Four years later, TARP was still a mistake

Earlier today, General Motors announced it would buy back about 200 million shares of itself from the Treasury Department – at a loss to the taxpayers of over $5 billion (CBS). The Treasury still owns 300 million shares of GM, and unless the share price hits $70, the “investment” will come to a loss.

Now, as numerous TARP supporters will insist, it’s not just about the bottom line of a profit-loss statement. I said something similar when it looked like TARP would be a money-making venture (overall, it’s looking more like a money-loser now). The difference is this: the “other factors” surrounding TARP make it a far less sensible move.

While I’m fairly sure I hold the minority view among the BD contributors, I have opposed TARP from the start. My reasons then still, in my view, hold up well. To wit…

TARP was the wrong medicine, based on the wrong diagnosis. The weaknesses of mortgage-backed securities was highly overblown in the fall of 2008. Yes, numerous mortgages were heading into foreclosure territory, but not nearly enough to explain the dramatic fall in MBS prices. Making matters worse, the SEC regulated that all MBS holdings be listed as “mark-to-market” (i.e., listed in value at the depressed market price) rather than “mark-to-model” (determining how many mortgages in the MBS holdings were in trouble, and reducing the value in that manner). As a result, artificial losses totalling over $500 billion were slapped on the banking industry. William Issac, former FDIC Chairman, detailed the unnecessary carnage to CNN:

In recent years, firms were required by the Securities and Exchange Commission and the Federal Accounting Standards Board to use mark-to-market valuations for all the MBS on their books.

As more subprime borrowers started to default on their loans, that quickly eroded the value of many MBS pools. Major banks and financial firms around the globe have taken writedowns topping $500 billion in the last year, as a result.

For this reason, some have argued that fixing the rule would solve the credit crisis.

“The SEC has destroyed about $500 billion of capital by their continued insistence that mortgage-backed securities be valued at market value when there is no market,” said William Isaac, a former chairman of the FDIC.

“And because banks essentially lend $10 for every dollar of capital they have, they’ve essentially destroyed $5 trillion in lending capacity,” he added.

Isaac believes that since the overwhelming majority of loans packaged together in even the weakest MBS pools are not in foreclosure, it is proper to value these securities based on the flow of cash from all the loans instead of a non-existent market value.

Richard Kovacevich, who was head of Wells Fargo at the time, gives a specific example of this idiocy (Forbes):

People thought the world was coming to an end because everyone was reporting huge book but not actual losses because of MTM accounting. We had to write off $900 million on a prime mortgage portfolio that we thought had a maximum loss exposure of $100 million. Our current loss estimate for that portfolio is now just $35 million. But we had to report nearly a billion-dollar loss that never came to fruition. And that was just one relatively small portfolio. I could give you many more examples. Also, we wanted to purchase some assets because we knew they were undervalued. We were very reluctant to be a purchaser, however, because we would have to take an MTM loss if the asset went down further, even though we knew over the cycle it would be profitable. This caused the markets to cease functioning. It destroyed a lot of companies and ultimately forced the Fed to intervene with trillions of dollars and be the buyer of last resort. Mark-to-market accounting was a huge culprit in the financial crisis and caused unnecessarily massive damage to the economy, and to housing in particular

So did the Bush Administration order the SEC to change the rule? No, they instead demanded $700 billion from the taxpayers to ostensibly buy these MBS (the Troubled Assets of the Troubled Asset Relief Program), demanded the right to redirect the money however it saw fit after Congress appropriated it, and insisted the world would end if they didn’t get it.

This leads to the second problem – the damage to expectations. With the misdiagnosis and incorrect “cure,” the Administration made the economy appear worse than it really was. They exacerbated the problem with their insistence of a complete financial collapse without the $700 billion (the fact that only $418 billion ever left the Treasury – and less than $400 billion actually went to banks, is just part of the evidence of how the problem was overestimated). When cooler heads managed to convince the House of Representatives to hold off and vote this down, they were drowned out by the screaming from the Administration, the Fed, the Senate, and the House minority (which in this case does not mean the Democrats, but rather the minority of members who voted Aye the first time).

When the House revoted, enough Congressman were spooked into passing the debacle, but then the Administration made matters infinitely worse by using the dictatorial powers given to it and changing the plan to “recapitalizaion” (i.e., buying of stock in the banks). As a result, banks that were largely healthy could be lumped into the “bailout” mix. Kovacevich in particular recounts – to John Taylor and others – how he was threatened by Paulsen and Fed Chairman Ben Bernake into agreeing to the money for Wells Fargo. By forcing healthy banks to take the money and appear sick, TARP gave the impression that the banking sector was in far worse shape than it actually was. It should come as no surprise that the worst part of the Great Recession came in the final quarter of 2008, when these shenanigans were in full swing.

This also leads to the final strike against TARP – the damage to political accountability and limited government. TARP essentially turned Henry Paulsen into Julius Caesar, and as a result, a policy for which no one in Congress voted was enacted, in at least one case over the objection of one of the very “beneficiaries.”

Kovacevich’s comments on what he wanted Wells Fargo to do (namely buy undervalued MBS assets) but couldn’t due to mark-to-market shines light on why TARP’s extension into the auto industry was also a bad idea. Absent government interference, Wells Fargo would have seen the events of the fall of 2008 not as a disaster, but as an opportunity to snap up undervalued assets and make long-term investments. Competitors of GM and Chrysler would have been in a similar position, but like Wells Fargo, they were blocked by the government (in this case the bailout itself was the reason). While Ford’s ability to avoid bailout funds is a testament to its financial strength, its political support for GM and Chrysler getting bailed out was a sign of microeconomic ignorance, or perhaps they feared a more competitive auto industry replacing the wheezing oligopoly that GM and Chrysler’s survival represented – an oligopoly of which Ford is obviously still a part.

In summation, TARP was an economic mistake on several levels, even it had been a net positive for the Treasury in funding; that it appears not to be even that simply makes it worse.