Financial Crisis and Its Impacts

¶ … financial crisis and its impacts on the U.S. economy. The TARP program was created to deal with these impacts, and this paper will analyze TARP in terms of its success at addressing the impacts. The program has five main objectives, but can genuinely claim success only in one area thus far. TARP may not end up a failure, but successes are few as of yet.

In the fall of 2008, the financial crisis hit its critical mass. The crisis had been brewing for a couple of years, as the collapse of the housing bubble began to reveal a banking industry that was far too heavily invested in risky mortgages and mortgage-backed securities. First Bear Stearns was acquired to JP Morgan. Then in September two catastrophic banking failures occurred as first Lehman Brothers went under and then the FDIC orchestrated the sale of Washington Mutual to JP Morgan (Dash & Sorkin, 2008). Banks, wary of having too many bad assets on their books, began to constrict credit. Fearful of both the economic impacts of a credit crunch and the panic that would ensue among both the public and investors if more major bank failures occurred, the federal government initiated would be become known as the Troubled Asset Relief Program (TARP). This paper will examine TARP and its role in alleviating the financial crisis. Special attention will be paid to the ways in which TARP has achieved its goals and the ways in which it has failed to achieve its goals. TARP was controversial from the outset, with opposition and support coming from both economic conservatives and liberals alike. The outcomes of TARP will also be analyzed in the context of their concerns as well.

The Financial Crisis

It is widely argued, with considerable merit, that the Federal Reserve precipitated the financial crisis in the early part of this decade by holding interest rates at unusually and unsustainable levels. "The Federal Reserve's expansionary monetary policy supplied the means for unsustainable housing prices and unsustainable mortgage financing" (White, 2009). Investors wary of technology stocks were flush with money and seeking a haven. Thus, they turned to real estate. The monetary expansion also left banks with surplus capital to lend. This encouraged them to take on an increasing amount of risk in the form of subprime mortgages. A portion of this risk was then portioned off and sold in the form of allegedly high-grade mortgage-backed securities. When the Fed initiated a rapid increase in rates to slow the monetary expansion in the middle part of the decade, the housing market collapsed. Many of the subprime mortgages were made at low introductory rates, with higher rates improving after a few years. The borrowers were unable to make their new payments at the higher rate, and with housing prices stagnant or worse were also unable to liquidate.

Banks sitting on stockpiles of foreclosures found themselves unable to meet their liabilities or their reserve requirements, and began to restrict their lending as a result. As some banks began to collapse under the weight of their bad assets and others curtailed lending, the economy began to slow and then finally contract.

The problems, therefore, were manifold. The Fed contributed with its monetary expansion. Banks contributed by lowering their lending standards in an attempt to use their excess lending capacity. Consumers contributed by taking on mortgages they could not afford. Investors contributed by adopting a "herd mentality" with respect to the risky bundled securities of subprime mortgages (Tetangco, 2009).

The federal government and the regulators responsible for the banking industry took immediate steps to address the issue. The FDIC began aggressively managing the financial services industry, not just with the takeover of Washington Mutual but eventually with over one hundred other financial institutions as well (Glass, 2009). For its part, the federal government began to take steps to alleviate the distress on the banking industry.

Too Big to Fail

The Bush government, in consultation with a myriad of regulators and the two presidential candidates, acted to draft legislation to protect key financial industry players. The companies were deemed "too big to fail." The phrase, first coined during the Reagan administration -- and applied then to a handful of banks as well -- has been applied by governments multiple times throughout history (Smith & Yandle, 2009). The implication of the phrase is that if the firm that is too big to fail were to fail, that failure would result in considerable economic catastrophe. In the case of major U.S. banks such as Citigroup, AIG and a few other firms during the run of the economic crisis, two factors played into the government's decision to intervene.

The first factor is the interdependency in the financial system. If a major bank were to fail, its creditors would also likely fail. This is especially true during an ongoing financial crisis. The failure of one major firm would precipitate the failure of other firms, who were already in a precarious situation. This would have a spinoff effect, leading to a catastrophic collapse of the economy.

