The Trouble With TARP: Shareholders Trump Taxpayers
Image has not been found. URL: /wp-content/uploads/2009/01/frank.jpgRep. Barney Frank (D-Mass.)
As lawmakers grilled Wall Street CEOs last week over their use of federal bailout funds, Rep. Patrick McHenry (R-N.C.) asked the financial titans if their first obligation is to lend the money for the sake of the economy or to prop up their firms for the sake of investors.
The eight corporate executives responded identically, all proclaiming that the shareholders — not increased lending — are their utmost concern.
Illustration by: Matt Mahurin
“Thank you,” McHenry said. “I think we have completely resolved whether or not the TARP funds were for you to simply lend, or for the safety and soundness of our financial system.”
That brief exchange serves as a warning to Washington as credit markets remain frozen despite the injection of hundreds of billions of federal dollars into the financial system under the Troubled Assets Relief Program. Lawmakers supported the TARP with the expectation that banks would use the money to increase lending — then reacted angrily when Wall Street subsequently lent less. Yet finance experts from across the political spectrum say the reluctance of banks to lend more freely should come as no surprise.
After all, they point out, banks are in the moneymaking business, and Congress put no conditions on how TARP funds had to be spent. If hoarding the cash is deemed best for investors, then that’s what the firms are likely to do — federal bailout or none.
“The banks’ responsibility is to their shareholders,” said Desmond Lachman, economist at the conservative American Enterprise Institute. “They’re profit maximizers. They’re not supposed to worry too much about the economy on the whole.”
Elizabeth Warren, a Harvard University economist who chairs the congressional TARP oversight panel, delivered a similar message earlier this month. “If you’re under water, it makes no sense to lend,” Warren told the Senate Banking Committee. “You hang onto this money and hope that it sees you through.”
As the economy sinks further into recession, Washington policymakers are scrambling on a variety of fronts to reverse the trend. As one strategy, Congress last fall approved the $700 billion TARP program, designed to shore up the banks’ balance sheets and get them lending again. In January, lawmakers released the second half of the TARP allotment to the Obama administration, and Treasury Sec. Tim Geithner last week outlined a vague plan to combine that money with Federal Reserve funds and private investment in efforts to thaw the credit markets.
Yet recent reports reveal that the nation’s largest banks continue to tighten lending standards despite the enormous outflow of cash from Washington. Indeed, among 10 of the 13 largest TARP recipients, lending fell by $46 billion, or 1.4 percent, between the third quarter of 2008 (before TARP was enacted) and the fourth quarter, when those firms were receiving billions in TARP funds, according to an analysis by The Wall Street Journal released last month.
More recently, The Washington Post found that the banks receiving TARP funds have reduced their lending more dramatically than those that didn’t. The reason? “Rather than investing in the banks best equipped to increase lending,” the Post concluded, “the government invested disproportionately in banks that needed money to solve problems.”
Rep. Barney Frank (D-Mass.), chairman of the Financial Services Committee, defended the TARP last week, arguing that it would be “totally impractical” to solve the credit crisis from some framework outside of the existing finance system. “We have no option, if we are to get credit flowing again in this country, other than to work within the existing institutions,” Frank said.
Yet many economists say that the fall in lending indicates that the TARP approach — by attempting to prop up what are effectively failed Wall Street firms — was misguided from the start. James Galbraith, an economist at the University of Texas, said the program is doomed to fail. “It’s made in the hope that you can leverage TARP to get the banks lending again,” Galbraith said. “I can assure you that it’s just not going to happen.”
Galbraith argues that the weakest banks — even the giants — should be declared insolvent and reorganized under new management. “The problem will not be solved by a restoration of the status quo,” he said.
Wall Street, however, is pushing to return to business as usual. The collapse of the finance industry — largely self-inflicted — might be affecting everyone in the country, but the banks, even those that have accepted billions in federal funding, have hardly changed their philosophical approach to doing business. Investor interests will take priority, they insist, and lawmakers urging the firms to consider the larger economy are learning the hard way that to ask public companies not to maximize profits is to challenge their very reason for being — like asking cats not to chase mice.
Indeed, the bailed-out banks have strongly resisted mandatory limits on executive pay and shareholder dividends.
“Moral suasion is not so effective in influencing the decisions of a public corporation, whose primary responsibility is to their shareholders,” Darrell Duffie, professor of finance at Stanford University and president of the American Finance Association, said in an email. “We could ask all sorts of corporations to hire more workers in order to reduce unemployment. But would they?”
