Paulson's Ever-Changing Bailout

Watching Treasury Secretary Hank Paulson’s erratic behavior administering the federal “Troubled Asset Relief Program” (TARP) is a dizzying, if not sickening, proposition for consumers, taxpayers, and investors alike.

— In a press conference last Wednesday, Hank Paulson announced a change in the TARP, saying that the plan would now center around capital injections into banks rather than the purchase of distressed assets (bad mortgages or securities which the market is pricing below a “fair” value), which was the fundamental purpose of the TARP at its creation.

— On October 27, White House Spokesman Dana Perino said, “It’s possible that some of those financing arms (of the Big Three automakers) could be a part of the rescue package, the TARP….” Two weeks later, Secretary Paulson changed the Administration’s position, telling Bloomberg News, “The intent of the TARP was to deal with financial institutions and major systemic issues and getting lending going in capital institutions. Congress, I believe, should address the question of the auto industry.”

— Last week, Paulson said the TARP may be used to offer financial support to companies which provide credit in the forms of credit cards, student loans, and auto loans. Yes, Paulson said the TARP should help auto loan companies the day before he said TARP shouldn’t be involved in the auto industry.

— Late this Monday afternoon, in what may be the first sign of the realization that the men behind the curtain simply aren’t bigger than the market, Secretary Paulson said “The Treasury Department isn’t likely to ask for Congress for authority any time soon to use the second half of the $700 billion Troubled Asset Relief Program.”

— And on Tuesday, Paulson publicly disagreed with FDIC Chairwoman Sheila Bair, with Bair proposing $24 billion to help “modify” 1.5 billion near-foreclosure mortgages and Paulson adamantly opposing the idea in the face of pressure from House Financial Services Committee Barney Frank urging him to support Bair.

The erratic changes in the government’s plan aren’t just confusing the government. They also interfere with private sector attempts to work through the credit crisis. For example, Paulson’s switch last Wednesday away from using the TARP to buy distressed debt came one day after Citigroup announced a new plan to avoid foreclosure on $20 billion in mortgages held by 130,000 homeowners.

Citigroup is among a small handful of companies which is wading into the swirling financial waters, stirred up that much more by ever-changing government policy. According to George Mason University’s Professor of Economics Russell Roberts (interviewed for this article), “Any natural mechanism that would be taking place to begin the healing is going to be put on hold as long as the government is potential player in those markets, which is why the TARP should have had an extremely narrow and highly monitored focus. Instead it was treated as ‘Well, whatever needs doing, I have a big bank account.’ Unfortunately, while the flexibility of the TARP seems appealing, Paulson isn’t smart enough — that’s not a slap at Paulson, nobody is smart enough — to know exactly what course is going to make things better.

“And that flexibility spawns the uncertainty that has caused almost everyone to sit on the sidelines and see what the rules of the game are going to turn out to be,” said Roberts.

While one wants to give Paulson some benefit of the doubt — these times are so chaotic and unique that maybe nobody could “manage” the situation well — Paulson’s twisting in the wind is doing great damage to investor and consumer confidence. The stock market is falling through holes in the TARP, with the Dow Jones Industrial Average down 20 percent since the law creating the TARP was passed on October 3, 2008. (The market had been recovering somewhat in late October, but since the election of Barack Obama on November 4th, the market has fallen more than 10 percent, perhaps another vote of no confidence in the likely increasing government meddling in the economy.)

Beyond not knowing just what the Treasury will next want to cover (or uncover) with the TARP, investors have to be very skeptical that the plan is anything but the first step down a dangerous road of multiple “relief programs”, not just for financial institutions, but for a range of industries and even for profligate state governments. California Governor Schwarzenegger and New York Governor Paterson have already asked for federal bailouts for their states, while Paterson has asked the NY State legislature to cut spending by less than 2 percent.

Even if Paulson did leave us with any certainty what the TARP would be covering, there is still no reason to believe, especially, with the upcoming Obama Administration and very large Democratic majorities in Congress, that the costs will be kept down to the nearly-$1 trillion price tag we’ve seen so far. After all, just a few weeks after AIG was bailed out with a price tag initially as high as $85 billion, we’re now told that the AIG bailout package is going to cost as much $150 billion.

And just what is the TARP getting us? Its main goal was supposed to be to encourage bank lending by removing fear of their balance sheets tipping into insolvency. But bank lending isn’t happening — because the premise of why lending wasn’t happening was incomplete. According to Russell Roberts, proof of the claims that government intervention can’t force a market to function normally in abnormal times and that government can’t predict the effects of its behavior “is Paulson’s frustration that banks aren’t lending with the money he gave them.”

“If nobody wants to borrow the money, because they don’t know what is a good investment or because they’re afraid of losing their jobs, banks won’t be lending, and the whole mechanism turned out to be a waste,” Roberts added.

The moral hazard of the TARP and related programs is enormous. Once government has jumped in, saving some companies and letting others fail, it becomes exceptionally difficult (especially for Democrats) to refuse handouts for anyone with his hand out.

Then, once the government owns shares or debt in certain companies but not in others, it would be naive not to expect uneven legislation or regulation of those industries. If government owns shares in Bank A, but not Bank B, it is all but certain that Congress or the Executive Branch may pass rules or laws which, subtly or not so subtly, benefit Bank A but not Bank B. Am I the only one who wonders about a government which has been dominated for years (in the area of finance) by Goldman Sachs veterans allowing Lehman Brothers — and only Lehman Brothers — to fail?

It’s not as if there are a lot of great answers around. There is certainly no silver bullet to this economic crisis. As Professor Roberts notes, “Some suggestions during the week of the bailout bill’s passage would probably have been better, but there was no consensus and no certainty. But doing just one thing, even badly, would have been better than doing three different things, changing every two weeks. Even if the third one is the right one, the possibility — or the certainty with the new administration coming in — that things will change is going to create a lot of inertia. So I’m not very optimistic about the next couple of months at a minimum.”

The surest way to minimize the leakage through the TARP is to require it to cover as little as possible. The best first step the government can take is to narrow the focus of its attention, attempting to do everything possible to let the market take its course, even if it means some sacred cows, such as the powerful auto workers unions in Detroit, become hamburger. Unfortunately, given the make-up of the incoming Administration and Congress, those sacred cows are feeling nearly as safe as if they were walking the streets of Calcutta.

If there were any opportunity for Republicans to start reclaiming a position as a party of important ideas, such as understanding that an economy which doesn’t punish failure is an economy which doesn’t allow success, now is that opportunity. Getting there will require an Administration which is not known for admitting mistakes to come around to admitting a doozy and to start living by the wisest words we’ve heard from President Bush in years: “History has shown that the greater threat to economic prosperity is not too little government involvement in the market, it is too much government involvement in the market.”

Secretary Paulson’s announcement on Monday that he wants to pause any expansion of the TARP and his statement Tuesday that the bailout is “not a panacea” could represent just such an important admission. Or he might simply be bending to requests from Barack Obama’s transition team to let them hold the goodie bag for while so they can play Santa Claus — if a few weeks late — come January. Until we know the answer, we’re all stuck on this stomach-churning financial roller-coaster.