Thursday, December 9, 2010

More on TARP

Karl Smith has kindly responded to my post on TARP:

Then a broker-dealer went bankrupt. The process of chaos began to unfold. We had what looked very much like a run. Given that narrative the response was to somehow stem the run. This meant insuring creditors against losses.

Various schemes were proposed. In the end equity injections were settled upon. The terms where not what I would have wanted but I understand the pressure of being in the moment.

After the equity injections our measures of panic began to subside and indeed have not come back despite the fact that housing has not recovered. This lends credibility to those of us who said that housing and bad loans mattered only to the extent that they were possibly creating insolvency and fueling a run.

Do we know for sure that this is narrative is correct – no. However, the level of certainty I think Gupta is asking for is virtually never available to us in real time and is hard to ascertain even looking back. My core case is that the narrative holds and continues to hold as we accumulate more data.
The ultimate argument here is "Things were going very bad; we did something; and things ended up much better than we expected. Maybe things could have gone better, but things did end up going surprisingly well."

First -- there's the question of whether or not TARP "helped." Ultimately, this relies on the unknowable counterfactual of what the world looked like without TARP. It also relies on assuming that the entire recovery was due to TARP. Yet as Donald Marron points out, "One reason that TARP appears much less expensive than originally predicted is that many of its investments benefitted from other government actions whose costs show up elsewhere in the budget." We did a whole lot to help the banking sector, and would undoubtedly have done even more without TARP. So to give it the whole credit is probably a bit much.

There's also a key phrase here -- "in the end equity injections were settled on." This is an interesting way of putting it. What actually happened is that Treasury asked for a virtual blank check ostensibly to support asset purchases, and then decided to purchase bank equity instead because they wanted to.

It's worth emphasizing again that the narrative that Treasury was selling -- that the world would collapse if we didn't purchase toxic mortgage assets -- was completely wrong. In fact we didn't purchase many toxic assets, and the world went on. Had we enacted TARP as envisioned, written into law, and sold to the public -- the result would have been hundreds of billions of dollars of taxpayer losses.

So the fact that we "settled on" equity injections reflects my primary opposition to the bill -- that we basically left the decision of how to spend $700 billion dollars in the discretionary hands of the Treasury. We are indeed fortunate that Congress failed to implement any meaningful oversight on the bill and the ultimate decision Treasury opted for was not the worst thing in the world (though, of course, TARP money has also been used as a political slush fund for things like HAMP, auto bailouts, etc.). But what was at stake in the bill was really the democratic principle that the legislative branch, not unelected bureaucrats, decide what we spend money on. Do we really think that giving Treasury the right to spend hundreds of billions of dollars is a good idea? Can we continue to rely on them reading the right bloggers?

I am sympathetic to this view though I take a slightly different tact. I tend to think that the government should have simply squeezed the financial system for everything that it was worth on the grounds that its the responsibility of the Treasury Secretary to act in the best interest of his clients. The taxpayers were his clients. Making more money for you clients is generally preferable to making less thus he should have tried to make more money.

However, it is important to note that TARP as structured was profitable on the bank side. It wasn’t simply that the taxpayer got his or her money back. Their were warrants that that gave the taxpayers a bit of the upside. I just don’t think they were big enough.

I understand the moral outrage and all but my general take is that the Government in this capacity should act to maximize taxpayer profits, not express taxpayer outrage. I realize that this is not a majority view.

Since when is the government supposed to run a hedge fund? Since when should the maximization of "taxpayer profit" be an objective of government?

The issue here is why is the government doing this at all? If the government made money on at least some of its investments; and the banks did well; why couldn't private capital flow in?

Everyone agrees that banks in 2008 needed to be recapitalized. But it was an open question whether this would be achieved through bankruptcy, or some mechanism of forcing banks to raise capital, or so on. There were a lot of options, each with costs and benefits. Some of them wouldn't have involved public money.

Unfortunately, it looks from Swagel's account that Treasury -- though aware of this problem -- spent months doing nothing about this. They wound up in September with a three-page plan that, as I've mentioned, would have barely helped. Perhaps they had the excuse that they were rushed and didn't have the time to properly consider, say, Zingales' bankruptcy proposal. But it's been several years since then, and Treasury doesn't have any serious bank resolution mechanisms that don't require public money.

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