TARP Or Reconstruction? No Contest

At a conference hosted by Dēmos today, economic experts "lifted the TARP" to expose the flaws in the Treasury Department’s plans to repair the nation's financial markets.

“Lifting the TARP: Is a Reconstruction Finance Corporation a Better Way to Restore the Banking System?”, [1] took a critical look at the Toxic Asset Relief Program and the implicit assumptions and criteria for intervention via the Emergency Economic Stabilization Act of 2008 (EESA). Damon Silvers, who serves as associate general counsel of the AFL-CIO and deputy chairman of the Congressional Oversight Panel on the TARP but who was speaking for himself at the conference, said that the Treasury Department said those assumptions and intervention criteria were:

1.) Protect all existing investors, including equity holders by all means necessary
2.) Keep these transactions off the Federal balance sheet
3.) Basic interventions are targeted at infusing liquidity without due diligence regarding what is being purchased and what price is justified
4.) Losses that have happened are not real, but are caused by a temporary disturbance in confidence that can be staved off by buying time.

Page 11 of the Congressional Oversight Panel’s latest Oversight Report [2], released April 7, states, “This approach assumes that the decline in asset values and the accompanying drop in net wealth across the country are in large part the products of temporary liquidity discounts due to nonfunctioning markets for these assets and, thus, are reversible once market confidence is restored.” But that, “Treasury and key policymakers in the Administration argue that the recently-passed fiscal stimulus passage, Treasury’s foreclosure mitigation plan, and the public-private program to revive markets for toxic assets will strengthen the fundamental value of these assets.”

Thus, as the revelation of losses echoing through the system became more real, the strategy shifted its assumption that all can be restored to its previous state, to the fiat all must be restored to its previous state by implementing programs that subsidize the activities of those experiencing the greatest losses and vulnerability.

This tack represents denial. Even if it were possible or desirable to return to the old system of structured finance and the proliferation of derivatives, Treasury's current outlays fall short of the need. Goldman Sachs has projected losses from U.S.-originated credit assets at $2.1 trillion, the International Monetary Fund estimated $2.2 trillion and Nouriel Roubini estimates losses yet to be written down at $3.5 trillion.

Robert Kuttner, a Distinguished Senior Fellow at Demos and the Co-Editor of The American Prospect, stated unequivocally that trying to restore the old system is antithetical to rebuilding a sound economy given “structured finance is parasitic of the real economy.” Our objective, he emphasized, must be winding down these sectors to approximate a plain-vanilla, pre-1975 banking system.

Thus the bailout efforts that stem from a fundamentally misguided assumption will continue to be misguided. While restructuring is being avoided and markets, instruments and entities are being supported under the assumption these can be temporarily sponsored and resuscitated in the near future, recognizing these losses and managing the distribution of the pain in an orderly, preferably fair way is the only way out of our crisis.

Toward this end, the report focuses on historical examples of financial crises handled correctly. Silvers outlined the sequence of steps all successful interventions share in common:

1.) New management replaces the old in failing institutions, not for moral reasons, but because of the difficultly in objectively evaluating the mess you’ve just made.
2.) The true value portfolios must be made. A hard valuation of the assets of the entities must be made, generally on a cashflow basis, which requires management overseeing the valuation can be trusted to appropriately estimate this revenue.
3.) Once the gap is established, equity is wiped out.
4.) For the remaining fixed obligations there is some flexibility in resolution with possible haircuts and different scenarios possible for debt holders.
5.) In this process, the more taxpayers are participating in funding the restructuring of these failed entities, the more upside should be sought for the taxpayer once these entities are restored and the stake unwound.

Tellingly, Silvers stated, the length of time it takes to get through the three stages—denial, subsidy and government takeover—determines the speed at which the crisis can be resolved and is a directly proportionate to how corrupt the system is.

Kuttner said that the situation of Japan and its 1990s "lost decade"—during which their economy was stuck in the subsidy phase because it was just successful enough to not require the authorities to move to plan B—is where we are headed. The point of this conference was clearly to identify a plan B. As the title of the conference suggests, the answer to, “Is a Reconstruction Finance Corporation a Better Way to Restore the Banking System?” is a resounding "yes."

Two pages of necessary reading identified by Walker Todd, a Research Fellow at the American Institute for Economic Research and former legal and research officer at the Federal Reserve Bank of Cleveland, can be found here [3] under: “Six Lessons Learned from the RFC” page 27-28 and here [4] scrolling down to the bottom to “Stress Testing the Banks”.

As Silvers notes, every moment is a potential moment for correction, but with every moment that passes the more costly it becomes.