Authors: Adam Smith
Sometimes Bootleggers just have to go it alone. Circumstances arise that compel Bootleggers to mount a very public campaign for political benefits without Baptist protection, relying wholly on sheer lobbying might. This is the story of the Troubled Asset Relief Program. TARP was a response to the financial crisis of 2008–10, which shook the political landscape with as much force as it did the economy. Following the collapse of financial markets in September 2008, President George W. Bush repeatedly warned that an immediate political response was necessary to avoid another Great Depression. “Too big to fail” became a rallying cry for firms hoping for government rescue. A high-level scramble for pork came in the wake of financial disasters, as executives lobbied for greater support through newly invigorated political channels (Smith, Wagner, and Yandle 2011). The result was the creation of TARP, which would quickly evolve into a multifaceted mechanism for delivering massive subsidies to politically blessed failing enterprises.
Yet a populist backlash against the bailouts soon marred the seemingly happy exchange between lawmakers and ailing industries. Companies such as American International Group (AIG) came under heavy fire from lawmakers and their constituents for passing out executive bonuses widely seen as being over the top. As it turned out, the very lawmakers who would become AIG’s most vocal critics had approved the bailout contract that provided for those much-maligned bonuses. Knowing about such footnotes of history did not deter those same lawmakers from cheerfully proposing clawback legislation to cancel the bonuses in response to popular outrage.
With executive salaries at risk, many who had stood hat in hand hoping for Washington pork looked desperately for a TARP escape hatch. Requests for TARP monies, which previously showed no signs of abating, immediately slowed to a trickle—and among larger firms ceased completely. Suddenly, the very players who had been instrumental in creating this massive vehicle for pork couldn’t escape it fast enough.
We begin by describing the events that led to TARP’s creation. The subsequent section provides detail on the program’s initial conception and its evolution into a subsidy mechanism for ailing firms. The narrative illustrates lawmakers’ struggle to find political cover for a massively unpopular initiative tailored to benefit the same firms the public blamed for the economic crisis and show how TARP was increasingly used to benefit firms found palatable by more voters. We then document how the TARP mechanism was vilified as a result of AIG’s executive compensation packages, ultimately leading to the collapse of TARP-supported political arrangements. The chapter concludes with a note on how lawmakers have sought cover from the TARP fallout in the shade of the newly formed Consumer Financial Protection Bureau (CFPB).
TARP to the Rescue
The worldwide financial crisis of 2008–10 bankrupted families, spurred runs on banks, ruined hoary financial institutions, and brought serious volatility to financial and political markets alike (Cohan 2009; Hall and Woodward 2008; Posner 2009; Sowell 2009; L. White 2008; Yandle 2010a). The crisis hit its American apex in September 2008, as the global financial services firm Lehman Brothers failed, major banks trembled, and liquidity markets suddenly froze.
The immediate cause of this catastrophe was a collapse in the value of securities known as credit default swaps, financial assets that served as insurance policies for a variety of mortgage debt obligations. These insured mortgage debt packages enabled investment banks to trade assets that had previously been regarded as too risky to own by effectively bundling and dispersing the risk. In particular, by purchasing credit default swaps to cover their riskier loans, mortgage lenders were able to extend homeownership to less-affluent borrowers—a Baptist endeavor supported and celebrated by the Clinton and George W. Bush administrations. The credit expansion, which was also accommodated by federal housing finance programs, facilitated the inflation of an enormous housing bubble—one that eventually popped. The credit default swaps became essentially worthless as an epidemic of defaults in mortgage markets eradicated their underlying value (Diamond and Rajan 2009).
The first company to fall prey to this calamity was Bear Stearns, a global investment bank and securities trading and brokerage firm. On March 14, 2008, the Federal Reserve Bank of New York provided a $25 billion loan to avert a sudden failure of the well-connected investment bank (Paulson 2010, 112–14). Government officials worked to find a buyer for the company to avoid contagion effects. Days later, the firm—valued at $20 billion as recently as January 2007—was purchased by J. P. Morgan for $236 million (Paulson 2010, 115).
