TARP Part 1 of 3: The Origins of TARP

As markets crashed and credit ground to a halt in September 2008, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke met with senior legislators from the U.S. Senate and House of Representatives, informing them that if Congress didn’t inject $700 billion of taxpayer money into the U.S. banking system, the economy would collapse. Shortly after this meeting, Paulson announced plans for The Troubled Assets Relief Program, or TARP. Paulson and other Treasury officials originally claimed TARP would be used to purchase $700 billion worth of “toxic” assets and equity from financial institutions. After TARP evolved into a bailout program for the U.S. banking system, it became the focus of much controversy; especially when certain institutions that received TARP funds paid out oversized bonuses to executives and employees. Many critics of TARP claim the program did nothing to mitigate systemic risk, address unethical banking standards, or loosen credit.

The 2008 crisis was caused by the burst of the U.S. housing bubble and the resulting rise in sub-prime mortgage delinquencies. Suddenly, homeowners found themselves living in properties worth less than their mortgages, and many of them stopped making monthly payments. Mortgage delinquencies increased further after interest rates rose on sub-prime loans, and many homeowners unable to afford the higher monthly payments defaulted.

Unfortunately for the global financial system, U.S. and international banks, corporations, government-sponsored enterprises and other international financial institutions were deeply involved in the sub-prime mortgage market. Lenders would sell mortgages to investment banks, where traders would package the mortgages into securities and sell them to investors. When homeowners stopped making payments, mortgage-backed securities became largely worthless. As a result, banks stopped lending as they attempted to de-lever their balance sheets and repay investors, businesses laid off employees because they could no longer borrow money, and an increasing number of newly unemployed homeowners could no longer make payments on their mortgages. As the cycle repeated itself, each rotation seemed more daunting and vicious than the last. By the fall of 2008, sub-prime mortgage delinquencies had triggered substantial losses within financial institutions and had severely shaken investor confidence in credit markets.

The developments in the U.S. mortgage market were an aspect of a much larger and more encompassing credit boom, the impact of which transcended the mortgage market and affected all other forms of credit. After the dot-com bust and 9/11, the Fed lowered interest rates in an effort to stimulate the economy. Easy money increased the potential for returns, and investment banks, investment divisions of commercial banks, and other corporations started issuing thousands of new securities.

Within a short time, investment bankers faced more demand from investors seeking their high-yielding products than they had securities to sell. This led to an astonishing decline in lending standards and suspension of rational judgement concerning who would qualify for the mortgages bankers were financing. Moreover, bankers lumped commercial real estate loans, car loans, student loans, and other loans into securitization pools largely full of sub-prime mortgages. These widespread declines in underwriting standards, along with breakdowns in lending oversight by investors and rating agencies, increased reliance on complex credit instruments that proved fragile under stress, and unusually low compensation for risk-taking, enabled sub-prime mortgages to trigger the global financial collapse.

As the collapse began to take its toll, Bernanke and Paulson kept a close eye on the developments. First Bear Stearns went under in March 2008, forcing Bernanke to arrange a last-minute shotgun marriage with J.P Morgan to save the firm. Despite constant public reassurances that the financial system and economy were stable, Paulson and Bernanke were deeply worried. As columnist Andrew Ross Sorkin explains in his book ‘Too Big To Fail,’ Paulson communicated frequently with Dick Fuld, CEO of the now-bankrupt Lehman Brothers, as well as Lloyd Blankfein, CEO of Goldman Sachs, early in 2008. Fuld knew Lehman was in deep trouble, and had even begged Warren Buffett to take a $7 billion dollar stake in the firm shortly after Bear’s collapse; a request Buffett politely refused.

Around the time Bear imploded, Paulson had asked Neel Kashkari, special assistant to the Treasury, to draft a bailout proposal for Congress which Paulson hoped he would never have to use. Over the summer, however, Fannie Mae and Freddie Mac collapsed, and Bernanke was forced to use $85 billion worth of Federal Reserve funds to bail out the two GSE’s. AIG was next, eventually requiring some $120 billion from the Federal Reserve to stay afloat. As “moral hazard” weaved its way into legislative vocabulary, Paulson and Bernanke decided to let Lehman Brothers, the next victim of the sub-prime mortgage market, to go bankrupt. Lehman’s collapse triggered a larger collapse of the global financial system, and Paulson and Bernanke moved to push forward on TARP.

The U.S. Treasury, then, had envisioned the need for a bailout program before major companies started failing. Although Paulson knew he would need a substantial amount of capital for a full scale bailout, he did not know exactly how much. In a recent interview with ‘The Wall Street Journal,’ Neel Kashkari claimed he originally suggested $1 trillion for TARP, a figure Paulson rejected because he believed the public would never allow it. “How about $700 billion?” Kashkari then asked. Paulson agreed, and just like that, $700 billion became the magic number.

Under TARP, the U.S. Treasury would purchase toxic mortgage-backed securities directly from banks. Purchases of distressed assets would “mitigate systemic risk,” Paulson claimed. Shortly after TARP became law, however, Paulson decided to use TARP funds to buy stock in banks and other institutions deemed “too big to fail,” claiming this different approach would do more to relieve pressures on consumer credit, including auto loans and credit card debt.

Without knowing how Paulson’s original plan for TARP would have unfolded, it is hard to say if Paulson improved the program by changing it. Certain issues are apparent, however. The end of the credit boom has caused widespread economic and financial problems: rising credit risks and intense risk-aversion have pushed credit spreads to unprecedented levels, markets for securitized assets (except for mortgage securities with government guarantees) have shut down, and heightened systemic risks and falling asset values (exacerbated by tight credit) have taken a heavy toll on business and consumer confidence and have drastically slowed global economic activity. Today, many bankers, legislators, economists, and financial analysts continue to question the effectiveness of TARP.

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