Charging a bank for an implicit government guarantee to absorb losses? According to the Wall Street Journal, the Federal Reserve and Treasury are demanding that Bank of America pay $500 million to exit a bailout deal that was never actually signed.

That's a nice chunk of change, but taxpayers shouldn't be fooled into thinking this -- or any other bailout -- is a good deal.

A very dangerous misconception is taking root in the press, that in addition to saving the world financial system, the bank bailout is making taxpayers money.

"As big banks repay bailout, U.S. sees profit" read the headline in the New York Times on Monday. The story was parroted on evening newscasts.

The trouble is the popular view that TARP was the bailout. That very unpopular $700 billion program got all the attention because it was an easy story to tell a general audience. It had a big ugly price tag; it was debated very publicly in Congress; and, most important, the list of recipients and their take was made public all at once.

So when those recipients pay back TARP -- at a decent profit for taxpayers -- bailouts all of a sudden don't seem so bad.

But the bailout was much larger than TARP. There is FDIC's debt guarantee program, which still backs over $300 billion worth of financial sector debt; there are the Federal Reserve's emerging lending facilities, which have showered hundreds of billions of cash on banks in exchange for, well, we don't know what. There was the AIG bailout, which gave the company tens of billions more. There were changes in fair value accounting rules, which permitted banks to hide losses, and there is stupendous support for the housing market, which has rescued banks from huge write-offs.

All of these and more make up the implicit too-big-to-fail guarantee that the biggest financials have all received. The total cost won't be known for years, and the price tag is likely to be enormous.

Look no further than Fannie Mae and Freddie Mac. The moral of their story is that implicit guarantees alter the investment landscape in ways that are very destructive and, ultimately, very expensive.

Portfolio managers kept buying Fan and Fred backed mortgage paper even after the companies' capital structures had deteriorated significantly. They didn't care about fundamentals because they were buying a government guarantee.

But eventually the bill comes due. In Fannie's and Freddie's case, taxpayers have promised $400 billion to absorb losses.

Instead of learning from that mistake, policy-makers thought it wise to repeat it on a larger scale, backing not just the housing market, but most of the financial sector, too.

The $500 million that the Fed and Treasury could collect from Bank of America is a nice token sum. But it doesn't begin to pay the cost of BofA's implicit guarantee against failure.

Taxpayers should keep that in mind whenever they see misguided reports that they are making money from bailouts. The truth is that the biggest banks are still insolvent and, ultimately, their losses are likely to be absorbed by taxpayers.

(James Saft is a Reuters columnist. The opinions expressed are his own)

There is a long list of outfits which have done well out of the banking bailout, but the U.S. Treasury and Federal Reserve are not among them.

According to calculations made for the New York Times, the Treasury’s Troubled Asset Relief Program (TARP) has reaped profits of about $4 billion, or 15 percent annualized, as eight of the largest banks to participate have fully repaid what they owe.

Meanwhile unnamed Federal Reserve officials told the Financial Times that the central bank’s liquidity facilities have generated a “gain” of $14 billion since August of 2007.

The notion of TARP profits is only true if looked at in the narrowest sense, and even then may prove to be a return as real as those of the Florida condo flippers in the summer of 2007.

The Fed, on the other hand, incontrovertibly has earned more by buying and lending against poorer quality paper, but they did it by taking on more risk - a leaf out of the book of the industry they were helping to rescue.

Wait until the Fed starts making payday loans or gets into the reconditioned small appliance finance business, then you will see what kind of “gains” a bank with a printing press and the power to create money can really generate.

I suppose the idea is to make taxpayers and voters grateful that they had the opportunity to participate in such profitable ventures - doing well by doing good, or some similar fluff.

A number of leading banks have repaid their loans made under TARP, and the government has profited by warrants it held under the deals, but this is really only a bit of runoff from the great jet of liquidity that the government has concentrated on the industry as a whole.

“What this is more appropriately described as is a return of capital; to call this a profit is to ignore trillions of dollars in taxpayer monies that have been spent, lent, guaranteed, drawn against and otherwise consumed in what will likely be the greatest transfer of wealth in the planet’s history,” Barry Ritholz, of research firm Fusion IQ, wrote on his blog.

