REQUIRED READING: The closest historical analogue to the Troubled Asset Relief Program (TARP) is the Reconstruction Finance Corp. (RFC) of the 1930s. Like TARP, the RFC was created under a Republican administration, and expanded under the succeeding Democratic one – in the case of the RFC, the Hoover and Roosevelt administrations – as an emergency response to that era's financial crisis. In both cases, the original liquidity idea – loans for the RFC, troubled mortgage asset purchases for TARP – developed into a solvency idea: providing additional equity to banks in the form of preferred stock.
Consider the approaches available to a government to address a financial crisis. First, there is delay in recognizing losses while issuing assurances (e.g., ‘The subprime problems are contained.’)
Then, there are central bank lending operations, providing liquidity. But however freely the central bank lends, by definition, it is providing debt, not equity. No matter how much it lends to entities with negative capital, the capital is still negative. When the capital is gone, new capital – not just liquidity, is needed.
The RFC made preferred stock investments in banks to offset the capital that had been lost. Its goal was to have a modest overall positive return on the taxpayers' money and redemption of the preferred stock at par when growth resumed and the firms were refinanced in the private market. By and large, this strategy appears to have succeeded.
TARP has made investments in almost 700 financial companies. The RFC made investments in over 6,000 banks, including such major banks as National City Bank of New York, Chase National Bank, Manufacturers Trust Co., National Bank of Detroit and Continental Illinois. The vast majority of these were retired in full, after paying dividends along the way.
The RFC also assisted over 1,000 savings and loan institutions. Counting by the number of financial institutions involved, the RFC was about 10 times as big as TARP.
The RFC's bank equity investments totaled about $1.3 billion – scaled to the nominal gross domestic product (GDP) of 1933 versus 2008, this would be the equivalent of about $325 billion today – compared to TARP, which has a few gigantic investment positions. The RFC was also involved in numerous other areas, with a total of $10 billion spent fighting the Depression, which would be the GDP-scaled equivalent of about $2.5 trillion.
The RFC, like TARP, got involved in transportation companies. In the RFC's case, this was financing for railroads, which are said to have been the worst at paying of major investments. This seems likely to be true of TARP's automobile company investments, as well.
A business approach
The RFC was run by a conservative Texas Democrat, Jesse Jones, an eighth grade dropout who was a tough minded and successful entrepreneur.
‘There was a disposition on the part of President Roosevelt to use the RFC as a sort of grab bag or catchall in his spending programs,’ Jones wrote in his memoir ‘Fifty Billion Dollars – My Years with the RFC,’ ‘but I insisted on its being operated on a business basis with proper accounting methods.’
‘On a business basis.’ In my view, the managers of TARP are fiduciaries for the taxpayers as involuntary investors. The principal goal should be to run the program in a businesslike manner to return as much of the involuntary investment as possible to its owners, along with a reasonable overall profit. The predominant discipline should be that of investment management, not politics.
The language of the Emergency Economic Stabilization Act of 2008 (EESA), which authorized TARP, always speaks of TARP as acquiring assets. In acquiring preferred stock in banks, TARP became an investor in assets different from the original idea, but they are still assets, which can be managed in a businesslike way to recover the taxpayers' investment.
However, with the $50 billion Home Affordable Modification Program (HAMP), TARP is not acquiring an asset at all, but simply spending taxpayers' money to subsidize mortgage loan modifications, including subsidies to mortgage servicing companies. There is no asset acquired.
The Wall Street Journal reasonably suggested its fear that TARP is morphing into ‘an all purpose bailout fund.’ And very conveniently, whatever TARP spends is, under EESA, automatically appropriated by Congress. An obvious difference between the RFC and TARP is that the RFC was a corporation – a government corporation, to be sure, but a separate corporate entity, with dedicated management and a board of directors, its own borrowing authority, and of course, the ability to account for itself as a corporation.
‘U.S. policy-makers of the 1930s,’ wrote a student of the RFC, Walker Todd, ‘enacted a separate, politically accountable’ organization, with ‘a clearly defined network of checks and balances.’
In general, it seems that such interventions as TARP or the RFC, if they are to exist, are better established as separate corporations, rather than as ‘programs,’ mixed into other entities such as the Treasury or the Federal Reserve.
