Paulson Pulls Back the TARP

This morning, Secretary of the Treasury Henry Paulson provided an update on the use of the $700 billion bailout package so far and the plans for using the remaining funds.  Key sections of his remarks are presented below, along with my commentary interspersed.

"Current State of Global Financial System

"The actions taken by Treasury, the Federal Reserve and the FDIC in October have clearly helped stabilize our financial system. Before we acted, we were at a tipping point. Credit markets were largely frozen, denying financial institutions, businesses and consumers access to vital funding and credit. U.S. and European financial institutions were under extreme pressure, and investor confidence in our system was dangerously low.

"We also acted quickly and in coordination with colleagues around the world to stabilize the global financial system. Going into the Annual IMF/World Bank meetings in early October, I made clear that we would use the financial rescue package granted by Congress to purchase equity directly from financial institutions - the fastest and most productive means of using our new authorities to stabilize our financial system.

"We launched our capital purchase program the following week when we announced that nine of the largest U.S. financial institutions, holding approximately 55 percent of U.S. banking assets would sell $125 billion in preferred stock to the Treasury. At the same time, the FDIC announced it would temporarily guarantee all newly issued senior unsecured debt of participating organizations for up to three years. In addition, the FDIC provided an unlimited guarantee on non-interest bearing transaction accounts that expires at the end of next year."

Yes, credit conditions have eased significantly from the most locked-up levels of a month ago, but all the key indicators of the short-term credit market remain in far worse shape than they were before the fall of the house of Lehman.  While I wholeheartedly support the idea that it is far more effective use of funds to inject equity into the balance sheets of the banks than to prop up the banks by buying their assets at inflated prices, the terms of the preferred stock injection were entirely inadequate to protect the interests of the taxpayers.

"As I assess where we are today, I believe we have taken the necessary steps to prevent a broad systemic event. Both at home and around the world, we have already seen signs of improvement. Our system is stronger and more stable than just a few weeks ago.

"Although this is a major accomplishment, we have many challenges ahead of us. Our financial system remains fragile in the face of an economic downturn here and abroad, and financial institutions' balance sheets still hold significant illiquid assets. Market turmoil will not abate until the biggest part of the housing correction is behind us. Our primary focus must be recovery and repair."

I agree that market turmoil will not abate until the biggest part of the housing correction is behind us.  I think we are somewhere in the 5th inning of this process.  

However, as the economy slows, there are many other very serious areas of concern for the banking system beyond housing.  For example, commercial real estate is just starting its downturn.  While not as over-built as residential real estate, the downturn should be very painful coming on top of the residential losses.  The most vulnerable parts of commercial real estate will be retail, hotels and offices.  

Apartments should hold up somewhat better, but will not be immune, since there are many more single-family houses that are now available for rent which compete directly with apartment buildings.  Also, in a recession people tend to "double up" by taking in a roommate or kids moving back in with mom and dad.

"Implementing the Financial Rescue Package

"More recently, we have also taken extraordinary steps to support our financial markets and financial institutions. As credit markets froze in mid-September, the Administration asked Congress for broad tools and flexibility to rescue the financial system. We asked for $700 billion to purchase troubled assets from financial institutions. At the time, we believed that would be the most effective means of getting credit flowing again.

"During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets - our initial focus - would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks.

"Of course, before that time, the only instances in which the Treasury had taken equity positions was in rescuing a failing institution. Both the preferred stock purchase agreement for Fannie Mae (FNM) and Freddie Mac (FRE), and the Federal Reserve's secured lending facility for AIG (AIG) came with significant taxpayer protections and conditions.

"As we planned a capital purchase plan to support the overall financial system by strengthening balance sheets of a broad array of healthy banks, the terms had to be designed to encourage broad participation, balanced to ensure appropriate taxpayer protection and not impede the flow of private capital."

Two weeks is such a long time for Congress to have debated the spending of $700 billion tax dollars.  Of course, the world totally changed during that time, and there was no way that the Treasury could have anticipated that financial conditions would get worse and confidence might be shaken by the Secretary of the Treasury going to Congress with a detailed and well-crafted proposal of nearly three pages.  

He is correct that the actions that the Treasury and the Fed took prior to the bailout had significant taxpayer protections and conditions.  Of course, in the case of AIG those protections and conditions have been rescinded.   The cancellation of junkets by management at AIG might have had an adverse effect on the luxury resort industry.  Since then -- taxpayer protections?  Not so important.  

