First, let's start with a basic explanation of why the US financial system is so important. The financial system is an intermediary between individuals and corporations and between corporations and other corporations. Banks, insurance companies, mutual funds - all manner of financial companies -- pool many small deposits, premiums and investments into larger pools which are then lent out to business in the form of loans and investments. This in turn provides a steady line of credit to loan out to business and consumers to help them expand. In other words, the modern financial intermediary system is an absolute necessity to the US economy; if it collapses -- or if periods of extreme stress prevent it from operating efficiently -- the economy grinds to a halt.
For the last year and a half the Federal Reserve has done everything it can to keep the US financial system working and operating -- even if on life support. Essentially Bernanke is attempting to prevent a banking panic similar to 1929-1933 from collapsing the economy. As Milton Friendman outlines in his book A Monetary History of the United States a central reason for the Great Depression was a series of financial shocks in the early 1930s which essentially froze the credit system for an extended period of time. This is a primary reason the US economy contracted a total of 25% for the years 1929 - 1933. As financial events unfolded over the last few years, the possibility of systemic failure was high. As a result, the Federal Reserve has taken unprecedented actions. In addition, Congress got in the act by approving the TARP program The reasons for this approval are simple: the US financial system was under extreme stress which continues to this day. Consider the following:
Above is a chart of the financial sector ETF. In the last few years it has lost almost 75% of its value. In other words, investors are betting on severe problems -- at best. In fact, this is a chart that assumes at least one major bankruptcy if not more. In addition, none of these companies can raise capital given their depressed stock prices. As a result, they need other sources of equity financing.
In addition, consider these charts from the latest Quarterly Banking Profile from the FDIC:
24% of all financial institutions were unprofitable in the third quarter of 2008. That's higher than during the S&L crisis.
Earnings weakness has been a problem for three of the last four quarters.
The growth in troubled loans has remained high for the last year.
2008 was a record year for failed bank assets -- and that includes the S&L crisis of the late 1980s.
And consider this executive summary from the same report.
Troubled assets continued to mount at insured commercial banks and savings institutions in the third quarter of 2008, placing a growing burden on industry earnings. Expenses for credit losses topped $50 billion for a second consecutive quarter, absorbing one-third of the industry's net operating revenue (net interest income plus total noninterest income). Third quarter net income totaled $1.7 billion, a decline of $27.0 billion (94.0 percent) from the third quarter of 2007. The industry's quarterly return on assets (ROA) fell to 0.05 percent, compared to 0.92 percent a year earlier. This is the second-lowest quarterly ROA reported by the industry in the past 18 years. Evidence of a deteriorating operating environment was widespread. A majority of institutions (58.4 percent) reported year-over-year declines in quarterly net income, and an even larger proportion (64.0 percent) had lower quarterly ROAs. The erosion in profitability has thus far been greater for larger institutions. The median ROA at institutions with assets greater than $1 billion has fallen from 1.03 percent to 0.56 percent since the third quarter of 2007, while at community banks (institutions with assets less than $1 billion) the median ROA has declined from 0.97 percent to 0.72 percent. Almost one in every four institutions (24.1 percent) reported a net loss for the quarter, the highest percentage in any quarter since the fourth quarter of 1990, and the highest percentage in a third quarter in the 24 years that all insured institutions have reported quarterly earnings.
The above summary paints a picture of an industry under extreme stress. For further points regarding the severity of the current financial situation, see this article which notes that anecdotal information in the Beige Book and the Senior Lender's Survey over the last year highlights an industry in crisis. If this industry were not central to the modern economy, the policy response would be different. But because of the financial systems central role in the economy something must be done.
That brings us to what happened with the first TARP funds. First, here is a link to a PDF of all the institutions that received funds. In other words, we know who received the money. Now the central question is what did they do with the money? That appears to be where the real problems arise.
