An article in today’s Forbes online entitled Trouble with TARP, reports a growing concern by the Congressional Oversight Panel (COP) about the effectiveness of the $700 billion program. The COP reports that the effectiveness of the program is difficult to determine due to lack of transparency of how funds were spent. The COP report also states that the absence of any reporting guidelines for TARP participants impedes effective oversight.
The 145 page report starts with a retelling of the extreme conditions confronting the banking sector as the credit crisis exploded last autumn. It also outlines the choices confronting regulators, legislators and industry executives as the crisis deepened. We were led to believe by Treasury and Federal Reserve officials that the global banking system was in imminent danger of collapse. Nothing less then immediate and drastic measures taken by sovereign government officials and industry executives would prevent the catastrophic consequences of global economic carnage. The report makes it clear that these market conditions were so extreme that regulators were navigating through uncharted waters. Any remediation measures taken had little historical precedence to guide actions. Hence Paulson was given carte blanche to handle the crisis with unprecedented latitude and executive facility.

As this blog reported earlier this week, the TARP was originally designed to acquire troubled assets from banking institutions. TARP funds were earmarked to purchase mortgage backed securities and other derivatives whose distressed valuations severely eroded capital ratios and stressed banks balance sheets. Hank Paulson later shifted the strategy and decided to inject TARP funds into the banks equity base. This has done wonders for the shareholders of the banks but troubled assets remain on the banks balance sheet. As the recession continues, unemployment, home foreclosures, SME bankruptcies and the looming problem with commercial mortgage backed securities (CMBS) are placing a new round of added strain on the banking system.

The TALF program is designed to draw private money into partnership with the government to acquire troubled assets from banks. So far the program has received a tepid response. I suspect that the principal factors inhibiting the expansion of the TALF program are numerous. Chief among them is the inability of FASB to decide upon valuation guidelines of Level III Assets. Banks holding distressed securities may also be reluctant to part with these assets because they have tremendous upside potential as the economy improves.

The COP also questioned the effectiveness of TARP because stress tests were only conducted on 19 banks. The report states that additional stress tests may be required because the previous tests failed to account for the length and depth and length of the recession. Community banks are also of concern. They face a perfect storm in challenging macroeconomic conditions. Of particular concern is commercial real estate loans. Many economists are concerned that high rate of loan defaults in commercial loan portfolios pose great threats to the community banking sector.

Though interest rates remain low due to the actions of the Federal Reserve, lending by banks still remains weak. SME’s are capital starved and bankruptcy rates are quickly rising. SME’s are critical to any economic recovery scenario. A strong SME sector is also crucial for a vibrant and profitable banking system. Perhaps a second round of TARP funding may be required to get more credit flowing to SME’s. If banks start failing again it would be devastating. The Treasury and the Federal Reserve don’t have many bullets left to fire because of all the previous expenditures and a waning political will of the people to continue to fund a systemically damaged banking system.

Risk: banks, SME, economy, credit, market

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