Page 2 of 2 MONETARISM ENTERS BANKRUPTCY: Part
2 The burden of elitism
By
Henry C K Liu This report is the second in a series. Part 1:Monetarism
enters bankruptcy
Normally, in a free market, when a financial institution gets itself into
financial trouble, the party coming to its rescue would have the right to take
over ownership of the distressed institution and be entitled to all future
profit after the rescue. That is the basic rule of the game of capitalism: you
default on your liabilities; you lose your company to the party that bails you
out. Only when no private party steps in as rescuer because of the unappetizing
prospect of future profit would the government act as a rescuer of last resort
with taxpayer money. It is not nationalization; it is just business, albeit for
the common good.
But the Treasury when it functioned under secretary Henry
Paulson last year gave the distressed banks taxpayer money from the Trouble
Asset Relief Program (TARP) with no specific requirement for the banks to make
loans to revive the stalled economy. This allowed the banks to use taxpayer
money not to help the economy with making new loans but to de-leverage by
paying off liabilities the banks could not otherwise service. Subsequently, the
bailed-out banks began to show profits on the following quarters on
de-leveraged balance sheets, but with little impact on the still-impaired
economy.
Yet this profit is unsustainable unless the banks continue to receive more TARP
money every subsequent quarter. Instead of the government collecting the banks'
post-rescue profit, banks are allowed to merely pay back the TARP money at
below market rates at their convenience. This gave cause to the now popular
saying that the best way to legally rob a bank is to own one and run it to the
ground.
TARP allows the government to purchase up to $700 billion of "troubled" assets
and equity from financial institutions in order to strengthen the financial
sector. It is the largest component of government measures in 2008 to address
the financial crisis caused by the subprime mortgage meltdown that started in
July 2007.
"Troubled assets" are defined the Treasury as: (A) residential or commercial mortgages and any securities, obligations,
or other instruments that are based on or related to such mortgages, that in
each case was originated or issued on or before March 14, 2008, the purchase of
which the [Treasury] Secretary determines promotes financial market stability;
and (B) any other financial instrument that the Secretary, after
consultation with the Chairman of the Board of Governors of the Federal Reserve
System, determines the purchase of which is necessary to promote financial
market stability, but only upon transmittal of such determination, in writing,
to the appropriate committees of Congress."
In other words, "troubled assets", popularly known as toxic assets, are
illiquid, difficult-to-value assets held by banks and other financial
institutions. The TARP-targeted assets can be collateralized debt obligations
(CDOs) which were sold in a booming market until March 14, 2008, when they were
hit by widespread foreclosures on the underlying loans.
TARP, as implanted by the Treasury, is intended to improve the liquidity of
these assets by purchasing them using secondary market mechanisms, thus
allowing participating institutions to stabilize their balance sheets and avoid
further losses.
TARP does not allow banks to recoup losses already incurred on troubled assets
prior to October 3, 2008, but Treasury officials hope that once trading of
these assets resumes, their prices will stabilize and ultimately increase in
value, resulting in gains to both participating banks and the Treasury itself.
The concept of future gains from troubled assets comes from opinion of some in
the financial industry that these assets are commanding value that represents
losses from a much higher anticipated default rate than currently shows. But if
the default rate should continue to rise, such future gains may well be wiped
out. Thus far, market value continues to fall below the value of the troubled
assets paid by TARP.
The authority of the Treasury to establish and manage TARP under a newly
created Office of Financial Stability was mandated on October 3, 2008 by
Congress as HR 1424, enacting the Emergency Economic Stabilization Act of 2008.
On October 14, 2008, Treasury secretary Henry Paulson and president George W
Bush separately announced revisions in the TARP program. The Treasury announced
its intention to buy senior preferred stock and warrants in the nine largest US
banks. The shares would qualify as Tier 1 capital and were non-voting shares.
In order to qualify for this program, the Treasury required participating
institutions to meet certain criteria, including: (1) Ensuring that incentive compensation for senior executives does not
encourage unnecessary and excessive risks that threaten the value of the
financial institution; (2) Requiring clawback of any bonus or incentive compensation paid to a
senior executive based on statements of earnings, gains or other criteria that
are later proven to be materially inaccurate; (3) Prohibition on the financial institution from making any golden
parachute payment to a senior executive based on the Internal Revenue Code
provision; and (4) Agreement not to deduct for tax purposes executive compensation in
excess of $500,000 for each senior executive.
The Treasury also bought preferred stock and warrants from hundreds of smaller
banks, using the first $250 billion allotted to the program.