It is one thing to justify an enormous outlay and subsidy - and make no mistake this is what the bailouts were - on the basis that it was a needed evil, but it borders on the offensive to sell it as a successful investment.

DOING WELL FROM DOING LESS

The first to repay within any loan portfolio are by definition the strongest; it is only later that the laggards show the losses. We do not know how the TARP and other programs of support will look in three or four years time, but it is likely to be worse than they look today.

Moreover, the whole idea of rigging the game and then declaring a profit is wrong. Governments can ever and always create the conditions under which their financial sectors can turn nominal profits.

They do this in a number of ways; through lax regulation, by engineering low interest rates with a sharply sloping yield curve, by limiting competition, or by providing term financing when the markets won’t do so.

These profits though are effectively a tax on the rest of the economy, and I am betting that the taxpayer and government are not getting their fair share, which is virtually all of it.

Billions and billions of dollars are flowing elsewhere - to investors, to borrowers and to employees.

There is also the bald fact that, given that there were no effective funding markets at the time that many of the loans and investments were made, the government could have extracted far higher compensation for its support.

And what about opportunity cost? How would the government and taxpayer have fared if instead of rescuing the banks, and thereby privatizing much of the profit, it seized them and sold them off in the normal fashion? Or what about if the trillions of dollars in support were used in different ways, for different purposes, or even, heaven forfend, not spent at all?

As for the Fed and its gains, the key point is that this money, which represents the extra earned above what three-month Treasury bills would have generated, is not risk adjusted.

The Fed isn’t, and shouldn’t be, a hedge fund — leveraging up and going out the risk curve to generate profits.

It too, conceivably, can allocate credit to a particular part of the economy, say housing, and thereby make the loans it makes to that sector perform and generate “profits.” But this begs two questions; is it right for them to allocate credit in this way and are the profits real or symptoms of a bubble?

This will work for a while, but as we have seen, not forever.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

So much for more transparency in the financial system.

It's hard for regulators to demand greater transparency from Wall Street banks when they can't even live up to their own standard of greater disclosure. A case in point is the Treasury Department's press release touting its decision to permit "10 of the largest U.S. financial institutions" to begin repaying $68 billion in federal bailout money. The only trouble is Treasury doesn't name any of the banks that can begin repaying money to the Troubled Asset Relief Program.

Treasury, it appears, has left it up to each of the "10 of the largest U.S. financial institutions" to make their own announcements about their intentions to repay the TARP. And some, like Morgan Stanley, didn't waste anytime putting out a PR trumpeting its plan to repay $10 billion in TARP money.

Now it's not like this list of banks is any big secret. For weeks now, it's been well-known that Goldman Sachs, JPMorgan Chase, American Express, Bank of New York Mellon--to name a few--were itching to repay the bailout money.

But this is a question of government accountability. If Treasury has made a decision to allow banks to repay TARP, it should tell us which banks it has given the all clear to. Why should it be left up to the banks to tell us? After all, isn't it the taxpayers' money that's being passed around here.

Nor should Treasury officials pass on the names of the banks in so-called "background'' sessions with favorite reporters. The best government is one that is run in the open--not in some closed-door Washington, D.C. conference room.

This refusal on Treasury to do something as simple as print the names of the "10 of the largest U.S. financial institutions" is similar to the same kind of arrogance the NY Fed displayed during the early days of the goverment's bailout of American International Group. The NY Fed, if you recall, refused to provide a list of the banks it was buying rotting CDOs from, in order to retire some $70 billion in credit default swaps that AIG had written on those securities backed by subprime mortgages.

At the time, the NY Fed claimed if it divulged the names of the banks selling CDOs to a Fed-sponsored entity called Maiden Lane III, the financial firms might be wary of doing business with the government. That argument sounded like a bunch of  rubbish back then because the arrangement was beneficial to both the banks and AIG.

But wait a minute. Who was the president of the NY Fed when Maiden Lane III was put together. That's right Tim Geithner, the man who now runs Treasury.

