How TARP Began: An Exclusive Inside View
When it first came into existence last September, TARP—the troubled assets relief program—sounded like just another ungainly government acronym. But since then, it has become an integral—and controversial—part of America's recession economy.
TARP's chief architect was Henry "Hank" Paulson, President Bush's treasury secretary, who led the financial rescue along with Federal Reserve Chairman Ben Bernanke and New York Fed Chairman Tim Geithner, who's now Paulson's replacement at treasury. Their initial plan was to use the $700 billion in TARP funding approved by Congress last October to purge financial firms of their so-called toxic assets.
[See why the banks still aren't fixed.]
But TARP morphed into an über-bailout that included direct cash injections into banks, the auto rescue, the AIG intervention, and other government efforts to revive the economy. If it sounds like a trial-and-error experiment, well, that's how it felt to the policymakers who designed it, too. "When we looked for easy solutions, we kept coming up empty," says David Nason, who was a senior Treasury Department official during the Bush administration. "Hank used to say all the time, 'We're going to have to do this with duct tape and fishing wire.' "
Nason and some of his Treasury colleagues did much of the jury-rigging, running doomsday scenarios, negotiating emergency deals with banks, wooing incredulous members of Congress, and devising ways to deal with problems once considered unthinkable. Frustrated Treasury Department officials, for instance, foresaw much of the carnage but found themselves poorly equipped to stop it. Anxious finance ministers from around the world began calling Treasury last summer to find out what the government planned to do about the developing crisis. The most tense moment may have been the September failure of Lehman Brothers, which occurred with alarming speed after British financial regulators scotched a takeover bid by the British bank Barclays.
[See 6 surprises from the recent bank stress tests.]
Nason and two other former Treasury officials, Philip Swagel and Kevin Fromer, spoke recently at a panel discussion sponsored by the Milken Institute. Their remarks form one of the most thorough accounts to date of how the government struggled to contain the worst financial crisis since the Great Depression. (See a video of the full discussion, which I moderated.) Here's a condensed version of their remarks:
David Nason, former assistant treasury secretary for financial institutions: The first inflection point was March 16, 2008, which was the acquisition date by JPMorgan Chase of Bear Stearns. The sheer time it took for this institution to go from viable to nonviable was breathtaking. Just two days before, the regulator [the Securities and Exchange Commission] had said Bear had adequate liquidity of $8 billion. This is an important inflection point because it was the first time the government had stood up and said we are going to support nonbanking institutions. We knew at that point the times had changed. We knew the policy ramifications were going to be very difficult and far reaching.
[See 5 signs the bailouts are getting better.]
We worried most significantly about the consequences of other similarly situated firms. It was a very trying and stressful time because when we looked for easy solutions, we kept coming up empty. The government did not have a ready-access pool of money to support or manage the resolution of financial institutions. The political climate was very challenging—at the time, people saw this as a bailout for fat cats on Wall Street. And there was some jurisdictional squabbling in Washington.
Philip Swagel, former assistant treasury secretary for economic policy: Right after Bear failed, the economy looked like it was actually in pretty good shape considering the problems in housing and the financial sector. Overall growth was positive, driven especially by exports. In the wake of Bear's failure, we looked at options, including many things that are now familiar: buying assets, insuring assets, buying pieces of pieces of institutions, in other words injecting capital, and a massive bailout from the bottom from refinancing every troubled homeowner. And we said those are all things you could write down, but back then, you had rebate checks that had been enacted but weren't yet going out, and we had positive growth. It would have been hard to imagine getting the authority to do those things or the approval from Congress for a contingency fund in case things got worse.
Nason: The next inflection point was July 2008. The government was worried about the big investment banks, CDS [credit-default-swap] spreads were blowing out, we were also worried about Fannie Mae and Freddie Mac. These were some of the most leveraged institutions on Earth. Together, they had over $5 trillion in exposure if you consider the guarantee obligations that they had. Match that against about $60 billion in capital. We were also concerned that the housing correction was turning out to be significantly worse than the GSEs [government-sponsored enterprises, such as Fannie and Freddie] expected. We were very concerned that the GSEs were being overly optimistic about their ability to manage risk and withstand future losses.
[See the best and worst bailed-out banks.]
