Thing One and Thing Two: Supervisory Goodwill and TARP

Thing One and Thing Two

© 1957 & 1985, Dr. Seuss Enterprises, L.P.

Dr. Seuss, The Cat In The Hat, 1957

More than 50 years ago, Theodor Seuss Geisel wrote a children’s book about poorly implemented banking regulations. Perhaps you’ve read it: The Cat In The Hat.

As you may recall, two housebound children are looking for “something to do” one afternoon, when a talking cat walks into their lives with the promise of excitement. After some introductory diversions, Seuss introduces them to Supervisory Goodwill and the TARP Capital Purchase Program:

“In this box are two things

I will show to you now.

You will like these two things”,

Said the cat with a bow…

“Two things. And I call them

Thing One and Thing Two.

These Things will not bite you.

They want to have fun."

Then, out of the box

Came Thing Two and Thing One.

© 1957 & 1985, Dr. Seuss Enterprises, L.P.

In short order, the Things proceed to trash the house, much as Supervisory Goodwill did to the '80’s savings and loan industry and the ’08 incarnation of TARP will do to today’s banks.

For those unfamiliar with Thing One and Thing Two, let’s meet them.

For each, we’ll review a succinct newspaper account, so that you will understand that this is not some allegory of my invention. Then I’ll direct you to the enabling legislation. I will then summarize the similarities of Thing One and Thing Two, and conclude by highlighting the degree to which large and small institutions have been ensnared by TARP, or alternatively, are working furiously to eliminate the government’s current intervention.

Let’s begin with Thing One.

THING ONE: SUPERVISORY GOODWILL, 1989

As summarized by the LA Times following a court ruling earlier this decade:

• The regulators offered healthy thrifts a deal [in the 1980’s]: If they’d take over their wounded brethren, the regulators would let them record an asset on their balance sheets equal to the capital deficiency at the sick thrift. That asset, known as supervisory goodwill, could be gradually written off over 40 years.

• “They were basically trying to keep the problem swept under the rug,” said [a] veteran banking consultant…

• When Congress finally faced up to the ballooning problems in the industry in 1989, the resulting thrift bailout bill did away with the supervisory goodwill, requiring thrifts to reduce it [i.e., supervisory goodwill] to no more than 1.5% of their assets by the start of 1991 and to purge it entirely over the next three years. The action caused thrifts to record billions of dollars in losses.

Source: E. Scott Reckard, LA Times - US Loses Ruling in Challenge by S&L, 10 Aug 2004.

Below is a copy of the crucial language that Congress employed to betray the S&L’s trust in their regulators, referenced in the LA Times’ account:

An eligible savings association may include qualifying supervisory goodwill in calculating core capital. The amount of qualifying supervisory goodwill … may not exceed the applicable percentage of total assets … in the following table:

Source: Financial Institutions Reform Recovery & Enforcement Act (“FIRREA”) of 1989.

Now, let’s take a look at today’s Thing Two – the TARP Capital Purchase Program which absorbed more than $250 billion of the first $350 billion released under TARP.

THING TWO: TARP – TROUBLED ASSETS, 2008

A January 2009 Wall Street Journal Op Ed summarized the problems with TARP:

• TARP has two major shortcomings:

1. A lack of political support. Congress did not explicitly authorize capital investments in financial institutions when it created the $700 billion program three months ago…;
2. There is widespread confusion about the role capital plays in bank balance sheets… Treasury invests TARP funds by purchasing preferred stock in a bank, which adds to the bank's capital… [and] … serves as a cushion to absorb losses…

• Unfortunately, banks accepting TARP investments must, under the contract governing Treasury's investment in the bank, agree that Treasury can "unilaterally amend" the agreement "to comply with any changes . . . in applicable federal statutes." Through this provision the new Congress can impose on banks with TARP investments lending mandates or other obligations and restrictions…

Source: Bert Ely, Wall Street Journal – Op Ed, 5 January 2009.

As noted in my earlier Bait and Switch, TARP had been presented to Congress as a program for the purchase of “troubled assets” – primarily mortgages. Hence its name – Troubled Asset Relief Program.

And while TARP could purchase mortgages, the bill passed by Congress also contained the following language:

The term "troubled assets'' means… any other financial instrument that the Secretary [of the Treasury], 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.

Source: Emergency Economic Stabilization Act (“EESA”) of 2008.

The phrase – any other financial instrument – was the key phrase that permitted the Treasury to use the TARP funding to purchase preferred stock in financial institutions, rather than distressed mortgage assets.