It's hard to see how Geithner will have the courage to really reform the financial system when he still too willing to play footsie with Wall Street bankers and can't even do what he preaches on the need for transparency.

– James Saft is a Reuters columnist. The opinions expressed are his own –

The U.S. faces a lengthening series of request from industries and interests seeking shelter under the Troubled Asset Relief Program, most of which it should dismiss out of hand.

YRC Worldwide, a large trucking company, told the Wall Street Journal it will seek $1 billion in TARP funds to help relive it of its pension obligations.

YRC said that about half of the $2 billion it will owe in pension payments over the next four years covers the costs of retirees who worked not for it but for other companies, now vanished, that are part of a multi-employer pension plan.

That’s certainly an irony but doesn’t seem to be the basis for a claim on the public purse.

YRC is not systemically important and its pension woes, presumably the result of negotiation and free agreement, must be its own responsibility.

Next up: states and municipalities.

California Treasurer Bill Lockyer has asked Tim Geithner to provide assistance under the TARP, warning of a hit to public services and infrastructure if the money is not forthcoming.

Lockyer wants the TARP to provide insurance to banks who themselves provide insurance backstopping California’s short-term borrowings. That insurance would cover the banks in the event of a default by California making the deals a surefire moneymaker for the banks.

Lockyer says that because of the credit crunch the banks are imposing too high fees for their letters of credit. That is true, but only up to a point.

The real issue is that California, because of the recession and its own decisions about taxing and spending, is not a particularly good bet.

While California is most certainly systemically important, and while keeping government spending ticking over in a recession is arguably a good thing, this plan is not the way to do it.

As proposed, it is a subsidy to California and to the banks, or in other words one subsidy too far. Like so many other of the government actions during the crisis, this short-circuits market discipline and encourages risk taking in search of private gain but with public insurance.

If the U.S. wants to bail out California, by all means do it, but take responsibility for the decision and do it directly.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

– Jonathan Ford is a Reuters columnist. The views expressed are his own –

Goldman Sachs wants to do its duty by the American people and give them their TARP money back. Some spoilsports have urged the government simply to say no because allowing the investment bank to repay the cash would make other banks look bad.

But this seems rather un-American. Why shouldn’t taxpayers get their money back if Goldman really doesn’t need it? The point to insist upon is that they get all of it back — and on commercial terms.

To be clear, that means not just the $10 billion of TARP-related preference shares the government subscribed for last autumn, but also the rest of the Federal assistance Goldman has received.

That includes the $29 billion of FDIC backed bonds that Goldman has issued at low coupons, without which — as Jon Unia observes in a snappy letter to the Financial Times on April 22 — it might have posted a first-quarter loss rather than a profit. Goldman has, as it points out, issued bonds without a guarantee since last autumn, so it’s not impossible. The full $29 billion would need to be refinanced on commercial terms. After all, either you’re a private sector player or you’re not.

Unia also observes that if Goldman wants to prepay the prefs, it should be charged by the taxpayer for the temporary loan of the Federal balance sheet. This, after all, is what a commercial lender like Goldman would do if the boot was on the other foot.

There is even a mechanism for it to happen. As part of any pref repayment, Goldman could be obliged to buy out the warrants it issued to the Treasury at the same time as the prefs at a price negotiated between the two. This payment could be the prepayment premium.

My suggestion would be that in any such negotiation Treasury Secretary Tim Geithner should select a Rottweiler of an adviser to act on the taxpayers’ behalf — one who could not be accused of being in Goldman’s pocket. Who could fill that role? How about Dick Fuld?

The U.S. Treasury Department on Tuesday unveiled a revamped financial rescue plan to cleanse up to $500 billion in spoiled assets from banks’ books and support $1 trillion in new lending through an expanded Federal Reserve program. But initial market reaction reflected investors’ doubts about the plan, with stocks falling around 3 percent after the announcement by Treasury Secretary Timothy Geithner.

“For all the rhetoric that this is a new plan, they’ve done nothing but rehash and expand the old procedures,” said Steven Ricchiuto, chief economist at Mizuho Securities USA.