The second factor is the issue of consumer confidence. With housing prices dropping, gas prices high and banks failing, consumer confidence was shattered by the fall of 2008. Any further erosion of confidence, in particular with respect to the soundness of the nation's banking system, would result in a bank run or worse. This would precipitate a financial collapse, with all of the attendant problems.

The case for too big to fail sounds reasonable, but has its critics. Some critics attack the issue on the basis that government should not become involved to such as degree in business. Others take a less fundamental, more pragmatic approach and content that the economy can withstand such failures. Alternatively, it is posited that the banks are encouraged towards risk-taking behavior by the knowledge that they will be bailed out anyway because they are "too big to fail" (Smith & Yandle, 2008).

Smaller banks did not receive the too big to fail designation. The FDIC's role in the banking industry is to monitor the industry and become involved in the liquidation of banks when they become insolvent. Since the onset of the crisis, the FDIC has presided over 100 such liquidations. Aside from the WaMu action, most of the fallen banks have been small and medium sized regional players. The larger banks, however, were deemed too big to fail. Indeed the way in which the takeover of Washington Mutual was orchestrated indicates that the government viewed it as too big to fail as well. Its assets were transferred immediately to JP Morgan, which allowed operations to continue without interruption. The federal government's response to the other banks that were too big to fail was the bailout, which became known as the Troubled Asset Relief Program, or TARP.

Troubled Asset Relief

The troubled assets in question were the bad mortgages and their securitized variants. The securitized versions were marketed as being low risk (often AAA) securities because the risk of default of the mortgages that underlay the securities was believed to have been sufficiently diversified. However, the collapse of the real estate market was nationwide and the emphasis on subprime mortgages was widespread. As a consequence, the securities collapsed. So the troubled assets to be addressed in this bill were both the mortgages and the securities constructed from the mortgages.

TARP's overarching objective was to "improve the strength of financial institutions" (Federal Reserve, 2009), which were precariously weak at the time. This in turn was expected to deliver stability to the economy as a whole and slow the decline in consumer confidence. Essentially, TARP was a desperation move made during desperate times. This point is relevant in particular when evaluating TARP's effectiveness -- it must be weighed against the alternatives posited at the time. The main alternative was to do nothing and let the market forces work the situation out. This is a reasonable expectation if one takes a long-term view of markets and accepts that sometimes the market declines will be steep. This view is, however, not politically expedient, either for an outgoing President keen not to have a recession on his legacy nor an incoming President elected with a mandate to heal the nation's economic situation. The only other viable alternative would have been to do more than what TARP did.

In order to meet this overarching objective, TARP contained a number of key clauses. The first is the purchase of up to $700 billion of the so-called troubled assets from banks. This serves two purposes. The first is that the move clears the assets from the balance sheets of the financial institutions in question. In doing this, the banks are freed up to lend capital. Their capital ratios are stabilized, which allows them to lend again, rather than holding onto their capital. If banks are lending more, then firms are able to acquire capital for projects. In theory, this should first stabilize the economy and then stimulate economic growth and job creation.

The second purpose of the $700 purchase of troubled assets is to create a market for the securitized versions of these assets. As a result of the crisis, the market for these assets became illiquid. The value of securitized debt obligations became near zero, which severely impacted the balance sheet of all banks that held these assets. By creating a secondary market for these products, the government hopes to increase their value. This will improve the balance sheets of the banks.

The second key clause in TARP is that banks selling troubled assets to the government are required to give the government warrants. This, in theory, protects the government from losses. The theory is that the banks will see an increase in value as a result of the government's efforts, allowing the government to profit from the warrants.

Ancillary to TARP was the FDIC's excusing of troubled assets in its loss-share plan. In order to expedite the sale of the assets of the 100+ banks, the FDIC has limited the downside loss potential for the purchasers of failed banks. While this allows the banks to remain in business, it also places the downside risk of the troubled assets that helped to bring those banks down directly onto the backs of the American taxpayer (Paletta, 2009).

