As the banking system goes from bad to worse, it is vital for the Obama team to take quick advantage of the once-ignored guarantee powers provided in the Troubled Asset Relief Program.
This will work a lot faster than capital injections or a "bad bank." Using the federal government as an insurer, not an asset acquirer, is a lot easier on the federal deficit — a critical factor as President Obama faces a phalanx of unpleasant choices. Choosing among them will require disciplined focus on the financial market's recovery.
Using Tarp insurance powers is not a panacea. Given the condition of the banking system, nothing is. However, the guarantee powers provided in Section 102 of the Emergency Economic Stabilization Act are the least worst of a series of decisions that will all have far-reaching, high-risk implications.
It is for this reason that the United Kingdom has decided to rely on guarantees. The U.K. banking system is, of course, different from ours, but there's one fact that binds the U.S. and U.K. together: If the government buys assets from a bank it doesn't otherwise own, then those assets must be marked to market.
Doing so deepens the bank's hole, even if assets are then transferred. In sharp contrast, use of a federal guarantee revalues assets — upward and fast.
Importantly, federal guarantees also do not hurt healthy banks, and the United States still has plenty of them.
A huge problem with the Capital Purchase Program results from the Bush administration's decision to require all of the nation's largest banks to belly up to that costly bar. Fearing the market impact of differentiating the weak from the strong, the Treasury Department forced the nine largest firms to take the Tarp money, creating a precedent that forced all of the nation's insured depositories to seek capital to reassure their investors.
This quickly used up the $250 billion allotted for the program and, as it turned out, did not do much for Citigroup, Bank of America, or the truly weak institutions the Treasury first sought to mask with the broad bailout. And of course, the capital program did little to prevent foreclosures or support mortgage lending, because it was so widely provided.
Instead, targeting Tarp money to resilient institutions dedicated to mortgage finance would have been a far more effective use of the initial funding, as has now been made all too clear.
Unlike capital injections, a guarantee supports all banks holding or originating loans or asset-backed securities carrying the federal imprimatur. That has two immediate and beneficial effects: Capital is generated on the spot, because of the lower requirements applicable to guaranteed assets, and the market for the paper runs free and clear.
For evidence of the value of a federal backstop, look at the Federal Deposit Insurance Corp.'s temporary liquidity guarantee program — with it, banks of all sizes can offer debt. Like it, loans or asset-backed securities with a federal guarantee would have ready buyers.
Another important advantage of a guarantee program over asset purchases is the impact on the federal deficit. Unfortunately, the EESA is drafted so that every dollar used in a federal guarantee is deducted from the $700 billion program to the same extent as if it had been used for an asset purchase. However, this is not the way guarantees or insurance work for the real federal budget.
There, this form of support comes under what is called the credit budget — an appropriation is allocated according to the program's ultimate anticipated cost for the government after premiums, reserves, and losses are taken into account.
Since even the highest-risk guarantee program will not lose all its bets, the program is far more efficient from a fiscal perspective than direct outlays, which are gone the day they are spent, even if advocates hope for long-term return.
This is not to suggest that capital injections should be withheld, or that the bad-bank concept should be abandoned. Far from it. In this market, everything can and should be considered, because the financial system teeters on a frightening precipice.
Nor does this brief review address all the critical details of a successful guarantee program. For starters, it should not provide a full federal insurance policy for 100% of most assets, especially newly originated ones. A full-faith-and-credit backstop should be afforded only to designated mortgages or other obligations essential to recovery; if this aid isn't carefully targeted, then it's back to the bailout and, perhaps, a renewal of high-risk lending.
Limited, targeted, and forward-looking consumer and corporate guarantees would jump-start critical markets without the long-term implications of direct U.S. investment in financial institutions.
In fact, a federal guarantee is what the government is good at. We've done it for years — the FDIC, the SBA, and even the FHA (its woes notwithstanding) are just a few examples of government guarantees that have stabilized targeted sectors.
In sharp contrast, the United States has never owned banks except for those it has taken over after problems are recognized and the shop is shuttered. If capital injections remain the principal form of financial relief, then the banking system is on a slow road to nationalization or, at the very least, far more intrusive regulation that dictates who gets loans, how much, for how long, and at what rate.
This is far beyond the rewrite of prudential rules sure to come, and should the capital injections lead to this quasi-nationalization, then the United States will have a new form of financial policy to join the industrial one already evident in the automobile industry's bailout.
Under current market conditions, capital is critical, and it is not surprising that almost all comers want some from the Treasury. But it is not free, as the policy implications of the Citigroup and Bank of America transactions make all too transparent.
To the greatest degree possible, the Obama Treasury should circumscribe the banking system's bailout, and the insurance authority provides a ready tool to do so.