Rolling Out TARP II
Creating an unnecessarily subsidized market in toxic assets
The Treasury Department has created a bit of a conundrum for libertarians when it comes to the newly announced Jekyll and Hyde-like TARP II. On the one hand, the government is finally reaching out to the private sector through this initiative, recognizing the power of markets and price discovery as means to end the economic crisis. But on the other hand, the taxpayers are still taking up to 93 percent of the risk in this new venture. That's hardly an equitable solution and it could end up costing incalculable billions.
Since the Troubled Asset Relief Program (TARP) bailout was passed last September the money has been used for a host of recovery initiatives. The first half was used largely to recapitalize the banks by buying up equity shares. The second half, TARP II, will be focused on the initial goal of the bailout: to get the deadly mortgage-backed securities and toxic assets off bank balance sheets.
These real estate loans and securities have been rebranded as "Legacy Assets." They are essentially mortgages, subprime and other, abandoned or in foreclosure, leaving the bank holding the debt in the weak housing market. Because balance sheets are cluttered with unpaid loans, banks have limited the amount of credit they are willing to extend, part of the cause of the economic slow down.
TARP II will use $100 billion of the Congressionally approved money to create the Public-Private Investment Program (PPIP) , a plan to unite private capital with taxpayer dollars to buy up to $1 trillion of the Legacy Assets from banks, easing their debt levels, allowing credit to flow more freely.
Treasury Secretary Tim Geithner argues that creating a program like this will leverage the price discovery process of the free market to help find the right price to buy the Legacy Assets from banks, and is better than the government trying to value the toxic debt on their own. On this point, Geithner is absolutely right. On its own, the government would almost certainly overpay for the assets.
Another positive of the plan is that banks, who have been holding out on selling their assets at a loss because bailouts have been keeping them alive, will be forced to either clean their books or stop asking for taxpayer money. However, these positives are counted by the fact that through this new plan the American taxpayer winds up on the hook for most of the risk.
Here's how the public-private TARP II will work. First, banks will determine what Legacy Assets they want to sell and put them up on an auction block. Assets will probably be grouped together and sold in "pools." Second, the government will decide how much it thinks the assets are worth and announce what percentage of a sale it will cover. Private market actors will then bid for the assets. Bidders could be pension funds, mutual funds, private equity firms, or even individual investors with enough capital. The assets will be sold to the highest bidder.
Finally, the FDIC and Treasury Department will provide financing to the private investor, and together they will assume joint ownership of the asset. Private fund firms will be hired to manage the asset until prices rise to the point that the asset can be sold and both investors and taxpayers get a return on their investment.
At least that is how the program is supposed to work.
The very real possibility exists that Legacy Assets will never regain their value, which means a loss to whoever owns them. This is where the first major flaw in the Public-Private Investment Program becomes apparent: if an asset matures in value then everyone wins big, but if an asset suffers a loss it will be the taxpayer who takes the biggest hit.
When you do the math, after FDIC financing and Treasury funds, private investors may only have to put up 7 percent of the money in buying a pool of assets, leaving the government to take a 93 percent loss if necessary. Such a low private market share defeats the purpose of a public-private partnership in the first place.
A key advantage of public-private partnerships, whether through this investment program or by creating a toll road, is to transfer financial risk from the taxpayers to the private sector. But with financing structure as it is, investors have big upsides with little skin in the game, while the government is likely to take big losses .
And that kind of investment is how we got into this mess in the first place. The government cannot continue to socialize losses.
Of course the problem of troubled Legacy Assets won't go away over night. Some are arguing that the Private-Public Investment Program is a better option than nationalization or having the government buy up assets on their own. While that may be true, it doesn't mean PPIP is the best choice.
We have no idea how much PPIP may wind up costing the taxpayer. The FDIC will be guaranteeing loans to purchase assets, but that money won't come from the $100 billion TARP II money, it just appears out of thin air (the government's favorite magic trick). Depending on how much financing is needed and what kind of losses Legacy Assets yield long term, this program could cost nearly $1 trillion in taxpayer, inflated currency.
Though the TARP II program creates a market for buying and selling these assets, it's an unnecessarily subsidized one. These assets can be bought and sold now, in the current market. The catch is that the banks don't want to because they don't like the prices they are being offered, and bailouts have allowed them to hang on for a better deal. The best option is simply to let the banks that do not want to sell fail, and then divest the assets after going into bankruptcy.
There are other risks with the plan, including the possibility that banks will bid up their own auctions, but this can be stopped with the right oversight . The gravest concern is that there are high odds that many of the toxic Legacy Assets might never regain value, leaving the taxpayers with a heavy loss that should be felt by the banks.
Anthony Randazzo is a policy analyst at Reason Foundation. An archive of his work is here.
