The Treasury has been heavily criticized for its recent decision to abandon using Troubled Asset Relief Program (TARP) funds to acquire illiquid assets from banks and other financial institutions. But, while the patchwork of actions taken by the Treasury and the Fed over the past year provides ample fuel for criticism, that decision by Treasury Secretary Paulson was dead-on correct.

The TARP program has instead focused on injecting capital directly into institutions to stimulate lending, but this goal is not being met.   Without abandoning the original goal of cleansing troubled financial institutions’ balance sheets, TARP funds can and should be used in a far more expedient and transparent way, and the program should incorporate new goals like stemming foreclosures and stimulating economic activity.

The Failure of the Original TARP Strategy

The original asset repurchase program was doomed because it was inherently impractical. Trying to devise a methodology to appropriately price, transfer and manage assets too complex even for their creators to value properly would be akin to shuffling deck chairs on the Titanic. It might produce a flurry of activity, but little improvement in the underlying crisis could be expected. Inevitably, there would be another round of accusations and finger pointing for delays and squandered resources.

The real failure in abandoning the asset purchase program lies in the glaring absence of a viable alternative plan to promptly employ TARP’s funds. The recent increase in market volatility reflects frustration on both Wall Street and Main Street that the economy’s downward spiral has continued even after taxpayers granted Treasury astonishing resources and unprecedented authority to play a calming role in the market. There is a general feeling that the only evidence of post-election bi-partisanship is a perceived lack of urgency from both parties. Despite the “dead cat bounce” that seems to accompany each bailout or political appointment, the financial markets have been burdened with added government-induced uncertainty at a time when investors are starving for leadership and a promising, cohesive strategy.

The good news is that this bout of inertia preserves at least $350 billion of TARP funds that can now be deployed more purposefully. Decisively committing the remaining resources in a manner that paves the way to economic stability will restore government credibility and boost capital markets.

TARP with a Renewed Mission

With Treasury’s pockets still stuffed with TARP funds, it can facilitate the following worthwhile objectives:

• Cleanse the balance sheets of the institutions that present material systemic risk;
• Free up capital to promote lending at the consumer and business level; and
• Address the proliferation of foreclosures afflicting housing markets across the nation.

The TARP was never going to be a panacea for restoring lost value experienced by investors at large, which have been estimated at more than $ 9 trillion in the equity securities market alone. Any expectations along these lines were never more than wishful thinking. The TARP is a vehicle to support a return to market stability and economic growth and rising asset values.

Moving forward, TARP spending should have the following objectives:

Capital Investment:  The Treasury should stick with its plan to inject liquidity into financial institutions, but it should do so with the additional goal of cleansing toxic assets from these institutions’ balance sheets.  Institutions should be allowed and encouraged to sell such assets on the open market, and then “compensated” by adjusting the formula for determining the amount of capital support required once assets have been purged. Presently, the range of capital support an institution can receive is a percentage of its total risk-based assets (1%-3%). Since most TARP beneficiaries are “well capitalized” under regulatory standards (at least until their next round of write-offs), a more productive formula would consider the additional impairment suffered when institutions auction these illiquid assets to the private sector. TARP funds should reimburse the institution for the additional loss, if any, associated with such a sale. TARP funds could purchase additional equity, if warranted, to increase capital levels. The propriety of this approach is that the same dollar is spent toward two objectives: cleansing balance sheets and restoring capital. Renegotiation of the original investments to incorporate a revised formula may be necessary and appears to be realistic at this time.

The Treasury’s initial rationale for directly acquiring illiquid assets was that the government would ultimately realize an upside, because unusually stressed market conditions meant the assets were underpriced. Realizing an economic upside from direct investments in leading financial institutions with proven franchise value may be reasonable, but the prospects of profiting from hard-to-price securities, especially if they are to be managed by cumbersome government bureaucracy and third-party contractors, is far more remote. That challenge, then, should more appropriately be relegated to the private sector. Direct investment in financial institutions also means more accountability and transparency, as taxpayers can understand and follow the value of the government’s equity stakes in these institutions.  By contrast, taxpayers cannot monitor the value of the government’s derivative securities portfolio.

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