The Corner

Banking on the Bubble

My contribution to today’s jobs symposium focused on the still-weak state of the banks. Hours after I submitted the piece, Bank of America announced that it will soon repay its TARP funds (the bailout money it took under the Troubled Asset Relief Program). Does that mean that my thesis is bunk, that the banks are fine, and that their weakness is not the reason unemployment remains stubbornly high?

I think all it means is that the banks are desperate to get out from under the thumbs of Barack Obama, Barney Frank, and Ken Feinberg (the Treasury Department’s “Special Master” for compensation), and that they are taking advantage of the recent stock market rally to do so. That would be all well and good, but what if the rally is just another bubble?

There are disturbing signs that this might be the case. Households, pension funds, and foreign investors are staying away from stocks. So who is bidding them up? In his latest quarterly letter, investor David Einhorn (who called the Lehman collapse months before it happened) wrote that this rally “feels like a ‘professionals’ rally.” Stateside money managers are betting that stocks fell too far, and they are bidding them back up again. And to be sure, last September’s crash produced some bargain opportunities. But the stock market is now up 70 percent on the year.* Really? There were that many bargains out there?

Because from here, it looks like loan defaults are still speeding up, economic growth is still sluggish, unemployment is still high, and Americans are still saving rather than spending. Are we totally sure stocks aren’t overvalued? And what happens if they are, and the bubble pops, and these supposedly healthy banks need to un-repay their TARP funds? Larry Summers was worried about precisely this scenario when he hinted that maybe the government shouldn’t accept repayment of TARP funds until the economy showed clear signs of recovery. Here is what this publication’s editors had to say about that at the time:

Another explanation is that the banks that are trying to give back their TARP funds aren’t really healthy but are trying to create that perception. If successful, they could potentially gain a competitive advantage over their TARP’d competitors: in the form of lower borrowing costs, for one, and the ability to attract top talent by freeing themselves from TARP-related limitations on executive pay. They could use these advantages to try to dig themselves out, and, if that didn’t work, they could go back to Treasury for another loan. This would put the administration in a bind — it clearly doesn’t have the stomach to let these firms fail, but it couldn’t re-rescue them without paying a political price. The best solution, from that point of view, would be to refuse to accept repayment in the first place.

While that might be the politically expedient solution, it is not the right one. For one thing, the administration lacks the legal authority to refuse repayment of TARP funds. A provision of the stimulus bill gives banks the right to repay the money whenever they want, subject only to “consultation with the appropriate Federal banking agency.” Unfortunately for the larger banks, that means the Fed, which has acted during this crisis almost as an adjunct to the Treasury. If the Fed goes along with Geithner’s preference that TARP funds not be repaid, then that only underscores the need to disentangle these two agencies as quickly as possible.

More important, it is time to stop playing games with the markets and disguising the actual financial health of the banks. We are no longer dealing with the level of systemic risk we faced last fall. In fact, one could persuasively argue that, in the current environment, uncertainty stemming from government policy is doing more damage to the system than the orderly dissolution of insolvent banks would do.

If some banks want to pay back their TARP money, we should let them. If other banks are undercapitalized, we have a process to deal with that. The Federal Deposit Insurance Corporation is the one agency that has worked relatively well during this crisis. It has resolved 25 failed banks already this year. Instead of using it to subsidize Geithner’s misguided troubled-asset purchasing plan — a bad idea in any case — we should be strengthening FDIC for the task ahead, and doing whatever else is necessary to lay the groundwork for the orderly resolution of failed firms.

Summers was right to be concerned, but the administration has neither barred repayment of TARP funds nor laid the groundwork for the resolution of failed firms. It has dithered on the financial crisis while diverting the country’s political resources into debates about health care and global warming, problems which do not share the same “fierce urgency of now” as the banking crisis. It could be that a real recovery is just around the corner, in which case the administration will have managed to skate through the crisis with no real plan to address it. But if we run out of bubbles, and we face another collapse, Obama cannot evade responsibility by blaming Bush. So, if I were him, I would be kind of worried about that.

* Update: Should have been more clear here. I meant that the current rally has taken stocks up between 60-70 percent (depending on the index) from their lows earlier this year. Apologies.

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