Carl Lantz, U.S. interest rate strategist at Credit Suisse in New York, said details of a proposed public-private investment fund for mopping up toxic bank assets were “very vague”.

“It sounds like for this public-private investment fund they are still exploring a range of different structures for the program or seeking input from market participants,” he said. “That’s the the kind of stuff we heard on TARP One and suggests that given all this time they still don’t have anything very specific nailed down.”

James Ellman, president of Seacliff Capital in San Francisco, criticized the proposals. “Investors want clarity, simplicity, and resolution. This plan is seen as convoluted, obfuscating, and clouded. We know that Geithner was able to overrule many other Obama administration people, and said we should not be tough on bank equity holders or bank management. So equity holders got a better deal, and it’s still not a good deal.”

Do you have confidence in Geithner’s plans? Debate the announcement below. We’ll update this post with fresh comments from analysts and other market participants as we get them.

– Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission. The views expressed are his own. —

For every new president, campaign promises and inaugural idealism must give way to the hard choices that measure the mettle of their leadership.

Now Barack Obama must act pragmatically to fix the banks or the economy will sink under their weight.

Banks continue to suffer losses on bonds backed by failing mortgages, credit cards and auto loans, and questionable corporate debt. To assist, the Treasury has used TARP funds to purchase capital in healthy and deeply troubled banks alike; however, no one can calibrate how high bank losses will go, because no one knows how far housing prices will drop and how many loans will ultimately fail.

The Obama Treasury could put a floor under bank losses, through government guarantees on their bonds, or by creating an aggregator bank that purchases those securities from banks altogether.

Guarantees would give the banks profits on bonds whose underlying loans are mostly repaid, and shift to taxpayers losses from those bonds whose loans are mostly not repaid. That would require additional large subsidies from taxpayer to the banks.

An aggregator bank, however, could turn a profit. It could purchase all the commercial banks’ potentially questionable securities, at their current mark to market values, with its own common stock and funds provided by the TARP. Then the aggregator bank could balance profits on those securities whose loans pan out against losses on securities whose loans fail.

An aggregator bank could perform triage on mortgages. It could work out those whose homes can be saved with some adjustments in their loan balances, interest rates and repayment periods; foreclose on mortgages for homeowners who could not meet payments with reasonably concessions; and leave other loans alone.

Commercial banks acting alone cannot accomplish triage as effectively, because individually they can have little effect on how much housing values will fall. In contrast an aggregator bank, holding so many mortgages and working in cooperation with Fannie Mae and Freddie Mac, could have a salutary impact on housing values. It could put some breaks on falling home prices.

Beyond toxic securities, policymakers need to fix what got banks into this mess. The 1999 repeal of Glass-Steagall permitted the creation of financial supermarkets, like Citigroup, that combined commercial banks with investment banks, brokerages, and the bizarre universe of hedge and private equity funds.

Those nonbank financial firms are run by salesmen and financial engineers that don’t understand long-term commitments as bankers to borrowers with solid incomes and sound business plans.

Investment bankers, securities dealers and fund managers, essentially, get paid commissions on sales and for betting other peoples’ money on arbitrage opportunities. They put together people that have money with those that need money, and those people that can’t bear risk with those that can.

In contrast, commercial bankers, historically, had skin in the game—bank capital and a fiduciary responsibility to depositors. They were paid salaries, not commissions on the volume of loans they wrote or bought from mortgage brokers to package into bonds. They expected to be fired if their loans prove imprudent.

To investment bankers and securities dealers, it does not matter how risky a loan is, because they can always bundle it into a bond to sell it off or insure it with a swap. That’s nonsense, as we have learned. Adopting that thinking commercial banks got stuck with too many loan-backed bonds and buying swaps that were not backed by adequate assets.

Commercial banks need to be separate and more highly regulated. The ongoing process of breaking up Citigroup and placing its banking activities into a separate entity should be replicated at other Wall Street and large regional banks.

Freed from toxic assets and the complications of affiliations with financial institutions having other agendas, commercial banks could raise new private capital and make new prudent loans as President Obama’s stimulus package lifts consumer spending and business prospects.

