Why TARP was wrong

The main argument of TARP defenders is that things would have been much worse without it, because lots of basically solvent banks and other financial institutions would have been brought down by liquidity issues in the environment of uncertainty and panic, and this would have hit the broader economy even harder than what we have seen.

You don’t even attempt to address this claim in this post, so your post has little to say about whether TARP was a good idea.

I look forward to a future post that actually tackles the issue of whether “TARP was wrong.”

I agree with you that the “success” of TARP is overrated. Yes, the government has succeeded in getting most of its money back, all to the good. And yes, without some kind of support, there would have been more big failures and a bigger crash.

However, the real measure of TARP’s success should be whether it makes the next crisis more or less likely, more or less severe. That is the standard by which TARP does not look so good. Instead, it added to, rather than mitigating, the moral hazard problem–the problem that people who are protected from risks take too many risks. TARP should not have protected bank shareholders–they should have been wiped out, Swedish style. TARP should not have protected uninsured creditors of banks–they should have been subject to deep haircuts, as Ireland is doing with junior creditors of Anglo-Irish bank. And it should not have protected the personal bonuses and golden parachutes of executives who put their shareholders–and the rest of us, at risk.

Unless I am mistaken, TARP refers only to the US Govenerment run fund setup to help illiquid institutions weather the storm. It does not cover the $1 trillion or so of ‘toxic assets’ swallowed by the Federal Reserve as part of the crisis.

Much is made of the banks paying back nearly all the TARP funds, as if we have somehow been made whole by this. I might feel more whole if the (now healthy) banks are forced to repurchase those toxic assets at the same price they unloaded them onto the Federal Reserve. Only then will we truly know if the crisis was purely about liquidity, or if it was really about solvency, and the powers that be are hoping we won’t notice several hundred billion dollars worth of inflation if they can engineer it to be spread out over time.

There is also the issue of the very large, and ongoing, drain of taxpayer funds due to Fannie and Freddie. Since the goverment has to borrow to cover this, they are relying on the Fed to monetize this debt as well. More inflation to come…..

Yes, Main Street would be hurt by a collapse of the financial system, but this particular rescue appears rigged to shunt pain away from shareholders and creditors of these large institutions and onto US citizens via a combination of taxation and inflation.

So my understanding of TARP is that it didn’t buy bad mortgage backed securities, it was mainly a stock purchase fund:

$195 billion spent to buy bank equity shares in general

$40 billion to purchase preferred shares of American International Group (AIG)

$42 billion in stock purchases of Citigroup and Bank of America

$21 billion in loans to automakers and their financing arms through the Automotive Industry Financing Program

Two problems with Arnold’s analysis:

1. Hindsight bias
2. Timelyness

He may be 100% correct but its a little like saying Custer should not have gone to the Little Big Horn. The question is did we know enough at the time to state with confidence that TARP was going to fail?

If I remember correctly, there was panic in the air (partly created by the proponents of TARP). No one was sure how big the problem was.

That said, TARP should have been run down once panic subsided and we learned more. Perhaps 2-3 months? Turning it into a pot of money to deploy for unrelated causes is inexcusable.

One thing I have never seen you econ types address is the capacity of the government to handle the failure of one or more large financial institutions. I think there is general agreement that when any institution makes bad investments, it should fail. But what does this mean in practical terms? Somebody has to manage the failure. Everyone cannot just turn off the lights and leave. This requires accountants and lawyers and courts. In a large complex failure the process could take years.

But…

We cannot allow the process to go on for years, we need banking to function constantly.

I can easily see a conversation where someone tells Paulson that BofA, Citi, AIG and Wells have really screwed up and are in fact insolvent. He is given two choices:

1. Bail them out
2. Deploy his crack team of 22 professionals to run them all down

If the Treasury wanted to restore confidence in the financial system, they wouldn’t have so haphazardly handled the rescue. I opposed TARP, but if they were going to make such a fund to “restore confidence”, it should have been extended to Lehman Brothers. Like Mr. Dolan said, shareholders should have been wiped out and the counter-parties to their debt should have taken a big haircut.

We’ve insulated investors from making bad decisions and have eliminated market discipline on the financial industry. The little-to-zero confidence that was gained by the bailout are far outweighed by the future risks that we’ve brought upon ourselves. Besides the fact that investors have very little incentive to discipline the financial industry, we’ve also got a government that provides zero transparency into how their bailout decisions were made.

The view of TARP by it’s makers, I believe, are this:

* The US suffered a balance of payments crisis.
* So did Japan.
* Biggest threat is deflation.
* Spend money; it doesn’t matter where it comes from.
* Politicians love this, so easier to sell stimulus measures.

This is what happened:

* Congress spawns TARP
* Congress spawns stimulus
* When Congress/Treasury botched both, the Fed stepped in and printed our way out of the mess.

At least we aren’t suffering from hyperdeflation. Let us hope the hyperinflation the Fed sparked to cancel it out, doesn’t come back to bite us.