The Emergency Economic Stabilization Act requires financial institutions
selling assets to TARP to issue equity warrants (security that entitles its
holder to purchase shares in the issuing company for a specific price), or
equity or senior debt securities (for non-publicly listed companies) to the
Treasury. In the case of warrants, the Treasury will only receive warrants for
non-voting shares, or will agree not to vote the stock. This measure is
designed to protect taxpayers by giving the Treasury the possibility of
profiting through its new ownership stakes in these institutions.
Ideally, if the financial institutions benefit from government assistance and
recover their former strength, the government will also be able to profit from
their recovery. But if the companies receiving TARP money elect to pay back the
money after stabilization but prior to profitability, the government's right of
future profit will be revoked. In that case, the government would have assumed
all the risk but be squeezed out of any rewards just before imminent
profitability.
The prime goal of TARP is to encourage banks to resume lending at levels seen
before the crisis, both to each other and to consumers and businesses. If TARP
can stabilize bank capital ratios, it should theoretically allow them to
increase lending instead of hoarding cash to cushion against future, unforeseen
losses from troubled assets. Increased lending equates to a "loosening" of
credit, which the government hopes will restore order to the financial markets
and improve investor confidence in financial institutions and the markets. As
banks gain increased lending confidence, the inter-bank lending interest rates
should decrease, further facilitating lending. This goal has turned out to be
elusive as banks use the TARP money to de-leverage rather than to resume
lending.
The TARP operates as a "revolving purchase facility". The Treasury has a set
spending limit, $250 billion at the start of the program, with which it
purchased the assets, and then either will sell them or hold the assets and
collect the "coupons". The money received from sales and coupons is supposed to
go back into the pool, facilitating the purchase of more assets. The initial
$250 billion can be increased to $350 billion upon the president's
certification to Congress that such an increase is necessary. The remaining
$350 billion may be released to the Treasury upon a written report to Congress
from the Treasury with details of its plan for the money. Congress then has 15
days to vote to disapprove the increase before the money will be automatically
released. The first $350 billion was released on October 3, 2008, and Congress
voted to approve the release of the second $350 billion on January 15, 2009.
Another way that TARP money is being spent is to support the "Making Homes
Affordable" plan, which was implemented on March 4, 2009, using TARP money by
the Department of Treasury. Because "at risk" mortgages are defined as
"troubled assets" under TARP, the Treasury has the power to implement the plan.
Generally, it provides refinancing for mortgages held by Fannie Mae or Freddie
Mac. Privately held mortgages will be eligible for other incentives, including
a favorable loan modification for five years.
The first allocation of the TARP money was primarily used to buy preferred
stock, which is similar to debt in that it gets paid before common equity
shareholders. This has led some economists to argue that the plan may be
ineffective in inducing banks to lend efficiently.
In the original plan presented by secretary Paulson, the government would buy
troubled assets in insolvent banks then sell them at auction to private
investor and/or companies. Then overnight lending between banks came to a stand
still because banks did not trust each other to be prudent with their money. On
November 12, 2008, Paulson indicated that reviving the securitization market
for consumer credit would be a new priority in the second allotment.
The original plan was modified after Paulson met with British Prime Minister
Gordon Brown who came to the White House on November 15, 2008, for the first
Group of 20 summit on the global credit crisis. In an attempt to mitigate the
credit squeeze in Britain, Brown merely infused capital into banks via
preferred stock in order to clean up their balance sheets and effectively
nationalized many banks. The British plan seemed attractive to Paulson in that
it was relatively easy and seemingly boosted lending more quickly. The first
half of the asset purchases might not have been effective in getting banks to
lend again because they were reluctant to risk lending as before with low
lending standards.
On December 19, 2008, president Bush used his executive authority to declare
that TARP funds may be spent on any program he personally deemed necessary to
mitigate the financial crisis, and declared Section 102 to be nonbinding. This
allowed Bush to extend the use of TARP funds to support the auto industry, a
move backed by the United Auto Workers which hoped to avert massive
unemployment.
The Congressional Review Panel created to oversee the TARP concluded on January
9, 2009: "In particular, the Panel sees no evidence that the US Treasury has
used TARP funds to support the housing market by avoiding preventable
foreclosures." The panel also concluded that "Although half the money has not
yet been received by the banks, hundreds of billions of dollars have been
injected into the marketplace with no demonstrable effects on lending."
Government officials overseeing the bailout have acknowledged difficulties in
tracking the money and in measuring the bailout's effectiveness. On February 5,
2009, Elizabeth Warren, chairperson of the Congressional Oversight Panel, told
the Senate Banking Committee that during 2008, the federal government paid $254
billion for assets that were worth only $176 billion.
Next: Stress tests for banks
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.
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