribune had reported on February 21, 1939, again in distinction, that the "Dawes Loan" would lead to a $5 million loss for the government.
The Reconstruction Finance Corporation (RFC) had made the original loan to the Central Republic Bank of Chicago not long after its initial charter. The amount and the timing were shocking, even in 1932 when all seemed lost and bank failures abounded as depositors shunned whatever institution they even briefly perceived in ill-repair. Chicago as a very important central reserve city featured prominent banking concerns that were second only to New York, forming a vital financial gateway for monetary flow to the vast interior beyond.
Charles Gates Dawes was a highly visible member of the highest political and financial circles, having been, among other things, the 30th Vice President of the United States of America (under Coolidge). His "Dawes Plan" for postwar (WWI) reparations landed him a Nobel Prize in 1925, and then as ambassador to the UK after his term as Vice President. He was also a prominent Chicago banker, having organized the Central Trust Company of Illinois in 1902, serving as its president until just before his stint as Vice President.
The close nexus of banking and politics made him perhaps the most "obvious" choice to chair the newly chartered RFC. This fresh GSE was actually the second attempt at it, with a predecessor organization used in 1918 to control the financial aspects of armaments toward the US entry and involvement in the Great War. This second GSE would be the government's first large-scale involvement in the private economy during peacetime, as it represented a clear departure from all previous administrations prior to that point (and contrary to the "do nothing" revisions that color Herbert Hoover's time).
The RFC was signed into law on January 22, 1932, taking over the responsibilities given to the National Credit Corporation (itself organized only in autumn 1931). President Hoover would later write in his memoir about how his proposal was received by the Congressional leadership, then all Republicans:
"When I met with a group of Congressional leaders on October 6, 1931, presented a program for Congressional action if the bankers' movement [NCC] did not suffice. I hoped those present would approve my program in order to restore confidence which was rapidly degenerating into panic. The group seemed stunned. Only [Speaker of the House John Nance] Garner and [Senate Majority (Republican) Leader William] Borah reserved approval. The others seemed shocked at the revelation that our government for the first time in peacetime history might have to intervene to support private enterprise."
Indeed, the RFC would go on to expanded horizons only a year later with the inauguration of President Roosevelt, this time adding more power and scope to the extent which the corporation could be involved in financial affairs. The new administration in 1933, given its broad view of how finance might run at that highly despondent moment, sought to add "capital" investment to the range of options for financial "flow." Congressional approval was pursued to allow the RFC to purchase preferred stock, too, though the published history of such "approval" is somewhat indicative of these kinds of times.
"The Speaker recited the text from the one available draft, which bore last-minute corrections scribbled in pencil. With a unanimous shout, the House passed the bill, sight unseen, after only thirty-eight minutes of debate. The Senate, over the objections of a small band of Progressives [who were Republicans], Lafollette, Borah, Case, Dale, Nye and Shipstead, together with Senator Costigan, the lone Democrat voting no, approved the bill unamended 73-7 at 7:30 that evening and at 8:36 that same night it received the President's signature."
The expansion of the RFC's scope was somewhat counterintuitive in 1933 as it had been such a contentious issue in the 1932 election. At issue was Charles Dawes. Though he was appointed by President Hoover as its first Chairman, he still maintained relationships in the Chicago banking community, notably as a director of the Central Republic Bank of Chicago. The city having been wrested by depositor unease in the middle of 1932, Dawes left the RFC not long after taking initial control, and then immediately appealed to it to "save" Central Republic.
Three weeks after Dawes resigned from the RFC, in June 1932 Central Republic received a massive $90 million loan from it. He was not the only "connected" politician to gain loans for banks from the inside, as the new RFC president, Atlee Pomerene, secured $12 million in loans for his bank in Cleveland. The treasurer of the Republican National Committee, Joseph Nutt, gained $14 million for a Cleveland bank he co-owned and ran, while Republican Senator Phillips Goldsborough of Maryland on behalf of his Baltimore bank secured $7.4 million.
