Friday, January 16, 2009

On the bank bailout

I received this email as a subscriber to one of Morningstar's newsletters. Josh Peters, an analyst at the firm, has some comments on the bailout.

There's also been much hand wringing and media hyperbole about the Troubled Asset Relief Program, or TARP--that it isn't working, that we don't know where the money went, and so on. Now I'm both a taxpayer and a citizen, and I'm not at all happy with the idea that my tax dollars might go to subsidize the bad subprime lending by Mr. Suspenders and disastrous CDO investments of Mr. Wingtips. Wittier souls than I have likened capitalism without failure to religion without, shall we say, unpleasant and everlasting consequences. And I truly hope we'll see much stricter oversight of the way Wall Street does business going forward.

But there will be ample opportunity for investigation, outrage and retribution when the immediate crisis passes. I have never thought that the alternative, risking a full-throated implosion of the global financial system, was a workable alternative. In this light, I conclude that the idea the TARP is failing is just plain wrong. To date, the TARP has achieved exactly what I have expected--it put a halt to bank runs (both the "Mary Poppins" kind and the unseen run on Wall Street's short-term funding desks). When I use an ATM card these days and it works, I credit the TARP.

Levering up this capital and lending it out, well, that was never going to be an instant solution to the economy's ills. Even ordinary monetary and fiscal policy changes usually take months and years to have an effect on real economic activity. Most banks have just received these capital injections in the last month or so; moreover, if recent media reports have any credence, the demand for loans has dropped through the floor. Let's face it: American households and businesses don't need to pile more debt on their balance sheets; no good would come of a new credit bubble. Instead, it's those that are solvent-but-illiquid that need help refinancing existing debts. The old-fashioned commercial banks will have to pick up the slack left behind after Wall Street investment banks and their shadowy conduits went into the ditch, and as time passes, I continue to think this is what will happen.

As for this idea that "we don't know where the money went", you'd think that $200 billion of taxpayer money was set on fire or secretly dashed away to Swiss bank accounts. Even many members of Congress seem to hold this view. From one angle, I'll grant there isn't any practical way to track the specific use of these funds: Money is money, the ultimate fungible asset. Once inside the banking system, these specific dollars are still but a drop in the bucket. But we do know exactly what the government got for these funds: It was an investment, not an expenditure, and the Treasury now holds $200 billion worth of preferred shares earning a 5% dividend yield. Participating banks are obliged to pay dividends on these in vestments and, eventually, redeem the shares at par. Only in cases where common shareholders are wiped out would the government suffer a loss, but even in those events the losses would be no different than any private investor's loss.

Furthermore, the government received warrants on these banks' common shares, which ought to result in capital gains over the long run--helping offset, perhaps fully, the losses from failing institutions. Finally, the government borrowed the funds to invest at this 5% return for essentially nothing. This sounds like a terrific investment opportunity to me. So I look at the TARP as an initiative where doing good (helping shore up the financial system, and the real economy in time) will also allow the government--and, by extension, taxpayers--to do well, too.

I don't usually take such strong opinions that aren't strictly related to company-specific issues, or get so aggravated by the financial press. (Maybe it's just the fact that I've been watching CNBC today that has put me in an irritable mood.) I'm not always a contrarian: I heartily agree with the idea that the issuer-funded ratings agencies (Standard & Poor's, Moody's, etc.) should be disbanded, preferably yesterday. But while the leadership of Bernanke, Paulson, Geithner, et al and their Congressional partners hasn't been perfect, I can't look back and see how I or anyone else would have achieved superior results by doing things differently. In hindsight, for example, it's easy to see how letting Lehman fail was a mistake. But having made that call to disastrous effect, at least we can conclude it's a mistake that is exceedingly unlikely to be repeated.

In other words, this part of the financial system rescue is likely to be cost neutral or slightly positive to taxpayers. It increases the government's debt but the firms involved are paying more than the government paid in interest. It also may have kept the nation's larger banks from failing, which would be nightmarishly bad. When you are in crisis mode, there may be no time for oversight.

I understand that progressives are upset at what appears to be a handout. In this case, I'd encourage digging a bit beneath the surface. If the government had aided the banks but refused to aid consumers that would have been a different story. However, aid is now in the pipeline.

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