Banks To Repay TARP Money

The Treasury Department has approved the plans of ten banks to repay the TARP money they received as part of last year’s bailout of the banking system. The total cash going back is $68 billion, which can either be lent out again if the need arises or simply be used to reduce the government’s need to borrow from somewhere else.

In one way this is a good sign. Obviously the administration has more confidence in the banks than it did even a month or so ago. The names of the banks has not been released officially but reports suggest that JP Morgan Chase, Goldman Sachs, American Express, and Morgan Stanley are among them. Citigroup, Wells Fargo and Bank of America are not.

The banks have wanted to repay the government since they all passed the stress tests performed a month or so ago. Continued use of TARP money meant that they were subject to restrictions on the way they conducted themselves. All the banks chaffed at the notion of government scrutiny of their activities, and in particular, at the limits placed on pay scales. Bankers like to pay themselves big bonuses, and while they were on the government dole political pressure and legal straight jackets stopped them from making significant payments to ‘key’ people.

“The cost in cash and human misery that the bankers created is epic. They should pay for it.”

The government was adamant that the banks demonstrate an ability to raise capital from private sources before it would allow repayment, hence the frenzy of debt and equity issuance by the healthier banks over the past month. Now that most have managed to restore their access to the capital markets the regulators are satisfied that this first group can be weaned off taxpayer assistance.

But is this a good thing?

I am not so sure.

The banks who are now allowed to repay TARP cash all passed the stress tests. As you know I thought the stress tests were none too stressful. In fact I thought them to be easy. Not only that, but the banks all indulged in a period of negotiation subsequent to the tests, so the image created was not one of severe oversight but of indulgent cooperation. The regulators simply didn’t have the stomach to impose strong standards, and so the banks were required to rebuild themselves only up to fairly lenient levels of capital. And the ‘worst case scenario’ they all supposedly passed looks a lot like the most likely outcome for this year’s economy rather than a severe further downturn.

Given this, I don’t think that we truly know just how healthy these supposedly healthy banks are. They are all still sitting on substantial portfolios of toxic assets of doubtful worth. They will no doubt need to keep raising capital just to offset future losses on those portfolios. Which means that the amount of capital available to be deployed as loans is still limited.

So the flow of credit into the economy is by no mean assured even though we now have a slew of ‘healthy’ banks.

Meanwhile we now have two types of banks: those who have repaid their TARP money, and those who are still tethered to the Treasury Department. Clearly the latter are now at a significant competitive disadvantage. The credit markets will differentiate even more strongly between the ‘strong’ banks and the ‘weak’ banks which implies higher interest rate costs for the weaker ones and possibly even more difficulty in their capital raising efforts. Private investors will take the repayment green light as a government ‘seal of approval’ and thus channel their investment into the strong banks and away from the weak ones. This will make it harder for the likes of Citi to rebuild itself to the point that it, too, can be allowed to repay TARP.

The market has, of course, been drawing its own conclusions as to relative bank strengths, so all of this may not change the environment for capital raising very much. But it cannot be welcome news for shareholders of Citi, Wells, B. of A. etc that their organizations are still considered too weak to come off life support.

In broader terms there are very clear signs that the credit markets have settled down from their crisis levels of last September and October. Risk spreads are much lower, funds are flowing, and investors are willing to lend to banks gain. So there is a semblance of normality slowly returning. The recent spate of better news in the ‘real’, i.e. non-financial, economy has helped lift the mood of investors too.

But we should take great care not to declare the crisis over. The banking system remains very fragile and large losses on commercial real estate and credit card portfolios loom in the near future. Plus the banks are as opaque as ever in their activities. Nothing substantial has changed in the system except for the reduction in competitors and the new two tier system of good and weak banks that results from this TARP repayment. The biggest of our banks remain ‘too big to fail’ and can thus indulge in extravagant risk taking for the benefit of their bonus payouts knowing full well that the taxpayers will pick up the pieces.

This privatization of profit and socialization of loss is an anathema to the long term health of the economy. It has to stop. Bankers have to be made accountable for the losses that their excessive risk taking produces. It was failed bank management, and, in particular, a cavalier approach to risk, that brought the nation’s economy to its knees. The cost in cash and human misery that the bankers created is epic. They should pay for it.

This means radical and structural reform of the banking system.

There are proposals already floating around as to how this should be done. So far none are adequate, although some regulators are agitating for strong action. The latest salvo to be fired came from Federal Reserve Board Governor Dan Tarullo just this week who focused especially hard on the banks considered to be ‘systemic risks’. He advocates a fairly hard line to restrict the damage that rotten bank management and failed bank business models can do to us in the future. As of now though the debate is only warming up, and time is slipping by.

But for now the big banks will remain ‘too big to fail’ and thus we can expect them to retain control over public policy. This is the most important point we must confront. The banks have ‘captured’ the legislative process and thus can ensure that legislation is always modified in their favor. Even in these times of evident failure they have been able to push back against bankruptcy law changes that would have allowed easier mortgage payment modifications for borrowers. I am thus not expecting the administration to introduce the kind of stringent re-regulation I see as needed to prevent further banking mischief.

The banks, even in their currently impoverished state, still flood the electoral system with cash and other forms of largesse. In any other nation on earth this flood would be called corruption. Here we call it free speech. It is the sort of free speech advocated by the Mafia. I doubt whether our doughty legislators will be able to resist the suggestions of their local bankers, let alone those of the big Wall Street banks and the various trade associations that inhabit the shadows of Washington.

So while we applaud the repayment of TARP money, we may regret the continued power of the banks. They are not fixed yet. And the odds of getting them fixed, as in becoming socially acceptable and reliable institutions, is waning. As the immediacy of the crisis fades and the attention span of Congress shifts its focus somewhere else our window of opportunity for reform diminishes.

I wonder whether we have lost the chance to restore balance to the economy even though the debate is only now beginning. I hope not.

Addendum:

Clearly the Congressional Oversight Panel [‘COP’], led by Elizabeth Warren of Harvard University, agrees with me about those stress tests. The panel’s June report contains a critique of the tests written by two Berkeley professors. They conclude that the tests are too lenient given where unemployment already is [the tests worst case assumed an unemployment rate of 8.9% as an average for 2009]; that they don’t extend far enough into the future, while much of the commercial loan losses will occur in 2011 and beyond; and that they have been deliberately obscured so that understanding how they were carried out is very difficult. The COP concludes that the stress tests should be run again to adjust for these problems.