While there were Democrats that received loans from the RFC, it made good political fodder in the fall elections, specifically in the size of the Dawes loan, his prominence and the timing. So it was, to the public face anyway, a little strange to see the new Democratic administration not only embrace the RFC but vastly expand its reach. After all, it wasn't as if the RFC had been limited to some forgotten corner of the system, it was initially chartered to fill in the "hole" left by the banking system's patchwork structure.
The idea of currency elasticity was supposed to be provided by the Federal Reserve, but its powers were limited to only members of the Federal Reserve system (which it already took great pains, often punitive and perfunctory, to expand in its first decades). This duality of the American banking system left a liquidity hole that the Federal Reserve could not reach (though it is debatable as to whether this actually mattered). The scale of depositor action left the Hoover administration seeking alternate approaches, even to the point of going beyond anything ever seen before.
Mindful of the dangers of going too far, though, the RFC was limited by charter to much the same principles as the Federal Reserve was. That meant any loans to banks were to be collateralized, but here the RFC would invade primacy in the capital structure. A very narrow collateral regime meant that the RFC would take the best securities first.
And that led to what amounted to a contrary circumstance whereby the mission would change in 1933. An unexpectedly high proportion of the banks that were "aided" by RFC loans failed anyway, often not long after receiving the funds. Owen D. Young, Chairman of the Board of Directors of the Federal Reserve Bank of New York, presciently told the other FRBNY directors in July 1932, "Under present methods a loan from the Reconstruction Finance Corporation is largely used to pay off certain depositors before the bank ultimately closes, leaving the other depositors out on a limb because the Reconstruction Finance Corporation has gutted the bank of collateral in securing the loan. If this is all that is accomplished it might have been better to make no loans."
If anyone had known for certain, it would have been Owen Young, not the least of which was due to his close connection with Charles Dawes. Young co-authored the Dawes Plan that won Charles the Nobel Peace Prize, and then authored his own schematic, the "Young Plan" when it ultimately proved inadequate. While he did not get a Nobel, he was, coincidentally, Time Magazine's Man of the Year in 1929 of all years. But it was the old Chicago bank "loans" that tied them together in posterity under much less favorable color, as Young was party to a lawsuit (as General Electric's Chairman of all jobs) alongside Dawes in the aftermath of Central Republic's failure. In 1937, the $14 million judgment against shareholders of the old bank was to that point one of the largest in American history.
Nothing about this episode looks favorable upon those that engaged it or the ultimate ends to which they were supposed to serve. When Owen Young decried the tendency to use RFC funds, government funds, taxpayer funds, to pay off "certain" depositors, do we take him literally? The gist is obvious in not just that statement but in subsequent dealings including the later lawsuit(s). And, as he helpfully noted to FRBNY, to what good for all of it? The banking storm did not subside, in fact only growing worse a month after the Dawes Loan when the RFC's actions were made public in August 1932, igniting the start of what would be the third, final and most devastating wave of failures.
There are so many strands here that it is impossible to pick one that stands out the most. But that itself may be the most important part of the mess, as that is the nature of government involvement. It is political from the start, and cronyism doesn't even begin to describe what comes out of it.
The impairment to function because of those facts and contentions is perhaps relevant to this moment in time. I'm sure that everyone has been closely following the highly peculiar activity in the Federal Reserve's reverse repo operations from September 30. To recap: the Fed placed a ceiling on total activity of $300 billion in reverse repos because it began to detect what it thought was a growing preference, even dependency, on using the Fed rather than substitutes in the private market. The only reason the reverse repo stands as it is now is because, not all that dissimilar to the pre-1930's banking system, there is a duality in banking and financial liquidity as the current Fed cannot reach non-banks just as the predecessor Fed could not reach state banks.