The GSE equity prices were getting punished during this time. More important to us, however, was the debt market. It was very clear to us there's no way the U.S. financial system is going to allow a firm the size of Fannie Mae to collapse( NB DON ). We were very worried about the trillions in debt they had outstanding, and what it would do to confidence if we let that debt go.
At this time, the Treasury was getting calls from finance ministers' offices from different parts of the world inquiring, "What is the government's relationship with Fannie Mae and Freddie Mac?" It's odd, but this appeared to be the first time that people were focusing on the fact that these are quasi-governmental institutions.
During this time period, the home loan banks, another GSE with similar exposure to the housing market, decided to postpone an auction. Every auction was something that we focused on and were worried about.
[See the banks most likely to pay back their bailout funds.]
We made the decision based on this set of circumstances that we had to support the GSEs. How were we going to do that? What did we have in our toolbox? Essentially nothing. We had about $2 billion of backup credit support for the GSEs. For $1.4 trillion organizations. This was clearly not enough to support these institutions in any real way. And we had no ability to provide any kind of equity support at all. So we decided we had to go up to Congress, bite the bullet, and ask for authority to backstop these institutions.
On July 30, 2008, the president signed a bill into law to provide equity support to these institutions. And we had the ability to support their debt up to the federal debt limit.
We made the judgment not to request the authority to nationalize the GSEs. It would have muddied the political discussion. I'm not sure we would have gotten the authority, and at this time, there wasn't a pressing need to do so. There's a long, tortured story about how the GSEs and Washington interface. But we wanted to have broad authority to support the GSEs and prevent their collapse.
[See why the auto bailout is a good model for other struggling firms.]
The entire month of September was an inflection point under my definition. But the first inflection point associated with September is Sept. 7, 2008, when the GSEs were forced into conservatorship. That came after regulators determined that they were drastically undercapitalized.
Two days later, AIG's stock fell 19 percent. Lehman's discussions to sell itself to the Korean Development Bank failed. The next day, Lehman put itself on the market for sale, with no clear takers. After some very tense discussions about whether there would be a purchaser, like JPMorgan was for Bear Stearns, we were very distressed to know that there were no takers.
So from the 10th to the 14th, the Federal Reserve, with the Treasury's support, decided to flush the system with liquidity. The Federal Reserve expanded the level of collateral the primary dealer credit facility would take, they increased the collateral that the term securities lending facility could take, and they increased the ability of banks to support nonbanking institutions. The government was putting "foam on the runway" to try to deal with what we were afraid of, which was how the market would react to a Lehman Brothers bankruptcy.
The next day, Lehman Brothers filed for bankruptcy.
The question is: Did we let Lehman Brothers fail? That assumes it was a choice that we made. The simple truth is that the government was presented with an institution with a $600 billion balance sheet, with enormous leverage. Confidence in the institution was virtually nonexistent. The only way to stabilize a firm under these circumstances is to stop a run on the institution, stop counterparties from claiming their debts should immediately come due. That was manageable in the Bear Stearns situation because someone was willing to guarantee all or most of those liabilities.
[See how bailouts can butcher capitalism.]
The public posture was that government support would not be available. But there wasn't a single credible buyer at the table who was turned away by us.
So when people ask, "Why did you let Lehman Brothers fail?" I ask, "What is the deal that the government turned down that would have prevented Lehman's failure?" If there's not someone willing to take on a balance sheet as large as that of Lehman Brothers, what is the government to do? The government has a few options: We have a lending facility at the Fed, you could provide a loan to them secured against collateral, or you could guarantee all their liabilities. That might have been the right decision, but we had no authority to do that before TARP.( NB DON )
Looking back, if we could have plugged some of the holes in our authorities, maybe this could have been done differently. I don't think we would have gotten those authorities if we had asked for them before September.
[See why the feds rescue banks, not homeowners.]
Of course, things continued to be unpredictable. We didn't predict that the U.K. bankruptcy process would essentially destroy all confidence in that funding model and that business model. And we didn't expect that the commercial paper market would essentially shut down because Lehman Brothers' commercial paper was impaired. Those two markets were the transmission vehicles that killed confidence, which we didn't expect.