Let's look at a two key paragraph from a GAO report on TARP:
It is unclear how OFS and the regulators will monitor participating institutions' use of the capital investments. The standard agreement between the Treasury and the participating institutions includes a number of provisions, some in the recitals section at the beginning of the agreements and others that are detailed in the body of the agreement. The recitals refer to the participating institutions future actions in general terms -- for example, that "the company agrees to expand the flow of credit to US consumers and businesses on competitive terms" and "agrees to work diligently under existing programs, to modify the terms of residential mortgages." Treasury and regulators have publicly stated that they expect the institutions to use the funds in a manner consistent with the goals of the program, which include both the expansion of the flow of credit and the modification of the terms of residential mortgages. But it is unclear how OFS and the banking regulators will monitor how participating institutions are using the capital investments and whether these goals are being met. The standard agreement between Treasury and the participating institutions does not require that these institutions track or report how they plan to use, or do use, their capital investments.
We spoke with representatives of the eight large institutions that initially received funds under the CPP, and they told us that their institutions intended to use the funds in a manner consistent with the goals of CPP. Generally, the institutions stated that CPP capital would not be viewed differently from their other capital -- that is, the additional capital would be used to strengthen their capital bases, make business investments and acquisitions and lend to individuals and businesses. With the exception of two institutions, institution officials noted that money is fungible and that they did not intend to track or report CPP capital separately.
The contracts do not contain specific terms but instead use general terms and concepts. In other words, this is really poor contract drafting. That does not mean these are fatal flaws. I would argue that assuming the recitals (which are placed at the beginning of a contract to provide a general context) are fairly clear, the recipients don't have nearly as much leeway as the press about this program would imply. The bottom line is the program was put in place to bail-out financial institutions, allowing them to remain viable. For an institution turn around and argue "we didn't think the money was for that" strains credulity. The second paragraph from the GAO report cited above indicates the financial players are aware of the intention of these injections. This means all the parties are on the same page.
It's also important to remember the financial situation these institutions are in as expressed in the FDIC report above. Simply put, these institutions don't have a lot of options with what to do with the money. Loans are going bad at fast rates, loan loss reserves are increasing, and revenue is falling like a stone. Simply put, the money can realistically only go one of a few places -- Tier 1 capital or loan loss reserves. And given that the government's preferred shares are classified as Tier 1 capital on the institution's balance sheets, physically placing the money received in Tier 1 capital makes the most sense (or more accurately, using an appropriate accounting entry).
All that being said, there is a lack of credibility on the part of all the players here. Financial institutions' lack of prudence got us into this mess and Congress has shown a remarkable ability to not think anything through beyond the next news cycle. To solve the problem, the parties should do the following.
Add an addendum to all the contracts which states the money can go for one of three purposes:
1.) Pure Tier 1 capital
2.) Loan loss reserves, or
3.) Purchasing distressed institutions
If all parties agree then there is no issue form a legal perspective. Considering most of these institutions will probably need further financial help from the government it's in their interest to agree. In addition, future TARP contracts should have these provisions clearly stated at the beginning of the contract and then within the contract's terms.
In addition, it should also be stated the money will not go for any other purposes, including but not limited to dividends, bonuses, executive pay etc... Again -- I'm assuming the contracts already signed aren't specific enough in this regard.
One final point. The GAO report makes a very prudent observation. This program is a mere 60 days old. It is foolish to expect perfect execution -- especially considering the severity of the problem and the complexity of the solution. That's not to say mistakes should be tolerated. But mistakes should not be over-reacted to either.
My guess is that much of the anger over TARP has as much to do with how we got here rather than what is actually happening with the program. Put another way, there is understandable anger about the stupidity that has cost the US economy dearly over the last year. That anger is understandable. A perfect storm of lack of regulatory enforcement, greed and outright stupidity combined to place the US in the worst financial situation since the early parts of the Great Depression.
However, I would caution that the anger be stored away from the current discussion and instead brought out when we discuss reform which will be forthcoming. Right now the goal is to keep the economy moving -- or, perhaps more precisely, to keep it from falling off a cliff. It's a bit like lecturing a drunk driver while he's in the emergency room; yes, he needs to be dealt with, but it's more important at that time to keep him alive. That's what we have to do right now -- keep the economy alive.
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