The Troubled Asset Relief Program
By Stephen Smith
April 8th, 2009
Putting the financial system in working order remains the ultimate priority facing government policymakers. An economy’s natural, self-correcting mechanism during a recession is for interest rates to fall as the Federal Reserve lowers monetary conditions and demand for credit abates. The financial system is in such a distressed state that credit availability has remained difficult and borrowing rates have been elevated, despite historically low policy rates (Fed Funds rate at or near zero). The financial crisis continues to exaggerate the economic downturn by choking off the flow of cheap credit that has played a role in previous economic recoveries. The original idea of the $700 billion Troubled Asset Relief Program (TARP) was to relieve banks of the troubled assets that weighed on their balance sheets and depleted their capital. Most of the first portion of TARP (over $350 billion) was spent directly recapitalizing banks through the purchase of preferred stock, in addition to customized rescue operations for a handful of the country’s largest institutions. The unsettled environment and uncertainty about the value of impaired assets still on the balance sheets of financial firms has inhibited any potential recovery in confidence or lending.
When the credit market is not functioning or not able to repair itself, two critical things need to be done: first, a large amount of capital (taxpayer money) needs to be committed to the rescue effort so that there are sufficient resources to stabilize the system; second, troubled assets must be dealt with quickly so that financial institutions can recapitalize and achieve the necessary health and confidence to resume normal lending. The first portion of TARP helped satisfy solution number one. Directly recapitalizing banks through the purchase of preferred stock was a worthwhile approach that had previously worked in Sweden. The recapitalization since October may have worked if the price of distressed securities had stopped falling. The condition of the underlying borrowers of mortgages, auto loans, and commercial loans, however, have all declined in recent months, leaving a continuing deterioration in the value of banks’ loan portfolios, that has left a black hole of future losses on their balance sheets.
The missing piece was that TARP had not removed the troubled assets. Treasury Secretary Geithner recently announced details of a plan to rid bank balance sheets of these toxic assets. Under the plan, the government will pair $75 to $100 billion in TARP funds with money from private investors to purchase troubled assets at prices to be determined through an auction process called the Public Private Investment Fund. If all works as hoped, government financing and insurance incentives will spur private investors to purchase distressed assets from banks, providing liquidity and pricing for these assets. Investors should be more willing to provide new capital to banks once their fears are allayed by the improved transparency and health of the banks’ balance sheets. The credit system will then have laid the foundation for self repair, as banks are freed from concerns about solvency and can turn their focus to providing credit, and initiate a lending recovery that supports economic growth.
