A Primer on Priming the Pump

Remember last fall when the treasury secretary told us that the economy would be destroyed without the quick infusion into banks of $700 billion? Well, last week a new treasury secretary told Congress that averting disaster would take something closer to $2 trillion. It’s almost like our economy is being held hostage by Dr. Evil.

With $350 billion of the first rescue plan spent, the business and consumer lending it was meant to spur has barely budged. In this new plan, at least, it’s not all new taxpayer money at stake. The second $350 billion from the original plan would be plowed into the effort, and further government money would be committed to prod banks to make loans and to encourage private investors to buy up the now-toxic mortgage-backed securities by insuring against potential losses. The Federal Reserve would also commit money in the form of incentives for banks to not foreclose immediately on borrowers delinquent on their mortgage payments.

Treasury Secretary Timothy Geithner didn’t provide any firm numbers on how much additional taxpayer money would be needed for this new bank rescue plan, which is meant to accompany the nearly $800 billion stimulus package of tax cuts and spending. It was one of many details whose absence dismayed both Congress and Wall Street, which reacted to Geithner’s presentation by plunging more than 380 points. The Obama administration has promised to provide more specifics on the plan and its cost to taxpayers in the coming days.

In the meantime, to help make sense of what’s been proposed so far, BU Today turned to Mark Williams, an executive-in-residence at the School of Management, a former Federal Reserve examiner, and a risk management expert.

BU Today: Didn’t we already pass a bank-rescue package last fall?
Williams: Yes, we had the initial bailout, what we could call TARP I, the Troubled Asset Relief Program. This was the Bush administration program committing about $700 billion in taxpayer money specifically to shore up the banking system. The fundamental premise underlying TARP I was that the economy can only be as strong as its banks.

What does that mean?
Well, two thirds of our economy, as measured by GDP growth, is driven by consumer spending. If banks don’t lend, consumers can’t do their part — borrow and spend. Right now, what’s happening is that banks have been unwilling to lend, whether for student, consumer, or business loans.

The largest part of any bank’s balance sheet is typically its loan portfolio. Good loans generate income for banks. Bad loans can become cancerous to a bank and quickly cause it to reduce lending until it is able to return to better health. The premise of the initial TARP money was to use it to buy bad loans, giving banks the cash that they could lend out and energize the weak economy. But that was problematic, because of the difficulty in arriving at a fair price for these bad assets. So, instead of buying these bad assets, they decided to just inject money directly into the banks’ balance sheets by buying preferred stock in the banks with the TARP money. In essence, we, as taxpayers, became part owners of numerous banks. The understanding was that if we give them this capital, it should actually show up in the economy in the form of loans, so that consumers can borrow and spend, an important driver to our economy.

But it didn’t really work, did it?
Before the Bush administration concluded, only about half the money approved in TARP I had actually been handed out. And to use the metaphor of a sausage machine — we put billions of dollars into the machine, we turned the handle of the economy, but we were able to make only a few new pieces of sausage. With continued economic uncertainty, many banks decided that the best use of the TARP money was not to loan it out, but to hoard it and strengthen their balance sheets. So, with credit markets still frozen, the Treasury decided they needed to find a new way to stabilize banks. Now, with the Obama administration, we have Treasury Secretary Timothy Geithner at the helm. And what he’s proposed is an even bigger rescue program, priced at about $2 trillion, that I’ll call TARP II. So at this point, an underlying question is, if $700 billion wasn’t enough, will $2 trillion be enough?

Will $2 trillion be enough?
While I am not a trained economist, what is clear is that our economy and the global economy we are linked to are very complex and capital flows at the speed of light as it seeks returns around the globe. Supply and demand drives markets, but so do emotions. So, unfortunately, there’s no quick fix and only time will tell us if this increased dollar amount makes sense. TARP II does appear to be a little more targeted to the problem. There are three components to it. The first part is to dedicate up to $1 trillion through a public-private partnership to use government insurance and risk backstops as incentives for private investors to buy up those bad bank loans. Here, TARP II is going to have the same challenge that faced TARP I, and that will be finding a fair price for these assets.

The second part of the strategy dedicates up to $1 trillion — notice that it’s “up to,” because there’s a lot of discretion with how much, when, and to whom this money would be allocated — to spur lending. That is, money would go directly to making or supporting consumer loans.

The third part is to carve out $50 billion to keep people in their homes by giving banks financial incentives to work out deals with people who are delinquent on their mortgages.

One of the key ideas pushed by Representative Barney Frank (D-Mass.), the chair of the House Financial Services Committee, is that keeping people in their homes will reduce forced home foreclosure sales. If you can stabilize the real estate market, if consumers can start seeing that their houses aren’t depreciating, then consumers may start relaxing their wallets and start to spend again.

But given the popular anger about the first $700 billion, how does the government expect the public to support something three times as big?
Let’s put it this way: people aren’t going to like it. There is understandable skepticism among taxpayers. But they’re going to dislike TARP II less than they did TARP I. In the initial plan, all the risk was borne by taxpayers, but in this new plan, there’s more shared risk. For example, if you were a banker, you may not be inclined to give me a loan right now, because you’re risk-averse. But if the government steps in and says, “If you make this loan, and there are losses, we’ll insure the first 20 percent of those losses,” then, all of a sudden, that creates a different risk profile for you, the bank, and you’re more inclined to make that loan. And, importantly, that’s not actually taxpayer money out the door. Until there’s a bankruptcy and a loss, and we have to pay, there’s no out-of-pocket cost. In addition, the government is going to encourage more participation by private investors in purchasing toxic bank assets through intermediaries such as hedge funds, venture capital firms, and private equity companies.

Our economy is a boat that is taking on great amounts of water. We have multiple holes we’re trying to plug; TARP II is going to plug some of them, but not all of them. We have to be realistic. It took us years to get into this mess. It’s possibly going to take us years to get out.

Are we headed toward nationalized banks?
Nationalization is happening. Every time a bank goes back to the federal government and sticks its hand out for TARP money, it has to provide preferred stock and the taxpayers own more of it. At some point, then, the bank becomes de facto nationalized.

I do question whether the government should be in the banking business. But what we realize in this financial crisis is that banks provide a very important social good to the marketplace. Just like the electricity and water that we rely on, we need to have strong access to cash and the capital markets. If banks can’t provide that access, then we can’t borrow and consume. So, should the government be involved in banking? They probably shouldn’t be, but right now they need to be.

Chris Berdik can be reached at cberdik@bu.edu.