The Congressional Oversight Panel released a new report assessing the overall effectiveness of the Troubled Asset Relief Program (TARP) which was introduced six months ago. The executive summary is worth a quick review particularly given that TARP is very much in the news these days with the Wall Street Journal and others reporting an expansion of the program to life insurers that were previously not eligible for assistance.
Four Major Challenges
The Congressional Panel cites a letter from Treasury Secretary Geithner listing four major challenges that the government is attempting to address:
In a letter received by the Panel on April 2, 2009, Treasury Secretary Timothy Geithner described four major challenges that Treasury’s strategy seeks to address: (1) the collapse of the housing market; (2) frozen secondary markets that “have constrained the ability of even creditworthy small businesses and families” to get credit; (3) uncertainty about the health of financial institutions and the valuation of assets on their balance sheets; and (4) the existence of “troubled legacy assets” on the balance sheets of financial institutions that affect their capitalization and limit their ability to make loans.
Clearly many of these challenges are inter-related and persist six months after the TARP legislation was initially passed. Initially, TARP was intended to permit the government to purchase troubled assets directly from institutions but it has obviously been modified many times over a few short months. The seemingly ad-hoc nature of the equity injections into various financial institutions over the past six months has never appeared to be in keeping with the original intent of the legislation. Nevertheless, one must credit the government with avoiding a complete systemic collapse of the banking industry which was far from a remote possibility in early October.
This Goes Way Beyond Just TARP …
The report notes that the funds formally committed to TARP are a small percentage of the overall set of commitments made by various government entities over the past six months. In effect, the overall commitment has exceeded $4 trillion, making the $700 billion TARP commitment just a small piece of the overall puzzle:
… While Treasury has spent or committed $590.4 billion of TARP funds, according to Panel estimates, the Federal Reserve Board has expanded its balance sheet by more than $1.5 trillion in loans and purchases of government-sponsored enterprise (GSE) securities. The total value of all direct spending, loans and guarantees provided to date in conjunction with the federal government’s financial stability efforts (including those of the Federal Deposit Insurance Corporation (FDIC) as well as Treasury and the Federal Reserve Board) now exceeds $4 trillion.
The summary goes on to state that the intent of the report is to evaluate the overall effectiveness of this entire group of programs rather than just the funds formally associated with TARP.
Three Fundamentally Different Alternatives
The report states that there are generally three fundamentally different alternatives that are available to policy makers facing a financial meltdown, and an attempt is made to examine how each of these policy tools have been applied in past crisis situations both in the United States and abroad:
To deal with a troubled financial system, three fundamentally different policy alternatives are possible: liquidation, receivership, or subsidization. To place these alternatives in context, the report evaluates historical and contemporary efforts to confront financial crises and their relative success. The Panel focused on six historical experiences: (1) the U.S. Depression of the 1930s; (2) the bank run on and subsequent government seizure of Continental Illinois in 1984; (3) the savings and loan crisis of the late 1980s and establishment of the Resolution Trust Corporation; (4) the recapitalization of the FDIC bank insurance fund in 1991; (5) Sweden’s financial crisis of the early 1990s; and (6) what has become known as Japan’s “Lost Decade” of the 1990s.
I find it particularly interesting that the panel is focusing on Japan’s “Lost Decade” because that period was characterized by zombie banks that failed to recognize the true value of assets on the balance sheet and were politically immunized from the need to write down assets. The report describes some of the problems facing the “subsidy” approach:
Japan’s approach was characterized by a series of direct and indirect subsidizations. Subsidies may be direct, by providing banks with capital infusions, or indirect, by purchasing troubled assets at inflated prices or reducing prudential standards. Cash assistance can provide banks with bridge capital necessary to survive in tough economic times until growth begins again. But subsidies carry a risk of obscuring true valuations. They involve the added danger of distorting both specific markets and the larger economy. Subsidization also carries a risk that it will be open-ended, propping up insolvent banks for an extended period and delaying economic recovery.
This situation sounds suspiciously similar to the cash infusions being provided to major institutions in our present crisis. In addition, any effort by the government to prop up market prices of assets on the books of these institutions could only serve to further obscure true valuations and extend the distortions facing the system.
Current Assumptions and Actions
The report notes that Treasury is banking on an assumption that temporary liquidity constraints are responsible for the current situation:
One key assumption that underlies Treasury’s approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets. The debate turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.
I think that the last sentence is really the key question facing the country at the moment. Are current prices for mortgage related assets artificially depressed or do they reflect true values of the underlying assets?
If the government is incorrect regarding temporary liquidity concerns being responsible for the current situation, and if current prices actually reflect fundamentals, what TARP amounts to is very similar to the Japanese approach of the 1990s. That approach of subsidies and delaying the day of final reckoning resulted in Japan’s “lost decade”.
If valuations are truly impaired for reasons other than an unnatural market freeze, then it would be best to recognize the impact on the capital of financial institutions sooner rather than later. I could not predict housing prices during the boom and I cannot do so now, but I do know that home prices are only now approaching more “normal” levels as a multiple of household income and I would be very surprised to see any rebound in prices that would bail out the system without more pain.