Some experts have argued recently that any real solution to the financial meltdown will require an epic change in America’s business culture. In an op-ed appearing in The Washington Post earlier this month, Rakesh Khurana, a professor at Harvard Business School, and Andy Zelleke, co-director of the Center for Public Leadership at Harvard’s John F. Kennedy School of Government, called for an overhaul in the nation’s approach toward Wall Street omnipotence.
As a society, we have bought into a system in which we ask little of corporate leaders beyond the aggressive pursuit of short-term self-interest. For two decades, this model has formed the core paradigm taught to our business-school students. “Shareholder value” was of utmost importance. Notions of obligation to the society in which the corporation is embedded have been set aside, even mocked. CEOs loved this model, as it provided cover for their pursuit of kingly riches. And the rest of us have accepted it because it appeared, through the workings of the “invisible hand,” to be consistent with a globally competitive economy.
This system — and the predictably reckless choices made by some of its most powerful players — has brought our economy to the brink of collapse. To scold business may feel good and may even help move legislation along. But we need much more than a good scolding and limits on sky-high paydays. We need to rethink how American business ought to be run, including changes to fiduciary duties, legal liability, takeover rules and business education, among many other areas.
For their part, TARP recipients have defended their lending patterns, arguing that they’re doing everything they can, considering the economic turmoil, to restore credit markets. “Despite recessionary headwinds, we are lending,” Bank of America CEO Ken Lewis testified before the House Financial Services Committee last Wednesday.
Yet some lawmakers have grown tired of such claims. At last week’s hearing, Rep. Gary Ackerman (D-N.Y.) blasted the bank heads for their claims of free-lending, contending that lawmakers hear a much different story from constituents. “We all hear basically the same thing,” Ackerman said, “and that’s the voices from the other world, the real world, where people can’t get loans; where people can’t refinance their homes; where people can’t buy automobiles; can’t send their children to college.”
The practical effects of the lending decline are more than anecdotal. A new report from researchers at Duke University and the University of Illinois found that 59 percent of U.S. businesses have been affected directly by an inability to get financing.
Economists and industry representatives point out a number of factors why the banks have scaled back on lending. For one thing, many borrowers — both individual consumers and small business owners — had, in recent years, leveraged rising home equity when applying for loans. With the bursting of the housing bubble, much of that equity disappeared, leaving those borrowers with much less collateral. “It was like a Ponzi scheme that could go on until the bubble burst,” said Lachman of AEI.
Also, the recession has reduced the number of loan applications, as potential borrowers are switching to cash rather than taking on more debt in the face of uncertain markets. The banks, having been devastated once by an over-exposure to risky securities and unqualified borrowers, are hardly in a mood to dabble now in the same risky ventures.
“We make money when we make loans. That’s our business,” said Wells Fargo CEO John Stumpf. “[But] not every borrower that needs money can get it today. We have to be prudent.”
Many economists are quick to point out that such prudence is hardly a bad development. “Everyone wants them lending, but we want the loans to be good ones,” said Peter DeMarzo, professor of finance at Stanford University. “We certainly don’t want them doing the same lending they were before. It was the loose lending that got us into this mess to begin with.”
There are other reasons the banks might be reluctant to increase their lending. Sen. Christopher Dodd (D-Conn.), chairman of the Banking Committee, estimated earlier this month that the nation’s financial institutions face $1.2 trillion in commercial real-estate exposures over the next two years. The primary reason the banks are hoarding, Dodd said, is that “they know what’s coming.”
Consumer advocates aren’t convinced that the once-free lending banks have made a real effort to help homeowners and other borrowers survive the downturn. Kathleen Day, a spokeswoman for the Center for Responsible Lending, pointed out that it was the finance industry that pushed sub-prime loans on homeowners, many of whom were doing fine with existing fixed-rate mortgages. “They’ve gone from one extreme to the other,” Day said of the banks’ lending practices. “And neither is appropriate.”
The Geithner plan proposes to inject up to $2.5 trillion into the financial system, including private investment, Federal Reserve funds and the second $350 billion in TARP money. Many economists blasted the plan, both for its lack of detail and its adherence to the Bush administration mantra that throwing more money at Wall Street will fix the crisis. A central criticism: The government can attract private investment only by guaranteeing, with taxpayer money, that those investments won’t tank — a boon for shareholders at the expense of everyone else.
“The only class of people who we’re going to protect from harm are those with investments in the nation’s largest banks,” Galbraith said. “What kind of public policy is that?”