Jones also stated that he ‘insisted onâ�¦proper accounting methods.’ In contrast, it appears that in more than a year, no financial statements for TARP have been produced for the Congressional Oversight Panel or the public. While EESA only requires an annual fiscal year financial statement, presumably forthcoming though not yet produced, good managerial practice and proper accounting methods require, at a minimum, quarterly financial statements.
TARP should have full, regular, audited financial statements, that depict its financial status and results, exactly as if it were a corporation. There should be a balance sheet, with all assets, liabilities, accumulated profits or losses, and contingencies.
There should be a profit-and-loss statement and a statement of cashflows. The expenses should include the interest cost of the Treasury debt required to fund its disbursements, and like every financial operation, TARP management should be estimating probable losses on investments and reserving accordingly.
Had TARP been organized as a corporation, it would have facilitated this accountability. But even with its status as a ‘program,’ we should insist on appropriate and regular accounting. Everybody must agree with this basic requirement for financial responsibility.
Moreover, TARP's financial statements should include line-of-business reporting. Logical separate profit and loss reporting units would include the Capital Purchase Program, automotive program, Citigroup, American International Group, mortgage modification (of course, a total loss from the TARP point of view), and small-business and consumer programs.
An essential principle is that government crisis interventions should be kept temporary. They should not be allowed to morph into permanent economic distortions. ‘Emergencies markedly increase both the demand for and the supply of governmental controls,’ as Robert Higgs wrote in ‘Crisis and Leviathan.’ The emergency programs need to be turned off when the crisis is over, allowed to wind down over time and finally disappear, as the RFC did after having its life extended by the crisis of World War II.
Over the last several months, financial markets have greatly recovered and rediscovered their taste for risky assets. Although obvious problems remain, especially in the smaller banks, the extended panic of summer 2007 to spring 2009 has passed.
It is easy to imagine how much the Treasury and the administration generally would like to extend as long as possible the power and independent capacity they enjoy through the operation of TARP. But in my view, it is time to observe its target expiration date of Dec. 31, 2009. The very fact that TARP disbursements are, by law, automatically appropriated, is reason enough to enforce a timely expiration.
Current financial context
The collapse of the vast bubble in housing prices has had national average prices, as measured by the Case-Shiller National House Price Index, falling about 30% from their mid-2006 peak. Prices have now returned to their long-term trend line.
Of course, prices can overshoot the trend on the downside, too, but a great deal of adjustment has already taken place. However, we have experienced not just a bubble, but a double bubble in real estate prices: one in the residential sector and one in the commercial real estate sector. The two bubbles are remarkably similar in shape, but the second lags the first by about a year and a half.
Smaller banks are disproportionately concentrated in real estate risk, and in commercial real estate risk in particular. Their concentrations in real estate loans have been growing steadily since the early 1990s, and real estate loans became 74% of the aggregate loans of the 6,500 banks with assets of less than $1 billion. The implications of difficult credit conditions ahead are easy to see.
At the same time, the Federal Deposit Insurance Corp. (FDIC) has announced that its net worth is negative – that is, the deposit insurer is out of capital. Perhaps, before its Dec. 31 expiration, TARP should make a preferred stock investment in the FDIC?
According to a cumulative profit-and-loss statement published at the beginning of 1940, the RFC had a cumulative net profit, after providing for losses and the cost of debt, of $160 million on its capital of $500 million.
‘The program of putting capital into banks,’ wrote Jones, ‘was carried out without loss to the government or the taxpayer. On the contrary, it has shown profit through interest and dividends.’
If TARP should succeed in making a final overall profit, what should be done with that profit? I know that EESA provides that all revenues from and repayments of TARP investments must go to reduce the federal deficit.
Section 134 of EESA provides that if there is a final shortfall in TARP, ‘the president shall submit a legislative proposal that recoups from the financial industry an amount equal to the shortfall in order to ensure that TARP does not add to the deficit or national debt.’
Of course, Congress may not enact the required presidential proposal, but this provision is one more good reason to demand full and proper accounting from TARP.
Alex J. Pollock is a resident fellow with the American Enterprise Institute for Public Policy Research in Washington, D.C., and former president and CEO of the Federal Home Loan Bank of Chicago. He can be reached at apollock@aei.org. This article is adapted from recent comments made before the Congressional Oversight Panel of the Troubled Asset Relief Program.
