Amid talk that the Obama administration plans to use money from the Troubled Asset Relief Program (TARP) to fund a new stimulus package, it is important to understand what TARP actually accomplished, who benefited, and who paid the price. A major component of the administration’s new stimulus plan would eliminate fees and increase guarantees on loans offered through the Small Business Administration (SBA). Small businesses are the source of most job creation in the U.S., but they are having a hard time finding financing in the current environment. Obama’s speech at Brookings Tuesday stressed the need for government action to get credit flowing again to this sector, but it did not attempt to explain why such credit is currently hard to come by. That might be because any honest attempt to do so would lead back to the government’s flawed strategy for saving the banks.
Many banks binged on asset-backed securities and related derivatives as the real-estate bubble expanded. These assets soured as home prices fell and home loans started to fall into default, leading to the bailout of Bear Stearns, the collapse of Lehman Brothers, the rescue of AIG, and the passage of the Emergency Economic Stabilization Act, which created TARP. The Treasury Department under George W. Bush initially planned to use the $700 billion TARP fund to buy troubled assets from banks and other financial companies, thus repairing their balance sheets, saving them from insolvency, and enabling them to lend again.
Soon after the passage of the TARP bill, Treasury encountered a problem with its initial plan: The assets it would have had to buy were mostly garbage. In order to recapitalize the banks, Treasury would have had to overpay massively for this garbage, sparing bankers from the consequences of their behavior and sticking taxpayers with huge, unpopular losses. Treasury could have protected taxpayers by buying the garbage at a fair price, but that would have imposed heavy losses on the banks.
So instead, official Washington cobbled together the following solution: Treasury injected capital directly into the banks, through purchases of preferred stock; the Financial Accounting Standards Board modified fair-value accounting rules to reduce pressure on banks to write down the value of their troubled assets; the Federal Reserve cut interest rates to zero; and banking regulators allowed several non-depository financial institutions (such as the major investment banks) to convert themselves into bank holding companies and access the Fed’s discount window for cheap loans.
This strategy prevented the collapse of several major Wall Street banks, which would have had unpredictable consequences and almost certainly would have deepened the recession. Banks that had teetered on the brink of insolvency now had a capital cushion to help them ride out the storm, less pressure to write down their bad assets, and the ability to borrow at near-zero interest rates and lend to the government at 2 or 3 percent. Meanwhile, a rally in the stock market has buoyed their stock prices, and many are taking advantage of this by issuing new stock to the public and using the proceeds to pay back their TARP funds.
There is a reason why the banks made repaying the TARP funds such an urgent priority: You would, too, if Barack Obama and Barney Frank were telling you how to run your business. But putting TARP repayment at the top of the list while pursuing a low-risk strategy of borrowing at near-zero to buy Treasury bills, highly rated corporate debt, and blue-chip equities leaves little capital left over for investing in riskier small businesses, start-ups, and entrepreneurial enterprises. That’s a major reason why the small-business sector has found it so difficult to get financing, even as other economic indicators show signs of improvement.
In his speech at Brookings, Obama claimed that his administration’s wise stewardship of the TARP funds had yielded “savings” that he now plans to put to other uses. But his administration has actually taken the flawed bailout strategy it inherited and made it worse. Treasury Secretary Tim Geithner’s plan to deal with the troubled assets clogging up the system — the Public-Private Investment Partnership, or P-PIP — was remarkably lame and declared dead on arrival. And the “tough conditions” that policymakers imposed on banks receiving TARP funds were often the wrong ones.
A true get-tough strategy with the banks would have forced them to recognize their losses; restructured their balance sheets so that bank creditors and shareholders, not taxpayers, shouldered these losses; and managed spillover effects via the Fed and the FDIC. This process would not have been pretty, but it would have been the first step toward freeing up reserve capital for more productive uses. Instead, officials settled for politically popular limits on executive compensation, which led to the spectacle of bank managers’ tripping over themselves in a rush to pay back the money. That’s nice for taxpayers, but it doesn’t solve the underlying problem of an undercapitalized banking system that has little incentive to lend to small businesses.