Seventh in a series

WASHINGTON — Nearly a year after it was enacted, the consensus is that the Troubled Asset Relief Program saved the economy from ruin — but it did so at a heavy cost for bankers.

Regulators, bankers, academics and industry observers concluded in interviews that the rescue fundamentally changed the relationship between banks and the government, solidified the concept of "too big to fail" and unleashed a wave of populist anger against the industry.

"It changed the face of capitalism," said Cornelius Hurley, a former Federal Reserve Board lawyer who now directs the Morin Center for Banking and Financial Law at the Boston University School of Law. "It's a massive injection of taxpayer dollars into the banking system. It's going to be hard to recover from that. The hangover is going to be [felt] for a long time, even after all the Tarp money is paid back."

William Isaac, a former chairman of the Federal Deposit Insurance Corp., is decidedly more downbeat.

"I'm afraid [Tarp] is turning the banking system into a public utility, and it's hard to see how that gets turned around," Isaac said.

A year ago, there was a growing sense of panic. The government seized Fannie Mae and Freddie Mac on Sept. 7, Lehman Brothers filed for bankruptcy on Sept. 15 and the Fed bailed out American International Group Inc. a day later. Fed Chairman Ben Bernanke and then-Treasury Secretary Henry Paulson, under pressure to develop some kind of comprehensive solution, began circulating a three-page proposal that called for the government to begin buying bad assets from banks.

But shortly after Congress approved the $700 billion plan on Oct. 3, the Treasury made a radical shift. Instead of buying assets, the government would inject capital directly into financial institutions. Paulson began by inviting the nine largest commercial and investment banks to the Treasury on Oct. 14, and effectively forced them to take $125 billion from the government in return for preferred shares of stock and warrants.

It was as big a moment as any in financial regulatory history. It wasn't just that the government was investing in banks — itself a landmark move, considered by some as the first step toward nationalization — it was that the banks had no choice.

"It destroyed the working relationship between Treasury and some of the banks," said Robert Clarke, a senior partner at Bracewell & Giuliani, and a former comptroller of the currency. "It could have been done on an optional basis where it wasn't forced down their throats."

Looking back, many observers agree it was a mistake. The argument at the time was that having all of them take the money would ensure no stigma was attached to the funds. The troubled institutions would be able to use the capital to prop themselves up, while the healthy ones would essentially serve as cover for the others.

But that's not how it worked out. The healthy banks soon announced they did not need the funds, fueling speculation about the firms that said nothing. What's more, with the nine banks receiving half of the original $250 billion allotted to the Capital Purchase Plan, questions quickly arose about whether the Treasury needed even more money to prop up the system.

"It should have been much more voluntary," said Alan Blinder, a professor at Princeton University and a former Fed vice chairman. "It was wrongheaded, given there was a scarcity of money."

There were also questions about the terms of the government's investments. The banks had to pay annual dividends to the government on the preferred shares and interest on the warrants, but soon critics began asking why the Treasury had not extracted a greater price from the banks. The original contracts had given broad leeway to retroactively add restrictions — and pressure grew to do so.

As Congress and the Treasury began contemplating more requirements, the industry's skepticism about the government intensified.

"Initially banks were encouraged to take the investments without any strings attached," Comptroller of the Currency John Dugan said in an interview. "The more the program began to look like a bank bailout, the more strings were piled on later, and I think that created some perception problems about bait-and-switch. I think ultimately it was still a good thing that so many banks took the capital, because it helped shore up the system, but I think we've had to live with the stigma questions ever since."

After Paulson assured the public the Tarp money would be used by the banks to make more loans, lawmakers demanded proof. Though there was no real way to track how Tarp funds were being used, Treasury officials insisted they were developing metrics that would prove the money was put to good use.

The biggest controversy came in the spring, after AIG paid $165 million in bonuses to its senior executives even though the firm had been yanked back from the brink of insolvency by the government.