Such approaches would disappoint those who champion unbridled free markets but Wall Street’s financiers have abused the opportunities offered them by deregulation to the peril of the nation.

President Obama needs to craft solutions that address the world as he finds it not as intellectuals tell him it should be.

– John Kemp is a Reuters columnist.  The opinions expressed are his own –

After more than a year of denial, misdirected policies and a steadily worsening outlook, the past fortnight has witnessed a marked improvement. For the first time, there are reasons to be cautiously optimistic that the economy faces a recession rather than a prolonged slump, and recovery could get underway in H2 2009.

Markets share some of that optimism. The Dow Jones Industrial Index has risen 15.5 percent over four consecutive sessions, the most sustained rally since April 2008. It is not yet time to break out the champagne. But there are reasons to start looking through short-term weakness to focus on an eventual, albeit modest, recovery by the end of next year.

DENIAL AND MISDIRECTION

Regulators and much of the financial services industry have been in denial for more than a decade about the steady accumulation of risk within individual institutions and across the system as a whole.

Even when rising defaults on subprime loans caused the music to stop last summer, regulators and industry leaders failed to appreciate the structural nature of the crisis. There was much talk of isolated instances of poor risk-management and hope the downturn could be contained in the housing market and motor manufacturing.

Most thought the music would begin playing again after a brief pause, and the dance could resume much as before with only a few minor modifications.

As the crisis dragged on through winter and into spring and began to destabilize key financial institutions, the policy response focused on providing liquidity rather than the solvency of the banks and their borrowers.

In this view, banks were basically sound and the deterioration in asset quality was relatively minor. Toxic subprime loans were only a small part of total balance sheets.

Fire-sale prices for a growing number of assets reflected the lack of buyers amid heightened uncertainty, not their fundamental value. If sufficient liquidity could be created, and mark-to-market accounting rules eased, institutions could hold assets to maturity and realise their much higher intrinsic value.

The Fed responded by trying to organize takeovers for troubled institutions and providing a dizzying array of liquidity facilities on an unprecedented scale. The effort culminated with the creation of the U.S. Treasury’s Troubled Asset Relief Program (TARP). TARP was designed as a buyer of last resort for illiquid but supposedly valuable assets, able to stabilize the market and aid price discovery by paying more than fire-sale prices and closer to the intrinsic hold-to-maturity value.

The “Wall Street” first strategy focused on rescuing the banking system in order to keep credit flowing to consumers and businesses on “Main Street”. At no point did anyone admit the crisis of liquidity was in fact a crisis of solvency (too much debt and insufficient cashflow). Meanwhile, default rates on residential mortgages continued to climb, unemployment rose and the slowdown spread from housing and motor manufacturing to the rest of the economy.

The first hint of a reassessment came with the Treasury’s decision to re-program TARP funds from buying distressed assets to injecting capital into the banks. It was the first indication of growing concern about solvency rather than just liquidity. But the Fed and Treasury continued their focus on Wall Street first, hoping that capital injections and reserve creation would lead to a resumption of lending and forestall a deep contraction. It has not worked.

ALTERED FOCUS, NEW HOPE

In recent weeks, the dramatic failure of a series of high-profile financial institutions, mounting panic about the outlook, and clear signs businesses and households were beginning to cut spending sharply in anticipation of a depression-like drop in sales and employment next year have forced a much more dramatic reassessment.

Priority has shifted from monetary policy and financial system liquidity to fiscal policy and sustaining the real economy.

Perhaps the single most important shift is the deftness with which President-elect Barack Obama has handled the issue. By moving quickly to appoint an economic team of experienced heavyweights and announcing a stimulus package aimed at saving or creating 2.5 million jobs over two years, the incoming president has projected a calm confidence under fire and signaled an appreciation of the need to forestall a deep recession on Main Street.

Quick moves to fill the key posts, an assured performance at three press conferences in three days, and a bold but simple plan that looks big enough to make a difference but is easy to explain and communicate have given the impression fiscal policy is not ineffective and will make a difference. That in turn should blunt some of the pervasive fear and retrenchment spreading through the economy like a virus.

