TARP Takes a Wrong Turn

A few days ago we wrote our top suggestion for President-elect Obama.  Several blogging colleagues took up the theme, and we sincerely thank them for their interest and for stimulating discussion.  We plan a more complete review of opinion, but events have, once again, overtaken the schedule.  The current Administration is moving in the opposite direction.

Secretary Paulson announced that the TARP program would not purchase troubled securities, at least not in the way originally envisioned.  He stated that direct investment in financial institutions was a better use of TARP funds with more impact.

A Discouraging Turn of Events

Here we try to analyze markets rather than to offer prescriptive advice.  The "Letter to Obama" was a rare excursion for us.  While others stray far from their expertise, we like to stick to our "happy zone."

Here are two takes on the wrong turn in TARP.

Market Take.  Market participants, rightly or wrongly, now see the program as a funding source for anyone who claims a need.  They see it as socialism.  Most importantly, they interpret the failure to purchase distressed securities as an acknowledgment that these holdings are worthless.  Briefly put, the Treasury has undermined the very assets they hoped to support, and the leadership has lost the confidence of investors.

Political Take.  The decision to invest in preferred stock instead of troubled assets is an easy course.  It sounds great to the taxpayer.  The companies are held by private investors, so there is an inference of value for preferred shares.  This is better than buying what is perceived as "toxic waste."  It has an easily-understood causal mechanism -- a direct injection of capital.  The downside is that it has eliminated any clear public-interest distinction, inviting nearly anyone to apply for TARP funding.  It fails to address root causes.

Public Policy Take

Quite frankly, the investment and political types are not doing clear-headed public policy analysis.  This involves understanding the following points:

• Focusing on the cause of the problem.  The cause was originally troubled housing loans.  We could have addressed this directly at less cost than the current plan.  Instead, we have allowed mortgage securities to have an ever-decreasing mark-to-market value, and now face similar issues with Alt-A loans, student loans, and securitized credit card debt.  As long as this spiral continues, the need for additional government investment will continue.
• Recognizing the error of using a club instead of incentives.  The government is now instructing financial institutions to do more lending.  We are not learning the lesson of Fannie (FNM) and Freddie (FRE), where the government tried to combine public interest with a private company.  It did not work there, because the government asked private companies to behave more aggressively than their financial statements warranted.  We are going down the same road.  If you were a bank manager with TARP funds, would you choose to strengthen your balance sheet in the face of declining assets, or make more loans?  Simply instructing them will not work.
• Failure to develop and implement a coherent plan.  The current "plan" seems to change weekly.  Everyone sees this, so confidence is lost.  It is the country's misfortune that our leadership was far too slow to address the relevant issues.  We hope that the Obama Administration will carefully develop and implement an incentive-based approach, but the President-elect does not yet have control.  Our tradition of transition in government is being tested in a way that has no historical precedent.

The best hope for investors is that the new administration will quickly develop and announce proposals that get to the root of problems.  Their key appointments should reflect this.  The Bush Administration should cooperate during the transition.

It is a major burden for an incoming President.  Never before has a President-elect had such a responsibility before actually gaining the reins of power.

Comments

[Steven Hansen:]

"Never before has a President-elect had such a responsibility before actually gaining the reins of power."

jeff, for the last week i could not get this thought out of my head. bush is actually encouraging obama's new government to begin the handover process. it blows my mind.

either things are even worse then my pessimistic view, or bush is trying to pass the buck.

2008 Nov 13 05:03 AM

[birder:]

I actually think it is sort of cute. Here we have an economy drowning in debt and what is the administration's solution? Why we have to lend more, of course. Sure makes sense to me.

2008 Nov 13 08:25 AM

[David Martin:]

Obama has the same dead-beats and loosers in his team as those who created the problem.
Fellow grifters with Paulson, to a man.

2008 Nov 13 08:36 AM

[Tony Petroski:]

Jeff Miller, please calm down. "...transition in government is being tested in a way that has no historical precedent." Lincoln, Truman, Nixon, Adams, Jackson, Roosevelt (both of them), Reagan among many others may have made their case for historical precedent.

Paulson cobbled together a TARP program and pushed its necessity lest we all die before the markets open in Asia on Monday. Well the markets opened and we didn't die although, granted, the panic created by the political class of both parties turned a minor recession into a world-wide panic. The Brits jumped the gun and took equity positions in their own banks (in Great Britain it's legal to nationalize industry) and Paulson had to admire their initiative. But we can't do that here, after all, unlike the Brits, we have a written constitution and our government is one of enumerated powers. Well, Paulson scratched his chin, thought a few seconds, and then decided, "Let's copy the Brits. Since we're in the stew, why worry about constitutional punctilio?" Besides, the TARP would get started about the time the whole panic was over, so why not take the fast track?

Stalin said that "the death of one man is a tragedy--the death of a million men is a statistic." I recall the hand-wringing that took place during the bailout of Chrysler in the '70's and the government guarantee of a 600- million-dollar loan. Oh how quaint those days now seem. Well, here we go: We have a pot-full of money and many snouts in the trough.

2008 Nov 14 09:03 PM

[Jadogsl:]

if you read nothing else read the last link in this comment

Former Fed Officials agree...

Thanks for your comments, which are quite thoughtful. I will keep up this fight until SFAS 157 is suspended, as it is destroying our financial system and taking the economy with it.
Best regards, Bill William M. Isaac
Chairman
The Secura Group of LECG


--- On Fri, 11/21/08, Bob McTeer <soupcolddog@yahoo.... wrote:

From: Bob McTeer
Date: Friday, November 21, 2008, 10:22 AM

Thanks. I heard Sec Paulson on the radio yesterday refer to mark to market accounting as "pro cyclical." That's encouraging. Bob


Here is what they were responing to...

Did the enforcement of Fair Value Accounting i.e FAS 157 effective for fiscal years beginning after November 15, 2007 coincide with the early stages of the meltdown of the bond and equity markets ? Or was it a coincidence ?

There is no doubt that some financial-services firms found themselves ill-equipped to perform such acrobatics. Finance executives in the sector complained that the fair-value rules were "pro-cyclical" - that they were a self-fulfilling prophecy forcing banks to sell their securities in plummeting markets. ( paraphrased from CFO.com )

The big picture, a common sense view .... CSCO stock was at $80 in 2000. The cash flow value was $18. Had margin been against $18 instead of $80 the bubble in tech stocks may never have happened. Also in 2002, CSCO was at $11. Cash flow value ? $18. How do the purists defend Fair Value accounting 'allowing' margin loans against an $80 stocks really worth $18 by conservative estimates ? Migrate this example to Las Vegas real estate in 2005 and you have the achilles heal of Fair Value accounting.

The reverse is now happening, a downward spiral as assets sell below their intrinsic value.

George Soros speaks of reflexivity as the main component of his investing thesis. The key element is banks lending against overvalued assets create bubbles and the withdrawal of lending against falling asset values creates the bust. A mark to model across all spectrums, Margin...Home lending etc would REDUCE the risk to our financial system and bring sanity to our financial markets.

The real fix is INDEPENDENT firms that audit companies. Firing without cause should be eliminated when it comes to these firms. Whistleblower laws with teeth wouldn't hurt either. After all the problems where known within Enron and reported to upper management. It wasn't a mark to market issue it was a regulatory issue.


The case is made by an esteemed former official ... sec.gov/comments/4-573...

The effects are felt .....
www.researchrecap.com/.../

The proof is in .....
seekingalpha.com/artic...

2008 Nov 23 07:56 PM