That same day as Lehman, Bank of America acquired Merrill Lynch. We didn't have a second to catch our breath. The day after the Lehman bankruptcy, AIG got a $50 billion loan from the Federal Reserve. There was no significant discussion over whether the Federal Reserve was going to provide backup facilities to AIG because of two distinguishing characteristics: One, they were huge. They were global. They were bigger than Lehman Brothers. But the more important distinction is that the Fed is in the business of providing loans when it is "secured to its satisfaction." And AIG had the benefit of having solvent, highly regulated, very valuable insurance subsidiaries to which the Federal Reserve felt comfortable extending its loan facilities.
[See more companies likely to fail this year.]
After that we get to Sept. 17 2008, which was essentially the creation of the TARP concept. It was at that point that there was a meeting of the minds between Paulson, Bernanke, and Geithner that enough is enough, we're going to break the back of this crisis, and we're tired of not having the tools to deal with this crisis. And the judgment was made that we were going to ask for broad authority from Congress.
At that point, it was essentially 24-hour duty at the Treasury Department. Some people slept there.
Kevin Fromer, former assistant treasury secretary for legislative a ffairs: For context, this was a program about the size of the entire federal operating budget on an annual basis. Congress usually works through that process for 10 or 15 months, just to keep the lights on. We were asking Congress for $700 billion in basically a week or two. In the context of a national election. An election year is typically not the year to do big things.
We had one week left in the legislative calendar. It was not possible to do it in a week. I wasn't sure it was possible to do it at all. We needed to get somewhere fast, so we sent up the infamous three-page bill, which was draft legislative text the committees needed to start the discussions.
[See why the markets hate the idea of bank nationalization.]
Swagel: It was very difficult to say, if this shock happens, you will get this economic effect. In September, the nation as a whole didn't understand that what was happening in the credit markets would matter to them. There was this sort of Wall Street-Main Street divide. It was hard to explain to people why this mattered.
The week of Lehman and AIG, there was a panicked flight from mutual funds, and that led to a lockup in commercial paper. In our view, that was really the key, the CP market breaking down. That had a direct link to investment. Businesses use that to fund their daily operations. That would lead to a direct plunge in business spending, and that's exactly what we've seen over the last two quarters. A very sharp decline in business investment.
The one-month Libor [London interbank offered rate] spread is a measure of stress in bank lending. It's really, do you trust a bank to hold your money for a month. After that week, the stresses in the bank funding markets were huge. To us, that week, it looked very much like a run on the entire financial system. ( NB DON )
Nason: We were afraid of a complete and utter collapse of the global financial system.( NB DON )
Swagel: Imagine if the Fortune 500, blue-chip companies, can't buy paper clips or meet their payroll. All the things these firms rely on money-market funds and commercial paper for. And it goes downhill from there. It starts with the big firms and then every firm in the nation.
Fromer: This was an extremely difficult communications challenge. It made it enormously difficult to sell the package to Congress and for them to sell it back home. They were angry when they came back from home after the election. They had seen the amount of money they were being asked to put into institutions, getting anecdotal information from small businesses and lending institutions, and the picture was, we've invested significantly in these institutions, and we're not seeing credit flow to consumers and small businesses.
The markets were volatile for quite some time, and people became desensitized to volatility in the markets. What people didn't understand, which was quite reasonable, was the credit markets, how credit is provided in this country. That's not a criticism; it's arcane to anybody without a certain educational background. It's an almost-impossible-to-explain set of circumstances.
Nason: People were getting used to seeing the stock market go up and down. We were trying to explain, "What's happening in the equity market is not really what we're worried about. We're worried about some other market that you've never seen and aren't familiar with," and people look at you like you're insane because you're asking for $700 billion and you can't provide anything besides a chart to show why it's important.
[Here's the chart, which shows how rapidly widening credit spreads reflect a seizure in the credit markets.]
People could appreciate the money-market mutual funds situation. There is $3.3 trillion of money invested in money-market mutual funds. A panic in these funds helped in terms of selling the importance of our message. And the commercial-paper market stress was important in communicating this as well. If that market collapses, you could have huge employers saying, I'm going to start laying people off. I'm going to start shutting plants down, I'm going to start defaulting on my bonds, and that's going to trigger bankruptcy( NB DON ). Those are the kinds of things you had to say, in the doomsday scenario, to convince people that this was critical to the system.
