14 January 2009

A TARP is No Substitute for a Proper Repair

Out where I used to live, folks who had roof damage or decay would often get up on the roof and tie and nail down a blue tarp, rather than repair the roof.

Sometimes this was economic necessity. Sometimes it was laziness. I think that Treasury Secretary Henry Paulson is guilty of doing the same thing for another reason: extremely bad judgment.

Frankly, the whole Troubled Asset Relief Program, or TARP, bothers me.

It is not just that it is a whole lot of money. It is the way it was spent.

Exodio, one of my blog correspondents, refers to the day when TARP was passed as the day we went from the USA to the USSA - United Socialist States of America. I am not sure he is completely wrong about that.

Here are the words of Fed Chairman Bernanke in a speech given at the LSE this week:

[W]ith the worsening of the economy's growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions. Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets. A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. Should the Treasury decide to supplement injections of capital by removing troubled assets from institutions' balance sheets, as was initially proposed for the U.S. financial rescue plan, several approaches might be considered. Public purchases of troubled assets are one possibility. Another is to provide asset guarantees, under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks. Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank. These methods are similar from an economic perspective, though they would have somewhat different operational and accounting implications. In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.

Now I'm just a simple country preacher, and there is a lot about this mess I do not understand. There are some things that I think I know to be true:

The Troubled Asset Relief Program, as its name implies, and Bernanke states, was designed to finance the public purchase of troubled assets - a.k.a. toxic paper - held by endangered banks. These assets consisted mostly of securities backed by an interest in sub-prime mortgages. There would be ups and downs to doing so.

First, simply doing what the program was designed to do, buying these assets from the banks, would have given money to the banks and would have relieved them of these troubled assets. True, some sort of government created or subsidized mechanism would have been needed to manage these mortgages the government had just bought. But if we had simply paid the same banks to manage these assets, re-negotiating longer term, lower interest mortgages, then the banks would have had a new source of income and the foreclosure rate could have been stemmed, which, Bernanke says, "could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability."

Aside from the expanded liability for the government (owning long term mortgages of dubious value), the biggest losers in this process would have been the banks, because there was no way we were going to buy these troubled assets at face value. I am afraid that that may have been the key that caused Paulson and the Bush Administration to wave off this method in favor of direct investment in the banks. This was a serious mistake.

Since there was no perfect solution, I accept that we should choose the least bad solution. But given the choice between

1) having he government buy and hold a bunch of mortgages in what amounts to a giant subsidized housing scheme, or
2) the government buying interest in the form of preferred stock in a bunch of banks,

I would prefer the former. Much. Better to expand the public housing program exponentially than take this rather considerable step down the road to socialism.

At this writing, Wikipedia's Socialism entry starts:

Socialism refers to a broad set of economic theories of social organization advocating state or collective ownership and administration of the means of production ...

Yes Socialism. Who would have thought three years I would be accusing a Republican president who championed the "ownership society" of leading us down that road.

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