Confidence is an ephemeral commodity, but in a crisis it is the most important one. Repeated failures to stabilize the economy despite upbeat assurances have badly damaged the credibility of the existing Treasury and Fed teams. The presidential transition offers the possibility of a fresh start (much as Franklin Roosevelt’s transition offered one in 1933).

Some of the new appointees (Timothy Geithner for Treasury secretary and Lawrence Summers for the White House National Economic Council) are closely associated with policies of the last decade that are now coming under scrutiny. Details of the stimulus are sketchy.  But the change of cast is more important at present.

UNCONVENTIONAL STRATEGIES

Changed atmospherics have been buttressed by practical changes, most importantly at the Fed. The direct lending efforts announced on Tuesday (purchases of Fannie Mae and Freddie Mac bonds on the open market, and lending money to other institutions to buy securitized consumer, auto and credit card loans) offer a reasonable prospect of restoring some credit growth. They should make the Fed’s quantitative easing strategy effective and unblock the credit creation process.

More importantly, by buying GSE bonds on the open market and lending to others to buy more exotic asset-backed paper, the Fed is engaging in precisely the type of “unconventional” open market operations in a wider range of securities and maturities that could limit borrowing rates for households and corporations across the economy.

The use of unconventional operations to act on different parts of the yield curve and credit spreads has been discussed in the past as the ultimate response to a crisis. For the first time the Fed is putting it into practice.

Monetary policy is now supporting fiscal policy. Through its aggressive quantitative easing, the Fed has convinced investors short-term interest rates will remain low for an extended period. As a result it has managed to drag the yield on ten-year Treasury securities down from almost 4 percent to a little over 3 percent, achieving a key objective.

Lower yields should in turn make it much easier for the U.S. Treasury to get away the vast mountain of bills that need to be refunded and carry out the massive borrowing needed to fund the Obama administration’s massive stimulus program.

Similar reinforcing shifts in fiscal and monetary policy worldwide suggest senior policymakers share a common view of the problem and are adopting mutually reinforcing solutions.

None of this implies that the next 12-24 months will be easy. Continued adjustments will be painful (including a further shrinkage in the capacity of the financial services industry, and restructuring of U.S. motor manufacturing).

The economy will experience its deepest recession since 1979-1981. In the short term conditions look set to worsen further, and the crisis will leave a legacy of enormous public debt.

But provided the incoming administration can tailor an appropriate and credible stimulus package (that delivers front-loaded spending on labor-intensive items) and the Fed is able to support it by keeping long-term rates low and gradually compressing credit spreads, there does appear to be a way to ensure this a recession rather than a slump.

–John Kemp is a Reuters columnist.  The opinions expressed are his own–

LONDON (Reuters) - Experience shows financial crises escalate very rapidly, and need a swift and decisive response from policymakers to break the cycle of panic. Time to reflect, craft thoughtful policies and consider long-term consequences is a luxury policymakers generally don’t have.

But the problem with bold ad hoc responses is they often have unintended consequences. Individual policy actions may prove inconsistent with one another, fail to achieve objectives, and store up larger problems for the longer term.

Developments over the last week suggest the U.S rescue program has fallen into just this trap and is now rapidly unraveling.

The twin pillars of the rescue program are the multiplicity of liquidity and lending programs being offered by the Federal Reserve and the Treasury’s Troubled Asset Relief Program (TARP).

Both programs are now in deep trouble. In fact the various rescue packages risk becoming a textbook example of how poorly designed programs can fail to achieve their objectives.

LIQUIDITY EVERYWHERE BUT MAIN STREET

The Fed has grown its balance sheet from $884 billion to $2.055 trillion in the space of two months and extended almost $1 trillion in additional support to the banking system through the various emergency lending programs enacted or expanded over the last year.

But precious little of this additional liquidity is finding its way through to households and corporate borrowers. In fact, most of it is now sloshing around the banking system like so much excess ballast.

Banks have increased their reserve holdings on deposit with the Fed from $8 billion to $494 billion. This is $488 billion more than the Fed estimates they would ordinarily need to hold for payment clearing and prudential purposes.