After [the first TARP vote] failed in the House [on September 29], then the equity markets finally responded. [The Dow Jones industrial average plunged 778 points.]
Fromer: It was clearly a response that forced a number of people to say, "OK, we get it now."
Swagel: Even after the legislation passed, stresses in bank funding still got worse. So we got what we needed; we were thinking about buying assets, but we needed to think more broadly.
Nason: There were two purposes at the time. This is a critically important point and something the current administration is suffering under. The dual purposes were financial system stability and provision of credit to the economy. People are not focused at all on the fact that the former is the primary reason we went up and asked for emergency authority. To derail a total breakdown of the financial markets and the global financial system. And we believe and hope that the confluence of programs put into place in a very short period of time actually did that.
The second part of it is, getting credit flowing into the economy. People seem to only focus on, "Why isn't this money being put into the economy?" That's important, of course, but you have to remember a significant portion of this money was there to be a buffer against future losses.
Swagel: To me, the stabilization of the financial markets is the salient accomplishment of the TARP and the actions of the Treasury in the fall. The normal playbook for dealing with a bank crisis is first, winnow out the banking sector so the zombie institutions don't clog up the credit channels and divert resources. As a society, I'm not sure we're going to do that. Next is stabilize, inject capital into the firms that are left so they're still viable. And No. 3 is do something about the balance sheets. Give certainty about the performance of the assets and the viability of the firms. I think we did No. 2, we stabilized the system. No. 3 is still the ongoing challenge.
Nason: The reason the TARP morphed from asset purchases to injecting capital is really quite practical. Asset purchases were taking longer than we had hoped, and it was more complicated with the vendors. Also, we needed to be in lockstep with our brethren around the world. The U.K., France, and Germany were prepared to guarantee the liabilities of the banking sector and were going to deploy capital into their banks.
Fromer: The folks in place right now clearly have the advantage of looking back at what we did and the conditions that existed when we did it. They're benefiting from experience. A number of them were part of the process going back to last summer.
Swagel: The job of the TARP has not been done, but the first step is done. In terms of the larger picture of what matters to families, we're still pretty far away from getting back to normal.
Nason: There are still valuation problems with a lot of the assets on bank balance sheets. Then we still have to deal with inevitable credit contraction.
Fromer: It's not conceivable to me that there's a TARP II. It's going to take time for these programs to stand up and operate and invoke full participation from all quarters. Given dynamics right now, I think it's unlikely there will be another TARP."
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I found the paper fascinating. A few points:
“The Fed can lend,
however, against collateral to its satisfaction, so in principle the Fed could have lent
against Lehman’s unencumbered assets—essentially what it did with AIG. This would
not have saved the Lehman—indeed, it would have concentrated losses on the rest of the
firm—but it is possible that such lending could have provided time for a more orderly
dissolution of the firm (indeed, there are estimates that the disorderly bankruptcy reduced
the recovery value of the firm by billions of dollars). The feeling at Treasury, however,
was that Lehman’s management had been given abundant warning that no federal
assistance was in the offing, and market participants were aware of this and had time to
prepare. It was almost as if Lehman management was in a game of chicken and
determined not to swerve.”
1) The point is that saving Lehman would have allowed a more orderly unwinding, and, yes, the added losses were substantial.
2) Lehman assumed an implicit guarantee on a bailout, and acted as though they did. This should have been known, as later bailouts have shown that this was a widely understood part of the underlying basis of the financial system; namely, implicit government guarantees.
“The events together led to a run on money market
mutual funds, and this in turn caused commercial paper markets to freeze. If left
unstopped, this would have led issuers of commercial paper to turn to their backup lines
of credit—meaning that banks would have needed to massively fund these lines
simultaneously under circumstances that were never contemplated and then hoard capital
against those lines. As discussed by Ivashina and Scharfstein (2008), banks in the fall of
2008 did fund these lines as companies drew on them as a precautionary measure, but this
played out over time rather than all at once.
From the Treasury perspective, there appeared to be a broad run on the financial system.”
Yes, a Calling Run resulted, the beginning of Fisher’s Debt-Deflation Spiral. Since Bears had supposedly been saved to forestall a Calling Run, why the decision not to intervene here?
I have more points, but I’ll take up no more space.