Analysis of TARP

In order to determine the success of the Troubled Asset Relief Program, measures of success must be determined. The first objective was to stabilize the economy. This can be measure with a wide variety of economic metrics, including the stock market, the GDP and unemployment. The second objective was to stabilize the banking system. This can be measured on the basis of the bank run it TARP was supposed to prevent. However, it can also be measured by the number of bank failures. The third objective was to stimulate lending on the part of banks. The fourth objective was to create a secondary market for the trouble assets. The fifth objective was to do all of this without much waste.

With respect to the first objective, there is evidence that TARP has succeeded. The economy slumped through the fall of 2008, but began to stabilize in the winter of 2009. Growth of 3.5% was recorded for the third quarter of 2009, the first such quarter in over a year (Lam, 2009). The growth is expected to be coupled with pent-up demand and thereby continue for at least a few quarters. Furthermore, the stock market indices have all risen over the course of this year. The upswing in economic activity and the improvement in the stock market indicates that the first objective of TARP -- to stabilize the economy -- has succeeded.

The second objective has not been as much of a success. While consumer confidence in the banking system remains relatively high -- at least to the extent that a bank run has not yet occurred. That can be better attributed, however, to the FDIC's move to increase its guarantee on bank deposits beyond its usual $100,000. While the major banks have avoided collapse, over 100 regional banks have succumbed and this has placed significant stress on the FDIC. That agency has "proposed that banks pay their fees for the rest of the year as well as 2010, 2011 and 2012 by December 31" (Grey, 2009). This is to alleviate a major funding crunch at the FDIC that, if it occurred, could have jeopardized the banking system. In light of the stresses that the 100+ bank failures have put on the FDIC -- and by extension the taxpayer should the FDIC actually run out of money -- the banking system may not be as stable as it appears.

The third objective was to stimulate lending on the part of the banks. Indications are that the money has not been spent on lending. The prevailing attitude among banks is that they will not change their lending policies to suit public policy, and that as private entities they are free to do as they like with the TARP money they've received. To quote John Hope, chairman of a New Orleans-based bank "We're not going to change our business model or our credit policies to accommodate the needs of the public sector as they see it to have us make more loans" (McIntire, 2009). In general, the banks are not required to disclose what they have done with the money and few are willing to talk. The TARP watchdog is also working to uncover cases of misuse of TARP funds, and has uncovered 20 cases of fraud thus far (Liberto, 2009).

The fourth objective was to create a secondary market for the troubled assets. TARP has created this market, based on a public-private model in which the government funds entities willing to bid on the assets. The underlying theory of this model is that the assets are trading below their fundamental value and with government intervention, market participants will be willing to purchase the troubled assets, thereby increasing their value (Bebchuk, 2009). "Market participants attached valuations exceeding fundamental values…we should be similarly prepared to accept the possibility that market processes once again are not working well" (Ibid). Thus, the rationale for the fix holds that intervention can restart the market.

While the funds have been activate, such as a secondary market has not yet become viable. In part, the assets are complex. The difference of opinion as to the value of such assets can vary significantly among market participants, which results in an illiquid market. So in part, the trouble with the TARP plan is it still has not resulted in a mechanism by which an accurate price of complex derivatives such as collateralized debt obligations can be priced (Mahoney, 2009).

The fifth objective was to enact TARP with a minimum of waste. This objective represents accountability to the taxpayers. In general, TARP has failed with respect to this objective. The program lacked fundamental oversight on the spending of TARP money. AIG executives awarded themselves rich bonuses, forcing the enactment of strict anti-bonus rules. Banks were not obligated to disclose their spending, and there is strong reason to believe that much of the TARP funds were not spent on lending as the program intended. Furthermore, the Treasury Department does not have an adequate system to measure the value of the shares it received in exchange for the TARP funds.