The absence of effective regulatory oversight led to inappropriate compensation payments to companies like AIG.
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The principals behind TARP were relatively simple. The toxic assets on the bank's books prevented banks from making loans to businesses and consumers. Initially, TARP's purpose was to purchase the toxic assets from the banks in exchange for financing from the Fed. However, in practice, valuing the assets became a nightmare. In order to account for this concern, revised versions of TARP extended credit to banks in exchange for an equity position — again, in an attempt to shore up the banks faltering balance sheets and encourage lending. This financing strategy granted equity to the government, thereby creating the possibility that taxpayers could benefit from the investments made on their behalf if the value of the investment in the banks eventually moved up. (Read: " Banks Left Out of TARP Bailout Could Face Extinction.")
The TARP investments have yet to bear fruit. Although it may have improved the financial stability of the banking sector and, certainly in the case of AIG, staved off certain bankruptcy, it has failed to encourage banks to meaningfully increase loans to consumers and small businesses. As a result, while banks may be able to remain stable, their stability does the consumer no good. Effectively, the bailout was a bailout of the banking system and its bad bets.
TARP was unable to stimulate lending because it only provided support to the banks. By injecting fresh capital into the system, the expectation was that once the banks were stabilized, they would be willing to start lending again. That simply has not happened.
One reason that TARP was unable to stimulate lending is because banks are only half of the lending market. Unless banks are able to securitize loans that can be sold to investors, loan originators will have insufficient capital to begin lending at healthy levels. In order for these loans to be securitized, private investors must be willing to purchase the securities. To date, these investors have remained on the sidelines, wary of the safety of these bets.
Recently on 60 Minutes, Fed Chairman Ben Bernanke was asked what the first signs of the recovery would be. "Well, I think one sign would be that a large bank is successful in raising private equity. Right now, all the private money is sitting on the sidelines saying, 'We don't know what these banks are worth. We don't know that they're stable.' And they're not willing to put their money into the Bank."
Securitization & Private Capital
The Term Asset-Backed Securities Loan Facility ("TALF"), also known as the consumer loan program, is designed to increase consumer and small business loans by facilitating the securitization of certain loans offered by banks to the public. Specifically, TALF will encourage the securitization of these loans by lending up to $200 billion to investors of AAA-rated ABS. In order to encourage these private investors, including hedge funds, private equity funds, and other sophisticated investors, the loans provide unbelievably favorable terms. First, the effective interest rates of the loans will be incredibly low, currently as low as 2%. Second, unlike lending terms that the public has access to, prepayment of the loan is permitted without penalty. Third, as non-recourse loans, the investor can surrender the collateral, the ABS, in lieu of repaying the debt. Finally, in the event the collateral decreases in value, the Fed will not seek additional collateral to make up the difference.
In theory, investors, buoyed by the promise of these highly attractive loans, will purchase ABS, thereby creating demand for securitizers to issue new ABS. Once securitizers can begin issuing new ABS, they can go back to the bank, the loan originator, and purchase more loans for securitization. And, once banks are able to begin selling their loans to securitizers, they will be able to finance more consumer loans. Or, so the theory goes. (See pictures of the global financial crisis.)
In reality, because TALF investors are exposed to both economic and political risks, the success of the program is far from certain. The application of TALF is subject to a number of economic realities, any one of which could forestall the revitalization of the secondary market. Among TALF's requirements is that eligible loans must be backed by ABS that are AAA-rated by at least two rating agencies, like Moody's or Standard & Poors. Although a AAA-rated security would seem to be a safe bet, the rating agencies failure to properly rate ABS is one of the central reasons why so much bad debt ended up on the books of financial institutions in the first place. The market has yet to see any evidence that the agencies methodologies have meaningfully changed. This raises the question: why would investors purchase loans rated by a private company that has such a lousy track record?
Yet another issue which TALF will be unable to address is the sustainability of the secondary market. Prior to the market's collapse, these instruments were purchased by investors, re-securitized into new ABS, and resold in the secondary market. Although TALF has effectively created virtually risk free loans to investors, there is no incentive or protection for subsequent purchasers of the ABS. In the event the ABS purchased by the investors are unable to be repackaged and sold, the investor's incentive to purchase them is dramatically reduced. And, because it is unlikely that investors intend to treat the ABS as a long-term investment, absent this secondary market, investors will be disinclined from taking on the risk, however small it may be.
Finally, the required AAA-rating poses a significant limitation on the number of loans that can be securitized and purchased by investors with the Fed's financing. Individual AAA-rated loans represent only a fraction of all loans made to consumers. Prior to the credit crisis, a securitizer could improve the credit rating of an ABS whose underlying loans were lower than AAA-rated by taking out an insurance policy from a monoline insurance company. The policy provided that, in the event the underlying loans default, the policy guarantees the principal and interest of the ABS to the investor. Problematically, as of this year, there are no monoline insurers that have a AAA-rating by more than one rating agency. Thus, monoline insurance no longer serves as a viable credit enhancement technique. Furthermore, even if they were AAA-rated, TALF precludes their use for the purpose of credit enhancement.