TARP Making a Profit.

I think liberals are committing a conceptual mistake touting how much money was made as a result of the TARP fund. (I think it’s also a political mistake, but I’ll leave that aside.) I really liked Ryan Avent’s argument that, as long as the government didn’t collapse, it isn’t hard short-term to make money on an oligarchy when the government puts its full weight behind it:

It’s not hard to do well on investments like those the government made in the big banks and in GM. Where the banks were concerned, the government received shares at prices reflecting market fears that failure was imminent. Having made the decision to stand behind the firms, the government made clear that failure was not imminent. Share prices then recovered, and they rose still further as the crisis atmosphere gave way to economic recovery. If you can buy a company on the ropes and guarantee that it won’t fail, then you’re sure to make money. Indeed, quite a lot of people insisted at the time that the government would make money…

Take any business and extend to it a government guarantee against failure and its value will increase. Now, it’s fine that the government convinced markets that it wouldn’t allow the banks to fail; that was the whole point of the legislation. But having convinced markets that the banks won’t be allowed to fail, the government has accepted some set of unknown future obligations, which are growing all the time thanks to the moral hazard of the government guarantee. It could take itself off the hook for these obligations by credibly demonstrating that it would allow banks to fail in the future, but it hasn’t come close to doing so. The too-big-to-fail banks are bigger than ever, and the regulatory reform law didn’t come close to setting up a framework through which a large, complex, international firm could go down in a period of crisis.

I’d argue it a different way.  The way I explain it to myself is that we should think of a financial crisis as a three step process. First, there is a liquidity event, where the logic of the system can’t hold, the equilibrium switches to a “panic mode”, and in the flurry nobody can tell a solvent firm from an insolvent firm. The government, if credible and if it has the right tools, can step in to stop the panic. The emergency lending facilities and TARP constituted our policy reaction to the liquidity event.

To me the evidence is strong that there was a liquidity event in fall 2008 greater than than underlying solvency crisis, and whether or not TARP was the best approach to the situation, it was successful in stopping a shadow banking run.

The second step is a solvency event. There are bad debts out there, and they need to be sorted and written down. The system is calmed, and our new objective is to figure out the functioning firms from the zombie firms, splitting out good banks from bad banks. The policy responses here was the Public-Private Investment Program (P-PIP), also known as the “Geithner Plan”, which used FDIC as a backstop to pay hedge funds to buy toxic “legacy” assets, assets whose profits would be split with Treasury. This was largely abandoned, and in its place was the stress tests of early 2009 which gave an all-clear.

The last step is a reform event. Whatever tools were necessary to stop the panic needs to be formalized and held accountable. What was broken in the acts of maturity transformation, leveraging and transferring capital from lenders to borrowers need new regulation to remove agent and informational problems. This was the Dodd-Frank Act as well as the international regulation procedures, including Basel III.

These need to move together. Without subsequently handling the solvency issue after a liquidity event it does nothing to fix the sluggish growth and bad debt that hangs around the economy now. And without a strong measure to regulate the shadow banking sector all you’ve done is create moral hazard for the biggest players.

So it doesn’t matter if TARP makes a ton of money.  TARP is only one of three parts of what needed to be done, and to view it in isolation from, say, the stress tests, misses the forest for a tree. If this was misjudged, then no amount of TARP payouts is going to cover the fact that Bank of America and Citi will only get solvent by squeezing every penny out of the bad debt of Americans for the next decade, killing growth and churning deadweight losses for everyone else.   And then they’ll do it again.

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10 Responses to TARP Making a Profit.

  1. Andrew says:


    I like the three step framework. As far as I can tell, your own analysis of the second-lien problem, plus what we’ve subsequently learned about the servicer problems (foreclosure fraud) tell us that step 2 wasn’t done in good faith. As Adam Levitin put it in his appearance before the House committee, the Obama Administration has looked to protect the banking sector rather than make an honest accounting as to its solvency.

    On step 3, neither Dodd-Frank nor Basel III change the fundamental business models of big banks: the Volcker Rule is dead on arrival, and a Republican House is ready to strangle the new Consumer Finance Protection Board in its crib.

    Obviously, this leaves us in a very dangerous position: the Administration has put a lot of tangible capital, as well as political capital, behind very dubious enterprises. It hasn’t acquired much moral capital in return, and going into 2011, neither the banking sector’s balance sheet nor the political sector’s balance sheets have been cleaned up. Good times.

  2. Josh says:

    What puzzles/bothers me the last line from mike’s post “then they’ll do it again.” I agree with the sentiment/prediction, but I just don’t understand how we (or someone) doesn’t seem to be working in a focused way to frame the issue in this manner for the people to see and act upon in a politically meaningful way.

    The conservative spin machine (Norquist, Rove, Ailes, Olin Foundation, et al) could make the message get out there and stick, but they don’t agree with the content.

    Are there any liberal/progressive/fair market capitalists out there who are systematically working to build the message chain that someone can point me to to join up with?

  3. JW Mason says:

    Nails it.

    Will be interesting to see the responses to this.

