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The policy debate regarding the merits of TARP has taken an interesting turn in recent weeks with the Treasury Department’s claim that the program will likely turn a profit. The bank rescue portion of TARP has already returned a gross profit. Treasury also points out that when counting Fed seigniorage from printing money to buy interest-bearing assets, the government may even come out ahead when including the cost of the $150+ billion bailout of Fannie Mae and Freddie Mac. The message is that TARP and the associated rescue programs not only saved the economy from collapse, but were also a shrewd investment undertaken on behalf of taxpayers.
It is unfortunate Treasury decided to go down this path. TARP was a rescue program designed to inject money into firms at rates no private market participant would accept. TARP not only rescued individual firms, but also helped to stabilize financial markets and arrest the decline in asset prices. Once market participants were convinced that the government would do whatever was necessary to take the risk of systemic meltdown off the table, asset prices rose swiftly. In the 40 trading days following the March 6, 2009 lows, the value of the U.S. stock market increased by 36%. This spike in asset prices increased the fair value of the securities on banks’ balance sheets and the market value of bank equity. These market gains and those that followed restored the banks’ capital cushions and allowed most of the largest institutions to quickly repay TARP funds.
If TARP was the financial success described by Treasury, why shouldn’t the government do more lending, particularly to troubled businesses facing a liquidity crisis? Academic research finds that defaults across corporate borrowers are more correlated than would be expected given the correlation across corporate performance. This is because loan terms shift through time in response to changes in risk aversion, macroeconomic factors, and fund flows. A business that could finance itself on favorable terms at one point in the credit cycle could find itself completely shut out from loans in another. Why does the government tolerate these shifts in interest rates, credit spreads, and loan volumes? By providing capital at the bottom of the credit cycle, the government could earn a large profit from preventing most bankruptcies.
Thinking of TARP as a successful investment program rather than a necessary evil invites expanded government credit initiatives. Any worthwhile commercial activity or research that appears – to anyone – to be underfunded could be a candidate for a government loan. That’s because the government accounts for its lending programs without any concern for the distribution of potential outcomes. If the interest rate on a series of loans exceeds the expected losses, the program comes at no cost. Since 1983, the annual loss rate on junk bonds has been only about 2.5% (a 4.48% default rate and 45% recovery). This means that the government could offer every speculative grade borrower in the United States a 5-year loan with an interest rate of 3.4% and the program would generate an enormous profit, on average (0.82% five year Treasury rate plus the 2.5% expected loss, plus a margin of 8 basis points).
It is one thing for Treasury to defend the “need” for intervention generally and TARP specifically. It is quite another to make claims of financial success that, taken at face value, beg the question of why Treasury is leaving so much money on the table by not doing more?