Network News

X My Profile
View More Activity

Why Not Just Take the Money?

Late yesterday, the Federal Reserve announced guidelines for large banks (the nineteen that were subject to stress tests) that want to repay money invested by the Treasury Department as part of the Troubled Assets Relief Program. At first glance, this seems like a no-brainer: The banks want to give the money back, so why not just take it?

But that wasn't the point of the TARP investments in the first place. The goal of the government investments was to make sure that the banks were healthy - that they had enough capital to withstand the ongoing deterioration of their toxic assets and a severe economic downturn, in which many completely ordinary loans go bad as individuals lose their jobs and companies suffer losses. The government wants banks to have a lot of capital, so that people will have confidence in the financial system and the banks will be willing to lend money to support the economy.

However, in our current system, large banks - especially those considered too big to fail - have an incentive to hold as little capital as possible. Capital means shareholders, which means more people that profits have to be divided between. In this case, the government's TARP money is a lot like a loan (except for the case of Citigroup, where over half or the government's money is in common shares), so paying it back means fewer interest payments.

In short, reducing capital increases earnings per share - at the cost of increased risk. But, for banks that are are too big to fail, the government has sent clear signals that it will be there to bail them out should things go bad. So while small banks have an incentive to maintain healthy capital cushions - because, in case of failure, they will be taken over by the Federal Deposit Insurance Corporation - large banks can afford to skate on thinner ice. And as they get more and more confident about their ability to make money, they are willing to go on thinner and thinner ice. Paying back TARP money is the same thing as going onto thinner ice.

The Treasury Department and the Federal Reserve, by contrast, want to keep the big banks on thick ice. And hence the conditions on repaying TARP money basically require the banks to show that they can survive without federal guarantees. Therefore, the main conditions are showing the ability to raise money by selling bonds without an FDIC guarantee, and showing the ability to raise money by selling new stock.

This makes sense in principle, but it overlooks one major thing. Even if a bank repays its TARP capital and can sell bonds and stock, it is still benefiting from a variety of other government support mechanisms, such as the Public-Private Investment Program (subsidies to encourage investors to buy toxic assets from banks), the Term Asset-Backed Securities Lending Facility (Fed program to buy securities - some troubled, some not - from banks), or the asset guarantees the Fed has given to Citigroup, Bank of America, and JPMorgan Chase (as part of the Bear Stearns acquisition). Essentially banks are being allowed to pick and choose the programs they want to benefit from. Since TARP money comes with certain oversight and compensation requirements, they want to pay it back, but they are more than happy to accept help when it comes to selling toxic assets.

The problem is that if these banks are sick enough that they need some forms of federal assistance, then it seems like they are not healthy enough to pay back their TARP money. Put another way, it is possible that the only reason they feel confident enough to pay back the TARP money is that they are counting on the other forms of government support. Picking the government programs you like is a reasonable business strategy, and it seems like Treasury and the Fed are going along because they think that repaying TARP money will increase public confidence in banks. But I would be more confident if the major banks said they would not participate in any government assistance programs.

--James Kwak

By James Kwak  |  June 2, 2009; 12:53 PM ET
Categories:  Banking  
Save & Share:  Send E-mail   Facebook   Twitter   Digg   Yahoo Buzz   Del.icio.us   StumbleUpon   Technorati   Google Buzz   Previous: What's So Bad About Government Intervention?
Next: It's About Derivatives, Twice

Comments

The Term Asset-Backed Securities Lending Facility (TALF) isn't a "Fed program to buy securities - some troubled, some not - from banks." It's a Fed program to lend to investors who buy certain newly securitized ABS and certain qualifying legacy CMBS. The Fed isn't even financing 100% of the investor's purchase. It's financing par minus the haircut. Cost of funds isn't negligible either.

Also, investors aren't buying these ABS "from banks" -- or, at least, not from the major banks that issued FDIC-backed bonds (JPM, Goldman, etc.) and who are the subject of this post. The banks are only involved in their capacity as primary dealers or arrangers/bookrunners.

Seriously, Washington Post, it's time to bring in someone who knows what they're talking about for this blog. Amateur hour with the first-year law student and the career academic was fun while it lasted, but it's getting embarrassing.

Posted by: MarkJ2 | June 2, 2009 11:28 PM | Report abuse

Seems like they should be allowed to bail out once they meet the "Not Too Big To Fail Criteria" - which could consist of things like
1) Capital ratios significantly higher than Bazel
2) x % of debt long term, where x is something like 90%.
3) Complete visibility as to details of any potential liabilities such as CDS - updated daily.
4) No liabilities carried off the books - period.
5) other stuff like this - thought up by experts in the field not beholden to the banks.
6) All deals with foreign governments backed by 100% capital.

I don't think there is such a thing as a bank that is too big to fail. The problem is that the ramifications of failure have been hidden and thus are potentially infinite; and we have been afraid that in the end we would shaft the Chinese and they would stop buying our debt.

Posted by: RKnox | June 4, 2009 8:34 PM | Report abuse

The comments to this entry are closed.

 
 
RSS Feed
Subscribe to The Post

© 2010 The Washington Post Company