Although the jury is still out on whether the latest version of the bailout plan will save the financial markets from meltdown, we may be seeing a glimpse of the proverbial light at the end of the tunnel. Fifteen countries, led by the British, are directly injecting capital into their respective banking systems in exchange for partial ownership of the banks. In this country, Treasury Secretary Hank Paulson has changed his mind and, instead of activating his original $700 billion taxpayer “trouble asset relief program,” or TARP, to buy troubled mortgage securities, the program will now take direct ownership stakes in banks.
As noted in a recent column, Gretchen Morgenson of The New York Times believes that this is a positive development. While regulators are making up the rules as they go along, Ms. Morgenson opines that this is not necessarily a bad thing. TARP never answered the question of how much taxpayers would pay for troubled mortgages. Investors and taxpayers suspected that the government would pay too much money for these toxic waste mortgages simply to improve the banks’ bottom lines. The direct investment plan also raises serious questions including who will decide which banks receive the help, which will be allowed to fail, and what standards will be used to reach those decisions. Ms. Morgenson notes that these decisions will fall to Neel T. Kashkari, Assistant Treasury Secretary for Financial Stability. Not surprisingly, Mr. Kashkari is a 35-year-old former banker at Goldman Sachs who has just been out of business school for six years.
Of course, it is expected that he will have help from others at the Treasury Department, including Mr. Paulson, and from the Federal Reserve and other regulatory agencies. The more transparent the process is, the more confident taxpayers will be. Transparency, however, has never been Mr. Paulson’s priority.
The government’s biggest problem now is that regulators have been entrusted with enormous and unprecedented powers at a time when investors’ and taxpayers’ trust in government is at an all time low. It is hard to trust the people who are now scrambling to reassure investors with bold actions when as recently as July they had denied the existence of the problems. In the first half of 2007, almost every senior regulator in the federal government ? especially Mr. Paulson ? repeatedly assured us that troubles in the mortgage markets would be confined to subprime loans.
Ms. Morgenson does admit that there are a few straight talkers among the regulators, including Gary H. Stern, President of the Federal Reserve Bank of Minneapolis and co-author of Too Big to Fail: The Hazards of Bank Bailouts. Stern is uneasy in using taxpayer funds to bail out big and reckless financial institutions. His solution is an approach he calls “systematic focused supervision,” involving “early identification, enhanced prompt corrective action and stability related communication.”
First, regulators must identify the material exposures between large financial institutions and those institutions and capital markets. The regulators would thus know where the fault lines are before the earthquakes begin. Prompt corrective action is the second step. Banks should be closed while they still have positive capital or at most a small loss that can reduce spillovers that threaten the viability of other institutions that have exposure to it.
Finally, regulators must communicate the actions they are taking. Otherwise, some market participants might continue to believe that bailouts are possible because they have not been advised to the contrary.
Whatever steps regulators take to restore confidence of investors and taxpayers, such straight talk is an indispensable first step.