The announcement spurred a rush in Congress to crack down on executive compensation among Tarp recipients. In March, the House voted 328 to 93 to tax at 90% all bonuses paid to companies that received $5 billion or more from Tarp. The approval came just hours after the measure was introduced. Though the Senate never took up the measure, the speed with which lawmakers moved spooked bankers.

Many saw it as a dangerous precedent. The public felt a right to dictate compensation to bankers because it was taxpayer money that stabilized the system.

"I understand the public uproar on the salaries and bonuses, but I think that will lead to some questioning of the role of the financial system in our society and our economy," said Phillip Swagel, who was a Treasury official when Tarp was created and is now a professor at Georgetown University. "If there is this implicit government backstop of the financial system, why are the salaries so high? They get the upside and we as taxpayers get the downside. I don't have the answer, but I think that's a legacy."

Many community bankers, who already viewed the program as unfair, also felt painted with the same brush as the biggest banks. While early drafts of legislation targeted the largest recipients of Tarp, it was not long before lawmakers were discussing new restrictions on all recipients.

"The compensation stuff would have been fine for the systemic banks, but when the Tarp went from the systemic banks to others … I think the program became confused," said Doug Faucette, a partner at Locke Lord Bissell & Liddell LLP. "It started out being one thing and it evolved to be something totally different."

The result was that Tarp money quickly became tainted. Almost overnight, the program went from being a popular one that banks were rushing to join to one they were running to exit. Jamie Dimon, the chief executive of JPMorgan Chase & Co., branded Tarp money a "scarlet letter," and began publicly declaring his intention to repay it.

So far, 37 institutions have repaid over $70 billion. Of the initial nine banks that received capital, all but Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. have repaid their money. Treasury officials expect another $50 billion to be repaid in the next 12 to 18 months.

"The fact that it has been paid back so quickly showed Treasury missed the mark it wanted to hit," said Wayne Abernathy, executive director of financial institutions policy for the American Bankers Association. "If the purpose was for banks to expand their activities, they would have hung on to it. Instead it was perceived in a negative light and many banks gave it back at every opportunity."

Tarp also stirred public outrage at bankers, who were blamed for starting the housing crisis. The banking industry suddenly found itself with much less clout on Capitol Hill. The largest banks, in particular, felt the sting, with many lobbyists privately complaining that lawmakers wanted nothing to do with them.

Tarp is still so unpopular that several Republican Senators sent a letter Monday to Treasury Secretary Tim Geithner, requesting he allow the program to expire on Dec. 31. "While we understand that our economy is still recovering, we believe it can function without added Tarp funding," the senators wrote.

At a March meeting with the executives from the largest banks, President Obama summarized the public's view of banks. "My administration is the only thing between you and pitchforks," Obama said.

That animus spurred a crackdown on credit card practices. Though the Fed had already taken similar steps, lawmakers quickly took up and passed a bill that restricts credit card lenders even further. Congress is now weighing similar action to limit overdraft fees.

Regulators are feeling the heat, too, and intent on proving their consumer protection and systemic risk bona fides. The Fed announced last week that it would conduct consumer protection exams on all nonbank operating subsidiaries of bank holding companies. Both the central bank and the OCC are working on their own executive compensation restrictions designed to prevent banks from offering bonuses that induce excessive risk taking.

Some observers said it could be years before the industry's reputation recovers and bankers regain some clout on Capitol Hill. "Clearly there has been a lot of populist anger about bank bailouts. … I think that will be something that remains as a legacy" of Tarp, said David Min, associate director for financial markets policy at the Center for American Progress.

One lasting impact is that even the banks that repaid Tarp owe something to the public, policymakers argue. In a speech last week, President Obama said bankers remain indebted to the government. "The fact is many of the firms that are now returning to prosperity owe a debt to the American people," he said.

That feeling is likely to stay for decades, observers said. "It's hard to unring the bell," said David Nason, a managing director at Promontory Financial Group and a former Treasury official in the Bush administration. "With all the significant government intervention that was necessary to avert this crisis, it will be hard to erase this from people's minds going forward."

Tomorrow: How Tarp solidified "too big to fail."

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