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Folding the TARP: Analysis of Treasury’s Changes to the Plan

Why fiscal stabilization will not be sustainable

Clearly the market isn’t too excited about Hank Paulson’s announcement from this morning that they will be changing the direction of how the funds under the TARP will be used. No shocker there, right? As you can see by the big bold headline from the Financial Times’, the US Dep’t of Treasury has decided to not use TARP funds to purchase toxic assets. Instead, the $700 billion will be targeted recapitalization programmes, specifically focusing on “markets that securitize consumer credit.”

As the CNBC talking heads were scrambling to talk to someone about this issue, so that they could tear their clothes and gnash their teeth in a dramatic display of scandalous disgust, I couldn’t help but ask myself, is this a surprise at all? To be honest with you, I’m surprised we didn’t hear this sooner, but I guess the folks on the Hill and at Treasury realized the political fallout from the bill as it was originally proposed was already creating quite the storm in the elections. Now, the politics of the year are mostly gone, I take this measure as an effort to simply come clean, stating what the initiative was always designed to do.

Those people that have proposed that the government should purchase toxic assets are missing the point, just like those who are suggesting we need wide-scale fiscal stabilization policy to stimulate the economy. Those types of measures may work in a theoretical vaccume, but in the real markets, purchasing toxic assets would only compound our problem. It would essentially be translating the posession of bad asssets from one owner to another, ultimately residing with the government, where the taxpayer is will be responsible for bearing the brunt of the impact.

The same goes for stimulus measures. Giving everyone a check for $1,000 isn’t going to solve our liquidity crisis. In case you haven’t heard, we’re in the middle of the greatest recession since the 1930’s. If you will recall, the only thing that could really get us out of that economic downturn was a war of global proportions (Note: I understand there’s more to the depressionary recovery than WWII, but bear with me, I’m summarizing). If you (or whoever you support in Washington) think that distributing thousand dollar bills is going to make everyone go out and purchase flat screens, then you’re clearly living in a cave. Based on the amount of debt out there and the challenges people are facing, the amount a stimulus initiative would inject into our economy isn’t remotely close to implement real stabilization. Moreover, this is like putting a band-aid on a flowing gunshot wound. It’s completely a short-term solution that doesn’t even begin to address the magnitude of the challenges we face.

According to a market strategist commenting on Bloomberg today, “We basically see the U.S. remaining in a recession through the first half of the year,” Binky Chadha, New York-based chief U.S. equity strategist at Deutsche Bank AG. “Earnings are probably not going to hit bottom until the economy hits bottom, and even then with a bit of a lag.” What this means is that we haven’t really even begun to see the full impact of this recession. Moreover, most economists expect this recession to last longer and perhaps be much more intense for longer stretches than previous ones.

Fiscal stabilization is not going to be the answer to solving this crisis, not even in the short or near term. This is the kind of thing economists build models for that most people think are irrelevant, because they assume we’ll never be in a position to have to address the variables they’re talking about. So, I can assure you, the problem cannot be addressed by lawyers and otherwise unqualified people who have been elected to serve in a political capacity by a political process by an electorate that not only doesn’t understand the issue at hand, but they played a significant role in contributing to the development of it.

In terms of the recent announcements from Treasury, I don’t think this is a negative thing, even though the markets are not responding well. In my opinion, the markets don’t like it, because it wasn’t what they originally thought the bailout/rescue package was designed to do. I don’t know why traders would have thought the government is just going to purchase all of the crappy assets and we’ll start with a clean slate, but apparently some of them were under that impression. Most policy experts and economists were fairly confident that Paulson would eventually have to back up the strategy and focus on more long-term sustainable solutions. This is where they are today.

According to the Wall Street Journal , “Treasury is expected to widen its program to inject capital into smaller, closely held banks, and is considering expanding its rescue to other nonbank financial institutions, such as insurers and specialty-finance companies. It may also do another round of financing for publicly traded banks.” What this means is that the strategy has changed (or perhaps it was always designed to function this way) from purchasing all of the “bad stuff” in the markets to injecting capital into good programmes that pose sustainability over the long-term. If you have followed any of my articles on the crisis, you will know that this is the recommendation I have pushed all along. Indeed, I was under the assumption that a “grassroots” approach to solving the crisis would be much more effective than attempting to allow Wall Street to solve it. We all know that wouldn’t be too effective.

Another key point of distinction about how the TARP programme has evolved is something highlighted in the WSJ article referenced above. Democrats now want TARP funds to be applied to rescuing the failing US auto sector. Now, I have different viewpoints on this topic, and unfortunately, I find myself going back and forth almost on a daily basis, in regards to this issue. But, I will admit this is a tough one.

On one hand, we have a very large sector of our economy that is literally running on fumes. There is absolutely zero stability in the auto sector and even less confidence in its ability to maintain profitability. What Ceberus was thinking in purchasing Chrysler, I will never know or understand, but wow, is this a horrible portion of our economy or what?

Conversely, this “horrible portion of our economy” is also responsible for millions of jobs, not to mention hundreds of billions of dollars that flow through it and around it in a variety of capacities. It would be a major hit to the economy to allow this sector to fail. Furthermore, what is craziest is that this isn’t a sector where demand has faded. It’s kind of like the airline industry – people are still flying, but that doesn’t mean the supply is any easier for the airlines. People are going to still need cars, whether they’re hybrids or gas-guzzling SUVs, but there is no sense of equilibrium between supply and demand; therefore, the auto makers cannot sustain themselves.

Thus, I believe we are going to have to step in at some point to help the folks in Michigan and other auto makers throughout the country. Unfortunately, this sector is going to need stabilization. I do not believe, however, that a threat of systemic failure is a basis for rescuing the auto industry. For instance, if the financial sector was not rescued, we weren’t just talking millions of jobs and billions of dollars, we were literally talking about the world’s wealth fading away. That is not the case with the auto makers; they do not play the same systemic role as say financial firms do, or even energy firms might. As such, I do not believe we should take the focus off of the current challenge by allocating TARP funds to the auto makers.

Ultimately, I am not sure that Democrats in Congress (or anyone in Washington, for that matter) truly understand the scale of a challenge that saving the auto industry will be. This isn’t something we’re going to be able to address by throwing a couple hundred billion dollars at. This is going to be a major effort in its own right, and we should place the necessary focus that the challenge deserves. However, I do not believe it is so urgent, to the point of posing a major systemic threat, that we need to allocate those funds away from current programmes today.

This post was originally published on my blog at www.marktomarket.typepad.com.

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