Increased reserve holdings have absorbed perhaps half of the liquidity placed into the banking system from the Fed. Much of the rest has almost certainly been invested into the mountain of Treasury bills the U.S Treasury has been issuing. Only a very small proportion is left for re-lending to the real economy.

It is much safer for the banks to lend surplus funds to the Fed and the Treasury than lend to one another let alone to households and corporations. There is no credit risk. Nor is there any liquidity risk because reserve balances can be accessed on demand, and the Treasury bills have short maturities and can be readily re-discounted.

The Fed has made these perverse incentives worse by agreeing to start paying interest on excess reserves. Previously, the lack of interest payments gave banks an incentive to minimize reserve balances. But now reserves pay interest the net cost is low.

Even low returns on Fed balances start to look attractive when adjusted for the high levels of credit and liquidity risk in extending longer-term credits to other banks and real-sector borrowers.

SURPLUS MONEY, NOT ENOUGH CREDIT

Policymakers have ignored the distinction between money and credit (or to use monetarist terminology between narrow money and broad money). The Fed can create unlimited (narrow) money by adding reserves to the banking system. But it cannot create credit (broad money, or lending from the banking system and other financial institutions to one another and to end customers).

This is precisely the problem the Bank of Japan faced throughout the late 1990s and into the present decade. The bank reduced interest rates close to zero, and even resorted to “quantitative easing”.

The result was a huge increase in narrow money but little or no growth in the broader money aggregates as the banks preferred to keep the increased liquidity in their vaults rather than boost lending to customers.

The problem is that credit extensions depend on healthy banks being willing and able to lend, and healthy borrowers willing to borrow and able to repay. Once the economy is trapped into a more than usually serious recession, sound and prudently managed institutions have no incentive to take on more leverage to expand their operations, while lending to weaker institutions that need the money presents an unacceptably high credit and liquidity risk.

Yesterday’s inter-agency statement from the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation (http://www.federalreserve.gov/newsevents/press/bcreg/20081112a.htm) notes sternly “the agencies expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers”. But the stern injunction to start lending again is probably futile.

Until collateral values (especially residential and commercial property) stabilize and there is greater certainty about the economic outlook, there is no incentive for creditworthy institutions to borrow, or banks to lend. But without lending, the contraction will deepen.

THE $700 BILLION TARP SLUSH FUND

TARP is beset by even bigger problems. Recall the $700 billion fund was originally created to provide a buyer of last resort for mortgage-backed securities and other assets that had become illiquid and were allegedly trading only at firesale values, if at all, that did not reflect their fundamental underlying worth. TARP was supposed to aid price discovery and deal with a crisis of liquidity.

But the TARP provided the Treasury secretary with almost unlimited authority over how to use the money, subject only to an oversight board composed mostly of executive branch officials and powers for Congress to invoke the “nuclear option” and disapprove further funding beyond an initial $350 billion.

The fund has quickly mutated. The Treasury used $125 billion for capital injections into nine large national banks, some of whom claimed they did not want or need it. Another $125 billion is being made available for capital injections smaller regional and community banks. Some $40 billion is now being used to support AIG. The Treasury now has just $60 billion of TARP authority before it must risk returning to Congress.

PROGRAM CREEP

Yesterday, the Treasury admitted it now has no plans to begin buying troubled assets, gutting the program’s original purpose completely.

Congress came under intense pressure to approve TARP with the promise that asset purchases could begin within a matter of days of the president signing the bill. Legislators show increasing signs of restiveness that TARP has transmuted into a giant $700 discretionary fund outside the regular appropriation process.

There is frustration that TARP funds are being used to bolster balance sheets (and thereby take off pressure to cut dividends and bonuses), and perhaps pursue consolidation, while there is no new credit flow to households and corporations.

Meanwhile an ever-lengthening list of industries are bidding for TARP bailouts. The Treasury has already extended the program to insurers. American Express and other institutions have turned themselves into commercial banks to access all the federal support on offer.

The auto industry is pressing its own claims to be “systemically important” for a share of the bailout funds. Congress and the administration are now arguing over where to draw the line. TARP is not big enough to bail out all these industries.

