Some Questions on the Credit Crunch

Friday brought news that U.S. Treasury Secretary Henry Paulson believes Congress should release to him the second $350 billion (of $700 billion total) for the Trouble Assets Relief Program (TARP), so it can be distributed to banks and lenders. Meanwhile, President Bush announced that he would use the remaining $17.4 billion of the first TARP installment to shore up troubled automakers General Motors (GM) and Chrysler, with an eye toward their rapid restructuring by March of 2009.

Increasingly, though, there are doubts about the way the TARP money has been utilized. Initially, it was - as the name suggests - intended to fund direct purchase by the government of illiquid, "toxic" securities and mortgages from banks. The goal of such purchases was to simply remove liabilities from bank balance sheets and return those institutions to full fiscal health. Public resistance to this plan, however - as well as the actions of foreign governments in addressing their own financial crises - convinced Secretary Paulson to pursue another path.

As a result, TARP has been used to buy interests in financial giants like Citigroup and American International Group (AIG), with the idea that this infusion of cash will allow them to begin lending again, something that is crucial to the workings of the American economy. Ostensibly, taxpayers would be afforded some protection through the purchase of equity stakes, since, as the banks recover, their stock prices will rise, and it might even be possible for the public to make a profit.

All well and good, but it's entirely unclear that the sort of strictly disciplined approach needed to make this plan work has been undertaken. In addition to serious concerns about the lack of oversight on TARP, there are some very legitimate questions about whether or not the financial sector has simply gotten a nice, fat government subsidy with no obligation to resume doing what needs to be done to keep the credit markets flowing.

Banks still aren't lending, and the plight of the car companies, for instance, is at least somewhat directly tied to that fact. With the Bush Administration's insistence on removing a key provision regulating executive pay, bonuses and dividends for TARP recipients - as well as the GOP's clear intent to use the automobile industry's tremulous state to try and defang the United Auto Workers (UAW) - it is increasingly difficult to be certain that efforts to confront the consequences of massive deregulation are being made in good faith.

Which brings me to some key questions.

First, why aren't we pushing for more financial institutions to do what Credit Suisse is doing? The Swiss bank has announced that it will pay executive bonuses in illiquid assets, rather than cash, equity or options:

The bank will use leveraged loans and commercial mortgage-backed debt, some of the securities blamed for generating the worst financial crisis since the Great Depression, to fund executive compensation packages, people familiar with the matter said. The new policy applies only to managing directors and directors, the two most senior ranks at the Zurich-based company, according to a memo sent to employees today.

“While the solution we have come up with may not be ideal for everyone, we believe it strikes the appropriate balance among the interests of our employees, shareholders and regulators and helps position us well for 2009,” Chief Executive Officer Brady Dougan and Paul Callelo, CEO of the investment bank, said in the memo.

The securities will be placed into a so-called Partner Asset Facility, and affected employees at the bank, Switzerland’s second biggest, will be given stakes in the facility as part of their pay. Bonuses will take the first hit should the securities decline further in value.

“It’s monstrously clever,” said Dirk Hoffman-Becking, an analyst at Sanford C. Bernstein Ltd. in London who has a “market perform” rating on Credit Suisse stock. “From a shareholders’ perspective it’s great because you’ve got rid of some of the assets and regulators will be pleased because you’ve organized a risk transfer.”

For employees, “there’s some upside in there and if the alternative is nothing, it’s a lot better than nothing,” Hoffman-Becking said.

Second, why are we allowing financial firms to maintain and distribute massive bonus pools? Any company that needs to turn to public financing in order to survive has no business handing out bonuses to anyone, no matter how well workers may have performed against their individual goals for the fiscal year. The justification for these bonuses - that they are vital for the retention of good employees - is utterly ludicrous in the face of company performance, the current job market, and the fact that these once-mighty financial titans are teetering on the brink of collapse.

Third, why are we lowering interest rates effectively to zero and aiming to pump more cash into the financial sector? Dropping interest rates might ease the reluctance of a few banks to lend, but the much larger effect is to drive demand for loans and mortgage refinancing without doing anything that encourages lending. There is already more than enough unmet desire for credit and new terms on housing loans, and pushing money into institutions that will not, in turn, lend it, accomplishes little other than to provide a lifeline to struggling companies that have shown an unwillingness to make tough restructuring choices and who continue to hand out large bonuses on the taxpayer's dime.

Perhaps it is time the for the government to simply bypass the banks that won't lend and set up a program whereby it makes commercial and even personal loans at a rate slightly higher than that set by the Federal Reserve. Such an approach would guarantee that the government will never offer rates that banks - at least in principle - cannot also meet, or even better. Companies that have maintained strong balance sheets, such as Wells Fargo, will have no trouble competing, but banks that are currently hoarding cash (especially public cash) will be cut out of the market unless they loosen their purse strings. More crucially, such a program wouldn't fuel excess demand for credit or push policies that don't address that demand, and individuals and firms that need loans would get them.

Finally, and perhaps most importantly, why are we ignoring the root of the problem and failing to address subprime mortgages directly? If banks are forced to lock in adjustable rate mortgages (ARMs) at the introductory rate - or even one only somewhat higher - the majority of homeowners who are struggling to make their payments would then be able to do so, and lenders would still make money, although not as much. It would certainly take some effort, but reader lokywoky lays out a plan of action in comments on a previous post:

Identify and map ALL the subprime loans back to their originators. De-link them from the derivative pools and nullify all the credit default swaps (which are worthless pieces of paper anyway). TELL the banks that they WILL renegotiate these loans - whether they are in default or not. The terms will be a 30-year fixed rate at the original "teaser" rate the buyer got when they signed the loan documents. The banks will write down any and all fees, late charges, foreclosure costs, etc. The principal of the loan would remain as it was after the most recent payment. If there are extenuating circumstances, the loan term may be extended to 35 or 40 years.
[...]
Anyway, liquidity at the bottom is what will fix this problem, not pouring money into the black hole of derivatives and designer crapshoot paper Ponzi schemes. Once the credit market is fixed, presto - no more bailouts for the auto companies will be needed. No more trillion dollars disappearing money from the treasury. And - my solution doesn't take one dime from the taxpayers. How about that!

Now that we are $350 billion in the hole for TARP, it appears that Congress will be asking Secretary Paulson some tough questions when he returns to Capitol Hill for more money. These should be among them.