Given the unprecedented credit market turmoil and central bank interventions of recent days, the US government’s mammoth $700bn Troubled Asset Relief Program (TARP), approved with great haste and huge expectations just a few days prior, is already looking like a sideshow. If the Federal Reserve is to return to being a lender of last resort, rather than first resort, Treasury Secretary Henry Paulson needs immediately to get TARP front and center of the economic relief effort.
The reason TARP has failed to calm the markets is that it is still almost completely undefined. The universe of troubled assets that the Treasury could potentially buy is far too large for anyone to speculate as to its likely economic effects. It is therefore critical that Secretary Paulson significantly narrow the scope of the intervention in a way that is clearly and transparently connected with the two most urgent tasks: reviving the credit markets and preventing a spiraling freefall in the housing market. Here is how it should be done.
First, the Treasury should announce that it will buy home mortgage loans, and only such loans. It has limited ammunition, and should not waste it on derivative contracts tied to mortgages, or to other forms of troubled debt, such as credit card debt and auto loans. If mortgage values stabilize, so will the values of derivatives tied to mortgages, and so will the values of other forms of debt which are currently being dragged down by the huge negative wealth shock of relentlessly falling home values. Furthermore, the public will understand the benefits of their government buying up home mortgages, and so are far more likely to rally around the intervention scheme.
Second, the Treasury should not aim to pay some discount relative to “hold to maturity value,” as Fed Chairman Ben Bernanke suggested, but some discount relative to what the current market price would be if there were a functioning market. This is clearly a lower number, as well it should be. That is because the motivation behind TARP is to revive the asset and credit markets, not for the government to replace them or to prop up insolvent institutions. If the Treasury offers, for a fixed period, say, 50 cents on the dollar for assets which might reasonably be valued today, in a functioning market where institutions trusted each other’s balance sheets, at 60 cents, four good things will happen.
One: institutions that are clearly solvent when their assets are valued at the Treasury’s offer price will generally choose not to sell, but merely to mark their assets to it. Since this floor price is credible, their counterparties will finally trust the valuations, and be far more willing to resume normal business with them.
Two: there are still plenty of well-heeled hedge funds and private equity firms in the market looking for opportunities, and they are likely to outbid the Treasury if they know there is a floor under the market.
Three: the Treasury will be able to focus its efforts on illiquidity, rather than insolvency, as only solvent institutions will want to sell at, or mark assets to, the Treasury’s offer price. Insolvent institutions should be liquidated or nationalized, in part or in toto, and not propped up as private zombie firms at taxpayer cost.
Four: abandoning mark-to-market accounting, a favorite idea of politicians, inevitably means assets being valued according to some politicized formula, which is likely to exacerbate rather than alleviate the problem of non-functioning markets. Better for the government to help make a market than to help cover up its absence.
TARP is needed to prevent further dangerous deterioration of the credit markets: the Fed’s extraordinary liquidity support is not enough. But currently TARP is nothing more than a lot of money and good intentions. It would have been far better if Secretary Paulson had been able to define and articulate his plan before he presented it to Congress, and his failure to do so is partly responsible for the market meltdown since the bill’s passage. But now it is urgent that he put some credible flesh on the program by targeting it directly at the mortgage markets.
Originally published at the FT and reproduced here with the author’s permission.