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Bailouts are common, but results are mixed

The stock market plummets, investors pull out money and loans dry up, triggering global financial turmoil. Enter the government, buying up bad mortgages.
/ Source: The Associated Press

The stock market plummets, investors pull out money and loans dry up, triggering global financial turmoil. Enter the government, buying up bad mortgages and other problem assets.

This scenario from the 1930s sounds eerily current, in part because the Bush administration is taking pages from the playbooks Herbert Hoover and Franklin D. Roosevelt used to unfreeze credit and keep Americans from losing their homes three-quarters of a century ago.

From the Great Depression to the Chrysler bailout in 1979 to the savings and loan crisis that cost taxpayers $125 billion in the 1990s, the current administration has many government interventions from which to learn. If the history of previous bailouts holds any single lesson, however, it's that the outcomes are unpredictable and the problems will take years to work out.

"Some of these measures have been effective in propping up the economy at times when our private sector needed a little help," said Scott Anderson, senior economist at Wells Fargo Economics. "And that's the role of the government. But in the long term there are negatives."

Some rescues have worked but have turned out to be instances of "pouring money down a rathole," according to economist Sam Peltzman, citing the 1971 bailout of defense contractor Lockheed Aircraft in particular. That intervention kept Lockheed afloat through $250 million in government loan guarantees, although critics say the government set a poor precedent of rewarding corporations that ran their businesses inefficiently.

"The individual cases can work out well," said Peltzman, professor emeritus of economics at the University of Chicago Graduate School of Business. "But in the long run you're just laying the groundwork for more because you're giving people an incentive to take too much risk, where a big part of the risk gets laid off on the taxpayer."

While the government stepped in to resolve banking panics several times in the nation's first 150 years, 20th-century precedents are heeded more closely — none more so than the country's worst financial meltdown.

A student of the Depression, Federal Reserve Chairman Ben Bernanke well knows that the government's slowness to step in following the Crash of 1929 is often blamed for contributing to what turned out to be a full decade of economic misery. By the time the government took comprehensive action, unemployment was 25 percent, much of the steel business had disappeared, and thousands of homeowners a week were losing their houses to banks.

The Hoover administration created the Reconstruction Finance Corp. in 1932 to spur economic activity by first lending money to financial, industrial and agricultural institutions, then injecting capital into thousands of banks by investing in their preferred stock.

The RFC fared well financially and did not ultimately prove a costly burden for taxpayers, according to Richard Sylla, financial historian and economist at New York University's Stern School of Business. By the time it closed up shop in 1957, it had made loans of about $50 billion.

The same held true for the Home Owners' Loan Corp., started under FDR in 1933 as part of the New Deal. The agency helped stop a flood of foreclosures by buying $3 billion worth of defaulted mortgages and refinancing more than a million loans at lower rates and longer terms.

The government also created the Federal Deposit Insurance Corp. the same year, guaranteeing the safety of checking and savings deposits in member banks following a wave of bank failures.

As with many interventions, the notion of the government putting taxpayers on the hook for a huge financial burden was not popular at first.

"The 1930s reforms were detested at the time," Sylla said, describing the initial public reaction. "But later on people said they really were pretty good."

The '70s and '80s brought a series of government rescues of corporations — including Lockheed and Continental Illinois National Bank and Trust — but none was more heralded than the 1979 bailout of Chrysler Corp. The nation's 10th-biggest company had fallen into near-collapse amid high oil prices that tanked demand for its big cars, and the Carter administration arranged for $1.2 billion in subsidized loans. That spurred a Chrysler comeback and ultimately netted a profit for the government when Chrysler made good on its obligations.

The Chrysler bailout is widely regarded as a success. But Barry Ritholtz, who writes the popular financial blog The Big Picture and is CEO of research firm FusionIQ, argues in a soon-to-be-published book, "Bailout Nation," that it actually helped cause the decline of the auto industry. Automakers kept on doing business as usual after the rescue, he maintains, rather than learning a needed lesson about Chrysler's decline and overhauling their attitude toward fuel efficiency and manufacturing quality.

"It's a slippery slope," Ritholtz said of government intervention. "In theory, you shouldn't be doing any bailouts unless it's truly systemic risk."

The S&L crisis was the costliest intervention ever — soon to be dwarfed by the current plan to buy up to $700 billion in mortgage-related assets. It was caused by the industry's expansion into commercial real-estate lending in the wake of deregulation and amid poor oversight, not unlike the explosion of subprime mortgage lending two decades later.

With increasing numbers of savings and loan associations insolvent, doomed by higher interest rates, Congress in 1989 established the Resolution Trust Corp., a government-owned asset management company charged with taking over troubled assets and paying depositors their lost funds. By the time it wrapped up business in the mid-'90s, more than 700 S&Ls had failed.

"I think the lesson learned from that was that we don't want to create an institution that's going to be around for 50 years," Anderson said. "We wound down the RTC fairly quickly, and hopefully we'll be able to do that this time."