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Monday, February 2, 2009

The TARP Dilemma

President Obama is getting out front of the next round of TARP money. First, he is making sure that there will be limits to executive pay. While this is a good idea, it is largely ceremonial on its own. What really needs to happen is that financial institutions must run their businesses with significantly more discipline. Giving fat bonuses while the business is going under is just one of many ways in which financial institutions were undisciplined in the past. Only addressing this one area does little. Of course, therein lies the rub. While the Obama administration wants to see discipline in executive pay, they also want to see the same kind of lack of discipline in other areas that got us into this mess.

President Barack Obama will require banks to boost lending to consumers and companies in return for taxpayer aid from the $700 billion bailout fund, in a departure from Bush administration policy, a key lawmaker said.

“You’re going to see the Obama administration,” learning lessons from the first phase of the program, “push for much more lending,” House Financial Services Committee Chairman Barney Frank, who helped write the financial-rescue law, said yesterday on ABC television’s This Week program. “There are going to be some real rules in there.”

This idea that banks need to lend the TARP money is the crux of the problem with TARP. Banks aren't lending for several factors. First, their own capital is limited. As such, lending extends beyond a healthy level. Second, the weak economy makes them fearful of extending too much credit. Third, there aren't all that many credit worthy individuals. As such, in many ways, banks are finally performing the proper oversight over their lending policies that they failed to do during the real estate boom. Now, the Obama administration is demanding that banks stop their due diligence and throw financial caution to the wind and begin to lend with reckless abandon.

This is combined with the fact that the fed funds rate is at a quarter of one percent. As such, if banks are overextended because they have borrowed too much, they can make up the shortfall with almost no interest. If this sounds familiar, it should. This is exactly the attitude that brought us stated loans, no money down loans, and the combination there of. In other words, the Obama administration wants banks to act exactly as they acted over the course of the previous five years.

Giving banks money will NOT bring more potential borrowers into their banks. What it will mean is that banks will extend loans to more of the people that show up. Again, this is exactly the attitude that got us into this mess. There's more. The Obama administration is too smart for their own good. The seem to think they have resolved the problem I am speaking of.

As a condition of federal assistance, healthy banks without major capital shortfalls will increase lending above baseline levels,” Geithner said.

So, they'll only require this of healthy banks. First, most banks aren't healthy. Second, if a bank is healthy why is it getting any assistance at all? TARP, in effect, tries to solve the symptom and not the disease. Banks aren't lending but that is the symptom. They aren't lending for the reasons I mentioned and of course many more. Forcing them to lend before those conditions are resolved only means taking on risk they can't take at this time.

Just think about it. These banks will receive this TARP money and immediately lend it out often to borrowers well beyond their normal risk profile. Will this move the economy? Possibly, but not so much that it will reverse the trend. Will it mean their capital reserves are better off? Of course not. As such, as soon as they have spent the TARP money, they are back in the same position. Whatever short term effect TARP will have it won't change any long term dynamic.

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