The Treasury clearly has a lot riding on the success of the TARP program, as it may be its last shot at restoring some semblance of normality to the markets.
There are concerns that TARP's immediate impact may be only cosmetic, and that the program might create major precedents for government involvement in the financial system. As it currently stands, TARP will have the Treasury buying troubled assets from banks, while separately injecting capital into selected institutions that apply for an infusion (as well as some that don't).
A quick look at Federal Deposit Insurance Corp. data gives a sense of the problem's magnitude. The total dollar value of residential loans on the books of FDIC-insured banks, as of June 30, was $2.8 trillion, of which $1.9 trillion were first liens and $893 billion were junior liens and home equity loans. Banks held another $335 billion in private-label CMOs. Liquidating bad assets at current market prices could result in losses of at least $350 billion, versus their roughly $1 trillion of Tier 1 capital (supporting $13.3 trillion in assets).
There are a number of problems with TARP that may limit its effectiveness. Given the prospect of having to allocate massive realized losses against their capital, it is unclear that banks have an incentive to sell assets into the program in its current form, particularly if capital levels of individual institutions are pushed below regulatory requirements. Conversely, there is something unsettling about the Treasury buying assets at arbitrary above-market prices (in order to reduce banks' realized losses), as this creates the potential for large-scale abuses while providing little to no transparency to asset pricing. TARP also does nothing to bring private capital back into play, which will be critical in returning the markets to more normal footing. Finally, injecting capital into institutions without clear guidelines will likely politicize the process, and give new meaning to the term "government-sponsored enterprise."
A truly effective program should have the goals of recapitalizing and liquefying the banking system while simultaneously improving the transparency of both the financial system and the market for mortgage assets. With some alterations, the TARP program could meet these diverse objectives. Instead of paying arbitrary above-market prices for assets, the Treasury could act as an auctioneer, taking advantage of the large amount of private money looking to buy discounted mortgage assets through hedge and "vulture" funds. In addition to bringing private capital into the process, the auctions would allow for price discovery in what is currently an extremely opaque market. Posting and disseminating auction levels should result in improved pricing for similar assets in the future. The Treasury could then make direct capital investment in banks that liquidate assets, to the extent of their losses. The Fed can aid the process by gradually limiting the mortgage products it allows as collateral for funding, reducing banks' ability to hold bad assets indefinitely.
In my estimation, this makes a lot more sense than the current haphazard approach being taken by the Treasury. Such an approach would help recapitalize the banking system while improving the transparency of both bank balance sheets and the market for mortgage-related assets. This approach also means that banks will receive capital for making difficult decisions and owning up to earlier mistakes, rather than injecting capital through an opaque process. Diluting the interests of current equity holders is a concern. However, the depressed level of stock prices vis-a-vis book value indicates that investors are making their own pessimistic estimates of asset values; as such, improved balance sheet transparency will ultimately bode well for stockholders.
Bill Berliner is a financial consultant based in Southern California. His e-mail address is bill@berlinerconsulting.net
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