Oct 10, 2011 8:28 PM GMT
The $700 billion “Troubled Asset Relief Program” (TARP) was enacted in Washington three years ago this week, and while most economists, policymakers and journalists still believe it made things better (“helping us avoid a second Great Depression,” they like to say), in fact it made things much worse – and today we’re still suffering from its bearish effects. As just one example, a similar scheme, modeled on TARP – the “European Financial Stability Facility” (EFSF) – is being adopted abroad, further undermining bank stocks.
Those who fail to grasp TARP’s true impact will find it difficult to comprehend the currently-bearish impact of the EFSF. The problem with most U.S. banks in 2008 was not that they were “under-capitalized” but that they held so many shaky (sub-prime) residential mortgage-backed securities (RMBS), assets which bank regulators insisted were some of the safest assets they could own, because they were “backed” by the taxpayer-backed mortgage GSEs (Fannie Mae and Freddie Mac) and thus required virtually no capital.
Instead of U.S. banks shedding bad assets, merging and raising private capital, TARP compelled them to take unwanted, high-cost capital injections with “strings attached” that became a noose around their necks. Similarly, the problem with Europe’s shakier banks today is not they’re “under-capitalized” but that they hold shaky government bonds (issued by Greece, Portugal, Italy, Spain, etc.), assets which bank regulators insisted were the safest things they could possibly own, and thus required little or no capital.
TARP didn’t prevent the crisis of September-October 2008 but contributed to it. Of course, the initial root cause of the bearishness was the U.S. recession that had already begun in December 2007, long before TARP was concocted, and which was caused by the Fed’s deliberate and prior inversion of the Treasury yield curve. That policy narrowed banks’ net interest margins, killed the incentive for credit intermediation (“borrowing short, lending long”), and cratered asset prices, wiping out some banks’ capital cushions.
In 2008, instead of closing down the handful of obviously insolvent banks (like Citigroup) and encouraging private purchases of bad mortgage assets from others, the U.S. Treasury forced hundreds of banks to take overly-expensive capital and subject themselves to business line restrictions and pay czars. Meanwhile Washington only bolstered the policies that encouraged excess leverage and reckless lending: FDIC coverage, the “too-big-to-fail doctrine, cheap Fed loans, and the mortgage GSEs (Fannie Mae and Freddie Mac).
Only a half-year before TARP’s enactment, in March 2008, the Fed made a huge policy mistake when it bailed out Bear Stearns and bought $30 billion of its bad assets while forcing J.P. Morgan to pay $10/share for the remainder. Everyone applauded that bailout, but it sent the message to other over-leveraged banks (like Lehman Brothers and Merrill Lynch) that they needn’t raise capital (although it was possible to do so in summer 200 and instead could gamble: if “heads” they’d win, but if “tails” U.S. taxpayers would lose.
Many attribute the 2008 panic to the failure of Lehman Brothers (in mid-September) and the “unexpected” decision by the Treasury and Fed not to bail it out. Yet Merrill Lynch, although a much bigger and more retail-oriented brokerage house, also failed in the fall of 2008, and was safely absorbed into Bank of America. The same could have been done with Lehman Brothers, but it waited too long, counting on political help; that fatal expectation was the real problem, not the failure itself, but the way Washington misled markets. Eventually Lehman’s remaining value was bought by Barclays Bank; it could have been done earlier, calmly.
Now consider market performance surrounding the passage of TARP on October 3, 2008. If it truly “helped,” wouldn’t you suspect that markets must have performed worse before it was enacted and far better afterward? In fact, the exact opposite happened. Due to the recession that began in December 2007, U.S. bank stocks had plunged 49% from early February to mid-July of 2008, but then rebounded sharply (+52%) in the two months through September 6th, retracing 76% of the prior peak. That could have marked the end of the banks’ bearish run, as they had performed similarly in prior recessions, falling sharply at first, then rebounding in anticipation of a post-recession recovery. But before long markets had to consider not that Washington might “come to the rescue” of the banks but rather that it would decide to run the banks.