But the fundamental problem is that neither Fed liquidity nor TARP deals with the root of the problem - the rising tide of defaults in the residential mortgage market, and the continued fall in home prices and collateral values.

There is a popular misconception that the renewed extension of credit will revive the real economy. But that is putting the cart before the horse. Credit will start flowing again only when banks and potential borrowers can see some sign that the economy, cash flows and collateral is stabilizing.

As several senior Fed officials have indicated, monetary policy has done all it can. Only fiscal policy, combined with the systematic rescheduling of loans and write-down of debt principal, can achieve stabilization in the real economy and the housing market.

–John Kemp is a Reuters columnist. The views expressed are his own–

By John Kemp

LONDON (Reuters) - The bitter political divisions between middle America and Wall Street on display when the House of Representatives first rejected the Emergency Economic Stabilization Act last month look set to be re-opened in even more dramatic form in the remaining months of the year.

Rep Henry Waxman, chairman of the powerful House Committee on Oversight and Government Reform, on Tuesday sent identical letters to the chief executives of nine major banks receiving $125 billion of capital injections under the Troubled Assets Relief Program (TARP) demanding details of total bonus payments for 2006, 2007 and 2008 (see http://oversight.house.gov/documents/20081028142314.pdf).

The issue of bonuses and dividend payouts from banks that accepted the TARP injection looks set to become highly charged.

It is going to be hard for the banks and Treasury to explain why so much taxpayer funding needs to go in through the front door, only for it to flow out again as staff bonuses and dividend payments to ordinary shareholders. Bonus and dividend payments could quickly absorb all the TARP capital funding.

The issue of responsibility for the credit crisis will intensify during the quarterly dividend and annual bonus payout period in Dec-Feb, just when a new administration will be taking office and Democrats are likely to extend their control over both houses of Congress.

The equation between bonus and dividend payments on the one hand and capitalization and TARP funding is a false one. But it will stoke fury in middle America about the cost of bailing out banks while homeowners continue to be foreclosed.

By heightening the political temperature at a key time, it will make a more radical solution to the crisis more likely. For example, buying off political hostility to the continued bonus and dividend payments will almost certainly force Congress and the incoming administration to consider widespread restructuring, loan guarantees and other financial support to homeowners and troubled companies (eg GM) which in turn will intensify the upward pressure on the budget deficit.

The toxic cocktail of TARP, compensation and dividends will complicate budget planning and makes it almost certain there will be significant slippage on the federal government’s budget deficit. Even before the crisis struck, the Congressional Budget Office (CBO) and White House Office of Management and Budget (OMB) were projecting deficits of around $450 billion in 2009.

TARP will add at least another $250 billion to the deficit — because CBO has already reportedly decided capital injections into banks will be counted as 100 pct spending (and 100% revenue when they are finally cashed in) rather than just counting the subsidy element of the credits and estimates of likely losses (which is what would have happened if the TARP had been utilized only to buy troubled assets, as the Treasury originally proposed).

OMB is likely to take a similar view. There is already speculation the Treasury could use TARP funds to help smooth a merger between General Motors and Chrysler. The more of TARP is used for equity injections rather than troubled asset purchases, the higher the deficit will be.

In addition, the worsening downturn may well cut income tax and corporation tax revenues, while boosting expenditure on unemployment insurance and aid to families with dependent children in the form of food stamps.

This is before Congress considers tax cuts, homeowner bailouts or extra spending to stem the tide of foreclosures and stimulate the economy. Using conservative estimates, the budget deficit for fiscal 2009 could easily hit a record $900 billion — $450 billion originally projected plus $250 billion of TARP equity capitalization plus $100 billion in underlying deterioration from the automatic stabilizers of lower tax receipts and higher welfare spending plus $100 billion of stimulus from extra tax cuts and spending.

The US government will therefore need to borrow about $900 billion to finance new deficits as well as around $2.3 trillion to roll over existing debt maturing within the next twelve months.

The cocktail of TARP, compensation, dividends and record debt issuance promises to be very bitter indeed.

(john.kemp@thomsonreuters.com)