A primary impediment coming from QE on the liquidity side has been, again, collateral. The Fed, though winding down to the merciful end of QE this month (hopefully, and that sentiment expresses not just the timing but that this coming QE-less period will be permanent and not once more an interlude), has shortened the available pool of usable securities in repo. Liquidity has been strained, as repo fails have surged in three discrete episodes beginning in mid-June.
The reverse repo program was determined to head off any such problems, as it was supposed to provide a bridge between the SOMA holdings and the market "need" for additional collateral. The mechanism for that bridge was presented by these non-bank participants, largely money market funds, that "bid" on "lending" to the Fed in exchange for collateral. What happened Tuesday, at quarter end of course, was that we found a situation where some non-banks, even potentially money market funds, were attempting to "lend" cash to the Federal Reserve Bank of New York at a negative interest rate so that they could "borrow" cash at an even lower negative interest rate from someone else.
Technically, that is what the pairing of transactions looked like, but the rationale for them was collateral; more precisely its continued short supply. A money market fund or any non-bank, or anyone with a right mind, would only lend cash at a negative rate if the collateral was the more important concern (as in, you can't get it anywhere else). But in this case, I highly doubt non-banks were short of collateral, being on the other side of that trade in almost every case. Instead, the profit motive was to gain a spread between "lending" cash and "borrowing" cash, regardless of whether it was negative on both sides - as long as the "cost" side was more negative it all "worked."
At least individually - in terms of systemic pressure it is, to me, so much like the RFC episode. The cumulative action of the collateral pressures here are to confound the Fed's desire, once again, to establish a hard or at least semi-hard rate floor in interbank markets. The intended outcome is almost guaranteed to be circumvented by the convoluted setup that pays less attention to guiding hands of markets than to whatever bureaucratic source is directing methodology. And, like the election of 1932, it lends itself far-too-easily toward identification with politics and even corruption whether or not such perceptions are at all warranted.
That in a nutshell is where finance has been led, as financial firms try to get profits from wherever they can find them, often in the massive footprints of the biggest player that cares little for them as they might be organically. That observation applies not just to repo, but a lot of the facets of systemic liquidity today and during the last few decades. Increasingly, financial firms are sourcing profits from everything but banking itself. It also speaks about why the larger firms grow larger at the expense, in and out of the downside, of smaller competitors. Are smaller firms going to bid on reverse repos at negative interest rates to move some collateral out of the SOMA "silo?" Only if they are party to JP Morgan's (and Bank of New York Mellon's) triparty repo system or a recognized and approved primary dealer.
It is far easier for the Fed to "manage" the largest players in these "markets" as it seeks to subsidize financial profits toward whatever policy goal it is seeking. Connections matter, it seems, far more than actual market forces and organic profitability. The results are such a convoluted system that nobody outside of it can understand how it all works, let alone whether or not any of it is "real."
Does it need to be that way? Such questions take on greater importance the less actual progress seems to be made toward those policy goals. Just as the RFC was making loans to politically connected banks under the very evident idea of "emergency necessity", we have no direct idea what the financial system "needs" because there is no clear sense of profits in any of it, as the heavy footprints of bureaucracy (and socialism) have turned these market agents into nothing more than policy tools. In the modern system, it's as if the RFC has been reborn in theory to a size and especially reach so far beyond what was thought revolutionary in 1931.
As it is, the RFC remained in place in that expanded role until it was finally wound down in reorganization in 1957 (its final report was issued on May 6, 1959). It outlasted not just the immediate emergency of banking duality in 1932 and 1933, but also the crisis in 1937 and even World War II and Korea. Having carved out its politically useful niche, everything else becomes secondary, even and especially the original mission it undertook. The financial equivalent of that now is what we have seen of "markets" going back to the 1980's and the conversion to interest rate targeting. The bureaucracy justifies itself at the expense of whatever function it displaces, in this case actual free markets in banking and liquidity. Left in its place is concentration and highly convoluted, and ultimately disastrously inefficient, function, the natural destination of all such corruption.
