TARP After One Year: Was It Necessary? Did It Work?Randall Holcombe • Wednesday September 30, 2009 10:06 AM PDT •
The Troubled Asset Relief Program (TARP) is a year old now. On September 19, 2008, Treasury Secretary Henry Paulson announced the need for a $700 billion program to purchase toxic assets held by banks to prevent a financial meltdown, and after some modification TARP was rapidly approved by Congress on October 3. Looking back after a year, was TARP necessary? Did it work
The answers are No, and No.
To look at the first question, consider what TARP was designed to do. Secretary Paulson said interbank lending had dried up because banks had these toxic assets (they were mortgage-backed securities) in their portfolios, and nobody knew what they were worth. Banks could not, therefore, be sure of the financial security of other banks, so were reluctant to lend, locking up financial markets. The solution, Paulson argued, was to approve TARP and use $700 billion to buy up those toxic assets. When the toxic assets were replaced by Treasury securities, banks would then have more solid balance sheets and interbank lending would resume.
It is easy to say the program wasn’t necessary, because the TARP money wasn’t used to buy those toxic assets, despite Paulson’s argument that it was necessary to do so. Instead, after some delay, TARP money was used to buy preferred stock in banks, shoring up their balance sheets by making the federal government part owner of the banks.
Secretary Paulson forced the nine largest banks to issue stock to the Treasury, paid for by TARP money, even though it appears that several of the banks didn’t want to participate. (Other banks participated too.) Secretary Paulson said that if some of the big banks participated and others didn’t, it would identify some banks as weaker than others, which Paulson believed was undesirable.
Instead of buying up toxic assets, which Paulson said was necessary, the TARP money was used to partially nationalize the banking industry. TARP money was also used to take federal ownership of AIG (after it was initially rescued by the Fed) and to provide bailout money for Chrysler and General Motors.
When the auto companies initially approached Secretary Paulson for a share of the TARP money he said it was only to be used for the purchase of toxic assets from financial institutions. But when Congress would not bail out the auto industry, Paulson changed his mind and put up TARP money.
Was it necessary to appropriate $700 billion to buy toxic assets? In hindsight we can see the answer is no, because the money wasn’t used that way. Instead it was used to purchase federal ownership of financial institutions and automobile manufacturers.
Did TARP work? We see that it didn’t work as originally intended, but are we better off because the federal government has partially nationalized those financial and manufacturing firms? We see that the TARP money didn’t prevent the bankruptcies of Chrysler and GM, it just delayed them for six months, and gave the federal government big ownership shares in the bankrupt companies.
As for the banks, it may be that some of them would have failed without the TARP money, but taking a longer view, that is not a bad thing. When firms take risks, they must balance the potential profits from success against the potential losses from failure, and the TARP support removes the last part of that balancing act. There may have been some dislocations in the short run from bank failures, but in the long run allowing them to go under preserves the incentive structure that makes a market economy run.
Banks are financial intermediaries that match up borrowers and lenders. When a bank goes under, it does not reduce the amount of money available to borrowers, or prevent savers from providing money that can be lent. Other financial intermediaries are available to borrowers and lenders to replace the activities that failed banks would have performed. There may have been some short-run dislocation, but in the long run we are better off allowing markets to allocate resources.
Ultimately, what TARP did was to provide funds for the government to take an ownership interest in private firms. Nationalizing our financial and industrial firms is not in the public interest. The federal government now owns 80% of AIG and 61% of GM. TARP was not necessary. It didn’t work. And what it actually did was undesirable.