COMPARISON OF THING ONE AND THING TWO

There are four fundamental similarities between Thing One (Supervisory Goodwill) and Thing Two (TARP).

1) Both lacked the support of Congress.

Supervisory Goodwill was the well-meaning invention of bank regulators with limited resources who viewed the S&L problem as an accounting problem that could be solved with accounting tricks. Once the costs of this “solution” became too expensive, it was repudiated by FIRREA, as noted above. The FDIC chairman at the time provided this reaction to FIRREA:

I made a commitment . . . and the government breached it and I find that very offensive . . . I made a promise . . . that we would count goodwill as part of capital for 15 years, amortized on a straight-line basis. It was a very conscious decision on our part. We knew what we were doing and I don't think anyone after me had the right to turn their backs on that…

Source: William Isaac, Former Chairman FDIC, MeritorPSFS.com.

TARP’s Capital Purchase Program, strictly speaking, was authorized by EESA’s “any other financial asset” language, as seen above. But Congress is attempting to distance themselves from the “old” use of TARP, and make TARP more acceptable to both Congress and their constituents.

See for example, HR 384, introduced this month to amend the … TARP provisions of the … 2008 EESA to strengthen accountability, close loopholes, increase transparency, and require Treasury to take significant steps on foreclosure mitigation.

2) Both were employed to address capital deficiencies in the affected institutions – Supervisory Goodwill for S&Ls, and TARP for banks.

3) Participants in either program were dependent upon the programs, and the continued grace of Congress or their regulators for their continued existence.

The impact of the Congressional repudiation of Supervisory Goodwill on S&Ls is described in the LA Times story, referenced above. To see what denial of TARP access would do today, one has only to read last week’s NY Times article on Citigroup (C):

[Citigroup’s] … plan to accelerate a dismantling of its financial supermarket came after a stern regulatory warning… delivered by … the chair of the FDIC, who told Citigroup than any further requests for cash would result in a breakup of its operations dictated by regulators.

Source: Eric Dash, The New York Times – Citigroup Plans To Split Itself Up, 14 Jan 2009.

4) Finally, both - either by practice (Supervisory Goodwill) or design (TARP) – demonstrate the arbitrariness of Congressional and Federal power.

With respect to Thing One (Supervisory Goodwill), its elimination by FIRREA surprised and betrayed the S&L’s regulators. This destroyed an industry that provided borrowers with fixed rate mortgages that were easily modifiable, since the loans were usually retained on the originators’ balance sheets.

With respect to Thing Two (TARP), the power is contained in the enabling legislation – the “unilateral amendment” language singled out in the Wall Street Journal. One can’t begin to imagine the future unintended consequences of such power.

Some banks, understanding TARP’s perils - and small enough to do something about it - are trying to reduce government ownership of their businesses to “pay back money received under the US Treasury’s bank recapitalization program,” as described by the Financial Times on 13 Jan 2009:

A handful of small banks have raised money in recent weeks from existing shareholders and private equity firms… IberiaBank, a Louisiana-based bank with $5.3 billion in assets and National Penn Bancshares, a Pennsylvania-based bank with $9.3 billion is assets [are among the first] … to raise fresh funds .. to provide an exit strategy for government financing…

Source: Saskia Scholtes, Financial Times – Banks Act To Trim Government Stake, 13 Jan 2009.

CONCLUSION

As we await the latest incarnation of TARP relief to clean up our economic mess, we can only hope that the new TARP will be as successful as Seuss’ cat:

And THEN!

Who was back in the house?

Why, the cat!

"Have no fear of this mess,"

Said the Cat in the Hat.

"I always pick up all my playthings

And so...

I will show you another

Good trick that I know!"

Then we saw him pick up

All the things that were down...

And he put them away.

Then he said, "That is that."

And then he was gone

With a tip of his hat.

© 1957 & 1985, Dr. Seuss Enterprises, L.P.

REFERENCES

E. Dash, The New York Times – Citigroup Plans To Split Itself Up, 14 Jan 2009.

B. Ely, Wall Street Journal – Op Ed, 5 Jan 2009

E. S. Reckard, LA Times - US Loses Ruling in Challenge by S&L, 10 Aug 2004.

Dr. Seuss, Random House - The Cat In The Hat, 1957

S. Scholtes, Financial Times – Banks Act To Trim Government Stake, 13 Jan 2009

Disclosure: no positions

Comments

[Toeser:]

I will be shocked if one large bank, U.S. Bank, does not give the money back. They will have portfolio stress, but I doubt sufficient enough for them to want the government's thumb on their head.

Jan 20 08:13 AM