Remember this - former Treasury secretary Hank Paulson’s dramatic November U-turn on the Tarp?
Paulson abandoned his original Tarp plan to snap up toxic assets in favour of buying (toxic) bank shares. The Tarp - Troubled Asset Relief Program - became the Terp - Troubled Equity Relief Program.
Paulson’s rationale for the move was given as:
“Our assessment at this time is that this is not the most effective way to use Tarp funds,” Mr Paulson said. He said the $410bn in uncommitted funds would be better spent on an expanded programme to recapitalise financial companies, support markets for securities backed by consumer debts and prevent foreclosures.
Phillip Swagel, who was the Treasury’s assistant secretary for economic policy under Paulson, is blowing that theory out of the water in a 50-page essay titled “The Financial Crisis: An Inside View“. The paper is worth a full read, but here are some quick select excerpts.
On the problem of legal constraints:
Legal constraints were omnipresent throughout the crisis, since Treasury and other government agencies such as the Federal Reserve must operate within existing legal authorities. Some steps that are attractive in principle turn out to be impractical in reality—with two key examples being the notion of forcing debt-for-equity swaps to address debt overhangs and forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time the word “force” is used as a verb (”the policy should be to force banks to do X or Y”), the next sentence should set forth the section of the U.S. legal code that allows such a course of action—otherwise, the policy suggestion is of theoretical but not practical interest.
And political ones:
Political constraints also affected the types of legislative authorities that could be requested in the first place, notably with regard to the initial conception of the TARP (Troubled Assets Relief Program). Secretary Paulson truly meant to acquire troubled assets in order to stabilize the financial system when he went up to Congress on Thursday, September 18, to request a $700 billion fund. One criticism of the initial “Paulson plan” is that it would have been better to inject capital into the system in the first place, since the banking system was undercapitalized and asset purchases inject capital only to the extent that too “high” a price is paid (this point is discussed more below). But if he had wanted to inject capital from the start, this would never have been approved by Congress. House Republicans would have balked at voting to allow the government to buy a large chunk of the banking system (such “nationalization” only came into vogue among Republicans in 2009), and Democratic members of the House would not have voted for such an unpopular bill without a reasonable number of Republican votes to provide the political cover of bipartisan action.
And on the Treasury’s internal machinations and motivations:
Other aspects of the decision-making were self-imposed hurdles rather than external constraints. Notable among these hurdles was chronic disorganization within the Treasury itself, and a broadly haphazard policy process within the Administration (and sometimes strained relations between Treasury and White House staff) that made it difficult to harness the full energies of the administration in a common direction. To many observers, Treasury also lacked an appreciation that the rationales behind actions and decisions were not being explained in sufficient detail; without understanding the motivation for each decision, outside observers found it difficult to figure out what further steps would be taken as events unfolded. Part of this was simply the difficulty of providing adequate explanation in real time as decisions were taken rapidly, while another part was the simple lack of trust in Treasury and the administration—many journalists and observers at times did not believe simple (and truthful) explanations for actions such as the switch from asset purchases to capital injections (a response to market developments).
On the Treasury’s grasp of the subprime crisis (slack, to say the least):
By early 2007, we were well aware of the looming problems in housing, especially among subprime borrowers as foreclosure rates increased and subprime mortgage originators such as New Century went out of business… The prediction we made at an interagency meeting in May 2007 was that we were nearing the worst of it in terms of foreclosure starts-these would remain elevated as the slowing economy played a role and the inventory of foreclosed homes would build throughout 2007, but that the foreclosure problem would subside after a peak in 2008. What we missed was that the regressions did not use information on the quality of the underwriting of subprime mortgages in 2005, 2006, and 2007. This was something pointed out by staff from the Federal Deposit Insurance Corporation (FDIC), who had already (correctly) pointed out that the situation in housing was bad and getting worse and would have important implications for the banking system and the broader economy.
On the PPIP and its forerunner the MLEC (aka ‘Super-SIV’):
While banks dealt with the problem on their own, the MLEC episode looked to the world and to many within Treasury like a basketball player going up in the air to pass without an open teammate in mind—a rough and awkward situation. Ironically, however, one of the elements of the Treasury bank rescue plan unveiled by the Obama administration in late March 2009 has elements of MLEC in that institutions are teaming with the federal government to purchase pools of assets, though with the (huge) advantage of being able to fund the purchases through lowcost government financing and with taxpayers assuming much of the downside risk.
Paulson of course, will get a chance to tell his own side of the story. The Wall Street Journal’s Real Time Economics blog reports that the ex-Treasury secretary is planning to publish his own account of the crisis by year-end. Suggested title: “The Financial Crisis: An Interloper’s View” ?
Related links:
The Financial Crisis: An Inside View - Brookings Paper by Phillip Swagel
Views on Paulson’s U-turn - FT Alphaville
The TERP - FT Alphaville