We needed the terms to be attractive enough to encourage the banks to take the money from the taxpayers.  For example, if we had insisted that the capital we were injecting into the balance sheets of the banks not be immediately sent out the back door in the form of dividends, private capital -- i.e. the shareholders of the banks -- might actually feel the effects of the bad decisions of the management of the firms.  Had we insisted for example that the managements of the banks not pay themselves and the other "talent" of their organization billions of dollars in bonuses this year, that "talent" might walk.  Never mind that there is plenty of other "talent" on the Street that is looking for work as the industry downsizes.

"Capital Purchase Plan

"We announced a plan on October 14th to purchase up to $250 billion in preferred stock in federally regulated banks and thrifts. By October 26th, we had $115 billion out the door to eight large institutions. In Washington, that is a land-speed record from announcing a program to getting funds out the door. We now have approved dozens of additional applications, and investments are being made in approved institutions.

"Although we are moving very quickly, it will take time to complete legal contracts and execute investments in the significant number of institutions who meet the eligibility requirements and are approved, but we are on the path to getting this done."

Yes it sounds like a complicated process, but there are only nine deals that are more or less cookie-cutter in design.

"Although this program's primary purpose is stabilizing our financial system, banks must also continue lending. During times like these with a slowing economy and some deterioration in credit conditions, even the healthiest banks tend to become more risk-averse and restrain lending, and regulators' actions have reinforced this lending restraint in the past.

"With a stronger capital base, our banks will be more confident and better positioned to play their necessary role to support economic activity. Today banking regulators issued a statement emphasizing that the extraordinary government actions taken by the Fed, Treasury and FDIC to stabilize and strengthen the banking system are not merely one-sided; all banks - not just those participating in the Capital Purchase Program - have benefited, so they all also have responsibilities in the areas of lending, dividend and compensation policies, and foreclosure mitigation. I commend this action and I am particularly focused on the importance of prudent bank lending to restore our economic growth."

Banks are lending -- they are lending to the Federal government in the form of 3-month T-bills.  They have been so enthusiastic in this desire to lend that they have pushed the yield on the 3-month bill down to 12 basis points.  Yes, several major banks like JP Morgan (JPM) have announced plans to start modifying more mortgages.  However, we have heard this before, with the HOPE NOW alliance, and so far not much has come of it.

"Priorities for Remaining TARP Funds

"We have evaluated options for most effectively deploying the remaining TARP funds, and have identified three critical priorities. First, we must continue to reinforce the stability of the financial system, so that banks and other institutions critical to the provision of credit are able to support economic recovery and growth. Although the financial system has stabilized, both banks and non-banks may well need more capital given their troubled asset holdings, projections for continued high rates of foreclosures and stagnant U.S. and world economic conditions.

"Second, the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit. Third, we continue to explore ways to reduce the risk of foreclosure.

"Over these past weeks, we have continued to examine the relative benefits of purchasing illiquid mortgage-related assets. Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources, in helping to strengthen our financial system and support lending. But other strategies I will outline will help to alleviate the pressure of illiquid assets."

Securitization of credit card receivables and support for them is the reason American Express (AXP) decided to become a bank holding company.  Paulson said he wanted to encourage broad participation in the program and he has succeeded.  Everyone wants to be a bank holding company now to get access to the TARP.  It will be interesting to see if GM (GM) and Ford (F) will qualify as banks to get access to the funds.  

Note that purchase of illiquid mortgage securities was the only use of TARP funds originally envisioned.  Well, this is one case where bait and switch turned out to be a good thing.  I'm a bit leery of the term "targeted forms of asset purchases."  Who are the targets (beneficiaries) and how will those targets be decided on?  

So far, both the Treasury and the Fed have been extremely secretive about where the funds are actually going.  Bloomberg recently filed a Freedom of Information Act suit to find out.  I hope they win the suit.

Read the full analyst report on FRE.

Read the full analyst report on GM.

Read the full analyst report on F.

Read the full analyst report on FNM

Read the full analyst report on FRE

Read the full analyst report on GM

Read the full analyst report on F

Read the full analyst report on JPM

Read the full analyst report on AXP

Read the full analyst report on AIG