  4. There is a reason why ALL the world’s governments have steered clear of ‘Door Number 2’ and the likely reason is all of finance is insolvent the same way the real (physical) economy is insolvent.

    Pulling the restructuring thread on world banking’s sweater causes the entire sweater to fall apart in pieces! I guess the Eurozone will get a test of this in a few weeks when Irish voters repudiate their bank’s debts and tell the EU to Fr*ck itself.

    If not them, it will be some other borrowing entity.

    The enterprise has leveraged itself again and again for a reason. To do otherwise is probably fatal.

  5. The three step process is a great way to look at the issue and tease out the individual elements. It lets us look at the short term solutions (which seem to have worked) from the long term reform solution (disaster!). As for the politics of touting the TARP profits, I think the Administration is reaching more broadly than the financial crisis, trying to say “look, we know you hated the bailout, but it actually didn’t cost anything. So we’re not big government at all…we’re small, man.”

    See the link below for the obscure Steve Martin reference


  6. MarketsMike says:

    Complet and utter Horse Hockey.

    Very easy to look in the rear view mirror and suggest that a better approach woud have had various complicated solution sets run in parallel. However, that is not how the world worked.

    First of all, these events began during a different administration, under Paulson’s watch, and he was clearly over matched by the magnitude. Second, without TARP the banks would have melted down, and we would have had a world wide depression – not recession – of previously unknown depth. This was easier to recognize, understand and implement than how to better analyze the banks and regulate them going forward. If that was easy to develop and implement it would have been done before.

    Part of the problem with analyzing (stress testing) the banks was how to establish the value of assets in an illiquid market. What was the mark on a portfolio of derivatives in January 2009? Of construction loans? The risk of a downside mark is that the mark itself helps spiral similar assets (and even the newly marked asset) down even further. So the regulators were in a very precarious place in analyzing and stress testing banks and their assets.

    As far as regulating, this is a process that requires international cooperation. Look how complicated it was just to try to impose income caps on bankers at banks receiving TARP funds (irrespective of the wisdom of such a path). The problem is that if the US acts unilaterally off-shore institutions may have an advantage in winning future business, and may encourage US banks to move more operations offshore. So while it is possible to quickly provide financial support to institutions it is not so easy to develop new ways to regulate them.

    That is why they chose to give the banks money – to ride through the period of illiquidity – because that was something that was within the government’s power to do. You are right that whether they made money is not really the point – but it was critically important that the banks were stabilized and that their doors stayed open.

    To be dismissive about it is either to be naive or to be purposefully obfuscating the truth.

  7. jpe says:

    “If you can buy a company on the ropes and guarantee that it won’t fail, then you’re sure to make money. Indeed, quite a lot of people insisted at the time that the government would make money…”

    But a lot of people were screeching that it was a terrible idea and we’d never get our money back. So it’s entirely appropriate to note TARP’s success given that many, many people thought the government wouldn’t make money.

    “If this was misjudged, then no amount of TARP payouts is going to cover the fact that Bank of America and Citi will only get solvent by squeezing every penny out of the bad debt of Americans for the next decade”

    It’s hard to understand what this means. If you’re using bad debt in the technical sense of a written-off debt, then it’s just empirically false: you can look at their 10-ks and see they’re writing new loans, etc. If you’re using it in a less literal sense of “making loans,” then it’s just nonsensical. It would mean “BOA and Citi will only get solvent by behaving like banks.” Not many people would disagree with that statement, and fewer still would find it objectionable.

  8. financeguy says:

    A lot of people at the time were saying we taxpayers wouldn’t get our money back, true (I could’ve been counted among them). But that was because we couldn’t see how the world was about to change, and I think this is where Avent’s analysis is simple and smart. We thought this was still survival-of-the-fittest capitalism, just with a little help proferred to some fallen giants in our newly disgraced banking system. Instead look what we got: 1. enshrinement of “No More Lehmans” thinking (hence no other major banks or financial institutions would be allowed to fail) 2. banking “stress tests” where you passed if you passed, and passed if you failed, and even if you failed and needed capital and couldn’t get capital, it was made clear that the government would get you that money 3. incredible, unprecedented intervention by the Fed, on a scale that the average Joe can’t begin to comprehend, to prop up the financial system: the Fed buying up $1.3 TRILLION of mortgage-backed securities for starters. If I could’ve seen all this in the crystal ball in the fall of 2008, I would’ve sung a different tune.

    As Avent says, “Take any business and extend to it a government guarantee against failure and its value will increase.” It was not immediately apparent in the aftermath of the TARP injections of capital that this would be the case, that the U.S. government would stand behind its big banks in the same way that say the Chinese government (and I’ve lived over there, and seen how that works) stands behinds its big banks. Over the next year, it did become apparent. What’s the fair value of a share of Fannie Mae, if you know the government will swoop in and rescue the company if it’s in trouble? What’s the fair value of a share of JPMorgan, if you believe the same thing to be true?

  9. jpe says:

    You’re right, it wasn’t immediately apparent to a lot of people like you. And you were wrong. Hence the stories about how people like you were wrong.

  10. Pingback: Weekly Link Round-up For December 3, 2010 | Blueleaf

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