Treasury Secretary Timothy Geithner next week will unveil the Obama administration’s much anticipated plan to use the remaining $350 billion in financial rescue money requested from Congress less than a month ago. The speed at which Geithner and the new administration’s other financial advisors are moving is commendable and necessary given our rapidly deteriorating economy, but equally important will be the guiding principles supporting the new plan.
We at the Center for American Progress suggest that four overarching principles should guide the Obama administration as it prepares to disburse this second round of funding under the $700 billion Troubled Asset Relief Program, or TARP funding that Congress initially approved amid the global financial markets meltdown in September last year. We believe these four guiding principles must remain paramount. First, taxpayers must be protected. Second, any actions taken to help financial institutions must be transparent. Third, all programs implemented under TARP must be part of a coherent economic stimulus and recovery strategy. And fourth, “moral hazard”—creating a set of incentives that serve to reward bad behavior—must be avoided to the greatest extent possible.
Adhering to these four principles would mark a definitive break with the TARP program under Bush administration Treasury Secretary Henry Paulson, which was widely viewed as a series of erratic, one-off interventions, including too many secret giveaways to the undeserving, which failed to address systemic problems. The Paulson Treasury did little to provide a sense of stability and strategic thinking. Indeed, had a comprehensive approach been implemented a year ago, many aspects of the current crisis could have been averted.
Instead, in the waning months of the Bush era financial institutions and institutional investors faced varying levels of market intervention and varying approaches to rescuing different kinds of failing financial institutions. The Paulson Treasury almost immediately scrapped the idea of buying troubled mortgage-related securities—the original purpose of the funding—shifting instead to its to so-called Capital Purchase Program, which entailed the government investing $200 billion in preferred shares across the financial terrain, and then to its now $40 billion Targeted Investment Program to help troubled banks that were clearly “too big to fail.” Moving forward, there needs to be a clear-cut strategy with well-articulated goals and bottom lines. This will both lead to better policy and give the financial markets a set of expectations that it can rely on.
First and foremost, taxpayer protection is critical. The cost of missteps is high. Protecting the taxpayer means seeking the best possible return on the investment of public dollars. Maximizing returns should be predicated on buying troubled financial assets from financial institutions at today’s discounted prices and demanding proper return for taxpayers. To date, the quality of Treasury’s bargaining on behalf of taxpayers is an open question.
There is no reason, for example, why Treasury should have “bargained” for a 5-percent dividend on the preferred shares it took in banks last fall and warrants equal to 15 percent of the equity investment in banks while Warren Buffett around the same time extracted 10-percent dividends for his equity investment in Goldman Sachs Group Inc. as well as warrants equal to the full amount of his equity stake.
To date, a number of those government investments clearly do not look like good deals for the taxpayer, as banks’ stock prices continue to fall. In the aggregate, the warrants for banks receiving more than $1 billion under the Capital Purchase Program have been “in the money” on fewer than 5 percent of all trading days since the equity investments were made by the government, with the majority of banks’ warrants never being in the money.
Going forward, Treasury needs to make sure that the prices it pays for troubled assets it eventually purchases from financial institutions—perhaps through a so-called “bad bank” that would consolidate troubled assets in a single institution—are determined so that taxpayer interests come before investor returns. The pricing of troubled assets held by troubled financial institutions is a complex issue, but minds will be focused if the underlying principle is for government to pay close to what the assets are currently worth in order to clear the financial system of troubled assets at a reasonable cost to taxpayers.
Moreover, mortgages and mortgage-backed securities acquired by the government should not simply be viewed as passive investments—offered for sale in the distant future at a time when the market improves. For the amount of money taxpayers have provided to Citigroup Inc. through TARP—$45 billion to date, not counting liability for up to $249 billion in mortgage-backed assets that may fail—it could have acquired all the currently outstanding Citigroup stock more than twice over. Yet Treasury is precluded from exerting any control over how Citigroup operates.
Instead, Treasury must actively manage the assets it acquires, restructuring troubled mortgages where possible to limit the risk of foreclosure. Bought at a sufficient discount to the asset’s original full value, there is plenty of room to create value for the taxpayers by modifying the loans down to a point where they can be sustained and then reselling them into the secondary mortgage market with a government guarantee. This process will not only recapitalize banks by exchanging risky mortgage-backed securities for cash or U.S. government securities, but it will help clear out the bad mortgage assets still clogging the financial system. Taxpayers benefit because of the higher selling price on the restructured, guaranteed mortgages.
Public accountability is equally important. The recent announcement that TARP investments would be publicized within 10 days is a sign of the philosophy of increased public accountability under the Obama administration. As new program elements are rolled out, terms and conditions for all parties also must be clearly laid out in advance. Similarly, to the extent that outside companies’ expertise is sought in advisory or management capacities, potential conflicts of interest must be publicized. These steps to increase transparency will promote the honest and ethical use of TARP funds.
This also ties into the issues of creating and managing a coherent strategy for Treasury activity. Before additional taxpayer funds are expended, laying out a clear strategy for how Treasury will proceed (and sticking to it) will provide a measure of comfort sorely lacking to date. A consistent strategy must not only focus on financial institutions but also on homeowners and their families in need of relief in these difficult times. Fixing Wall Street for its own sake rather than for the benefit of the nation as a whole would be grossly negligent and ultimately doomed to failure.
The problem of moral hazard—creating a set of incentives that serve to reward bad behavior—is particularly challenging when dealing with institutions deemed “too big to fail.” As many as four banks—Bank of America, Citigroup, JPMorgan Chase & Co., and Wells Fargo—have reached this dubious status, and once an entity is deemed too big to fail, the normal constraints on risk are thrown by the wayside as the threat of failure compels an intervention. The systemic risk these banks pose, therefore, puts an even higher burden on government for proper oversight and management, even absent formal guarantees on their losses.
Consider the outrageous behavior by Merrill Lynch in the days before their acquisition by Bank of America (aided by significant taxpayer funds) when they reported fourth quarter losses of $15.3 billion: They accelerated $3 billion to $4 billion in bonus payments to their employees. As the magnitude of the Merrill Lynch losses became known, Bank of America approached Treasury for help closing the deal, threatening to walk away because the costs were too high. And so, taxpayers lent Bank of America $20 billion to buy Merrill Lynch and also took on $97 billion in liabilities for commercial and residential mortgage-backed securities in Merrill’s portfolio.
Taxpayers investments in banks that are too big to fail carry significant risk, yet Treasury at this point must sit patiently on the sidelines hoping (in vain, I fear) that bank executives will act as good stewards of taxpayer money. At the very least, future equity investments through TARP must come with significant strings attached, including iron-clad commitments to widespread, substantive loan modifications, increased lending activity, and adoption of the highest standards of corporate governance and accounting. Noncompliance should bring severe penalties.
These four guiding principles—protecting taxpayers, transparency, consistency, and avoiding moral hazard—will not ensure that new public investment in troubled financial institutions will bear fruit overnight. In fact, given the poor use of the first $350 billion in TARP funds by the Bush administration, the American public should seriously anticipate the possibility of a third round of financial rescue funds. But if TARP activities follow the guidelines set forth above, we may be able to move the financial system in the right direction.
In conjunction with the stimulus and recovery spending proposed by the Obama administration and now working its way through Congress, additional TARP spending will help create new jobs and needed reinvestment as financial institutions shed their bad assets, bolster their capital and deposits, and resume lending. Together, we should be able to return the country to a path of sustainable economic growth.
Andrew Jakabovics is Associate Director for the Economic Mobility Program at the Center for American Progress. To read more about the Center’s economic analysis and policy recommendations please go to the economy page of our website.