Let's Be Realistic about TARP
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The Troubled Asset Relief Program (TARP) saved the economy from collapse. In its absence, the holding companies of a number of large, complex financial institutions would have likely filed for bankruptcy. Given the inadequacy of the current Chapter 11 regime for dealing with all the competing claims of creditors, derivatives counterparties, depositors, partnerships, foreign subsidiaries, prime brokerage clients, and custodians, these bankruptcy filings would have likely resulted in a complete seizure of financial markets. Lending would have likely ceased completely until claims on bankrupt financial behemoths were resolved. Payrolls, payments to suppliers, and bank and brokerage account withdrawals would have likely been disrupted. In short, economic activity would have ground to a halt with the reduction in fourth quarter of 2008 GDP unlike anything on record.
TARP not only rescued the economy from Armageddon, but also turned a profit in the process. According to new estimates from the Treasury Department, TARP investments in banks are expected to generate a $24 billion profit, or a 10% return on the $245 billion initial outlay. While CBO still estimates the program will have a $19 billion net cost, this is due to investments in the domestic auto industry and AIG, which are expected to combine to cost $41 billion. All official scorekeepers agree that the investments in banks – TARP’s raison d’être – will turn a profit.
These basic facts about the program have given rise to an unseemly triumphalism among TARP supporters, including Treasury Secretary Tim Geithner, who called TARP the “most effective government program in recent memory.” In March, Treasury sent out a flurry of press releases touting TARP’s miraculous capacity to save the economy while simultaneously generating a profit for taxpayers. After reading these statements and speeches, one could be forgiven for wondering why the Treasury does not propose a giant TARP to rescue the Social Security trust fund.
This triumphalism seems borne of a view, prevalent among financial and government elites, that opposition to TARP stemmed from ignorance about the nature of the crisis. Proponents of TARP always seem to portray themselves as “tackling myths,” as though opposition to the program was built on lies, half-truths, and misunderstanding. Others have gone so far as to argue that the program’s critics “have no interest in facts.” TARP enthusiasts are quick to point to polls showing most Americans don’t realize what TARP was or understand why it was necessary. The basic narrative of a recent Politico article was that TARP was an enormous success but most voters are too ignorant to realize it, which is enormously frustrating for all of the very smart people who administered the program. The recent emphasis on the program’s profitability seems designed to place the program’s achievement in more concrete terms, as those unable to appreciate the need for TARP are not able to appreciate its extraordinary success at averting another Great Depression.
In many ways, the expressions of frustration and emphasis on critics’ ignorance are reminiscent of the health care debate. Rather than internalizing legitimate criticism of the proposed reckless expansion of government, proponents of the health care reform attributed voter opposition to fear-mongering and deceit about “death panels.” The choice was binary: either reform the health care finance system and expand insurance coverage in precisely the manner proposed, or embrace the broken, unaffordable status quo. With TARP, Secretary Geithner fictionalizes a scenario where leaders had to choose between either saving the financial system or allowing the economy to melt down. Presenting the choice as binary allows TARP defenders to avoid any discussion of specifics and relieves them of the burden of explaining why, of all possible interventions, this precise policy approach was best.
TARP is often used as a catch-all for the large number of financial rescue programs undertaken by various Federal agencies, the most consequential of which were the Federal Deposit Insurance Corporation (FDIC) guarantee of unsecured bank debt and the Federal Reserve’s ad hoc collateralized lending to commercial businesses and liberalization of its collateral requirements for bank borrowers. Although some argue that these programs should not be conflated with TARP, it was the TARP legislation that provided the de facto Congressional authorization for the entire rescue. TARP was cited explicitly in authority for the commercial paper funding facility and other Fed programs that involved the assumption of credit risk. Moreover, the $245 billion in bank investments were just one part of TARP, called the Capital Purchase Program (CPP). Using TARP to describe the constellation of bailout programs is perfectly reasonable because the TARP legislation was so open-ended as to serve as a legislative endorsement for whatever was to come.
A financial collapse was averted, but from October 14 when the CPP was announced, until March 2009, the S&P 500 Financials Index declined by 56%. This was partially because of the way TARP initially promoted opacity. To avoid a stigma being associated with accepting government funds, the Treasury forced both strong and weak banks to accept capital injections. This helped Citigroup and harmed J.P. Morgan. Market participants were not clued in on which banks were weak, but this had the unintended consequence of encouraging investors to avoid all banks. The fact that TARP only implicitly guaranteed the liabilities of the banking system was also of little comfort to investors panicked in the wake of WaMu and Lehman. It was not until the stress test more formally guaranteed the liabilities of the 19 largest banks that the panic ended. The stress test promoted transparency, but, more significantly, it made clear that the government was going to use TARP to fill any capital holes the examination uncovered. The probability of insolvency – i.e. stockholders being wiped out – fell to zero.
While this ended the panic, it came at a significant cost: market participants were told that the liabilities of large financial firms were essentially risk-less, or, at the very least, carried roughly the same credit risk as U.S. Treasury securities. Although diatribes against moral hazard focus on the way it distorts bank managers’ decision-making, the first-order effect is on creditors who are told that they need not worry about spending the considerable time and effort necessary to judge whether the firm they’re lending to is being managed prudently. Indeed, one would suspect that well-functioning credit markets would actually prevent organizations from becoming as large and complex as Citigroup because the information costs of assessing its solvency is so much greater than for smaller, simpler institutions. Academic research has demonstrated fairly convincingly that banks pay larger premiums in acquisitions that allow them to grow to a systemically significant size, a strong signal that the growth in size and complexity is done to subvert market processes.
These costs would be worth incurring if the specific features of TARP were necessary to stop the panic, but the program did not succeed because of its design. It succeeded because the financial system was of a manageable size relative to the economy. As e21 has explained previously, the liabilities of the U.S. financial system were $17.1 trillion (D.3), or about 118% of GDP, at their pre-crisis peak. This means the likely maximum cost of guaranteeing the financial system’s liabilities through TARP and the associated programs would be less than 25% of GDP, a large number but quite manageable for a federal government with a 40% debt-to-GDP ratio at the time. For Iceland (1,100% of GDP) and Ireland (nearly 400% of GDP), the problem was not that their bailouts differed materially from TARP, but that their governments simply lacked the financial capacity to credibly back-stop their largest financial institutions.
When one couples the moral hazard of TARP with the failure of Dodd-Frank to solve the “too big to fail” problem more directly, the risk is that there will be a larger, more dangerous financial system in the future that will be too large to save. As TARP inspector general Neil Barofsky explained, many people believed the implicit bargain of the TARP bailout was financial regulatory reform that addressed the risk large financial institutions pose to the economy. Instead, Congress passed a 2,300 page bill that created 300 new rules and several entirely new regulatory bodies to make economic decisions on behalf of tens of thousands of firms whose failure would have no impact on the broader financial system. At the same time, the largest banks have gotten bigger and their failure would still have the same devastating impact on the economy as in October 2008.
At the end of the day, it is not unreasonable to think that the only outcome that would have been worse than TARP and Dodd-Frank would have been economic collapse. If Secretary Geithner wishes to commemorate the success of TARP on these grounds, that’s perfectly reasonable. But he should spare us the charade about the wild success of a rescue and reform package that heightened the dangers facing the economy.