The impending crisis, however, was not averted by these measures, only delayed. In the fall of 2008, Lehman Brothers—a much larger investment firm with substantial holdings in subprime mortgage securities, now on their way to becoming worthless—saw its stock value fall dramatically. At the time, Lehman Brothers was the fourth-largest investment bank in the United States and consequently of critical importance to the integrity of financial markets. Despite efforts to facilitate a merger or acquisition with Bank of America and Barclays, Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008 (Cohan 2009, 442–47; Paulson 2010, 188–233). With more than $600 billion in debt, it was the largest bankruptcy in U.S. history (Mamudi 2008).
These dramatic events put the entire financial system at risk of collapse. Fearful that another Great Depression was on the way, government officials scrambled to find a solution to the burgeoning crisis. The nation’s top political leaders called for an immediate emergency response by the federal government (Paulson 2010). After attempts were made to merge the weakest companies with stronger ones, officials decided that massive injections of liquidity into investment banks were necessary to avoid collapse of credit markets worldwide. Unfortunately, such injections were not feasible under the existing rules of operation of the Federal Reserve and Treasury Department
Thus, TARP was initially justified as a novel and critically important response to this development. The program would remove bad assets from the balance sheets of major investment banks—the so-called toxic assets—and, in exchange, provide much-needed capital to sustain ongoing lending services. Congress passed this initiative on its second attempt, on October 3, 2008, as part of the Emergency Economic Stabilization Act of 2008. The law, as summarized in its own preamble, was an effort “to provide authority for the Federal Government to purchase and insure certain types of troubled assets for the purposes of providing stability to and preventing disruption in the economy and financial system.”
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Dealing with the Absent Baptist
Given the crisis atmosphere, government efforts initially met with public approval. After all, there were runs on banks and the public was concerned about the safety of their deposits. Only 11 percent of Americans polled by Gallup believed that the government should do nothing (Newport 2008a). Nevertheless, in the same poll, 56 percent of respondents wanted Congress to consider a different plan than the proposed TARP. Thus, as the TARP juggernaut took off, the broader electorate felt left behind.
Public officials were clearly worried about a backlash from voters and because of this took steps to limit TARP’s objectives by constraining how TARP monies could be spent. This is perhaps why Bush administration officials insisted that TARP would not exceed its mandate—at least before the law passed. Just one week later, on October 14, 2008, the objectives of TARP took a dramatic turn from purchasing toxic assets to injecting capital directly into the balance sheets of ailing banks by way of government purchase of equity ownership. This shift in direction opened the door for a new means of securing capital by ailing firms: direct subsidy using taxpayer dollars.
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Several factors contributed to this shift in objectives. First, direct purchase of toxic assets in a contrived public securities exchange would be hampered by considerable logistical difficulties, imposing large transaction costs in a crisis when time was of the essence. These transaction costs included setting up and administering a viable auction market that all parties would deem credible, a task well beyond the capacity of a time-constrained bureaucracy. Second, and perhaps more serious, any public offer to purchase at discount failing mortgage-backed securities would immediately affect, if not determine, the offering price of the securities, which could not be sold elsewhere. Put another way, government entry into the toxic assets market would bring with it a serious moral hazard problem. The very presence of a buyer paying bargain-basement prices would tend to make the typical balance sheet problem even worse. Finally, and most important to our story, unlike the purchase of equity ownership, the purchase of toxic assets would give lawmakers limited leverage in the operations of the firms, whereas taking ownership shares would enhance their ability to deliver pork to preferred interest groups.
The absence of a credible Baptist counterpart to the investment banks and other TARP Bootleggers left lawmakers with limited cover for this arrangement. An outright purchase of toxic assets would have granted Treasury discretion over only those assets rather than the firms themselves. Direct capital injections, in contrast, would put Treasury in the driver’s seat and come with the ability to specify how, and to what extent, profits would be distributed by the assisted firms. With an equity share and the power of the federal government, Treasury exercised a controlling interest in these firms.
In addition to these concerns, public officials needed to ensure that funds would not be allocated to politically disastrous outlets, such as executive bonuses. In anticipation of a public backlash against this perceived subsidy to Wall Street executives, participating companies reluctantly agreed to certain stipulations regarding executive compensation. These included:
(1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required claw back of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. (
Treasury.gov
Oct. 14, 2008)
These limitations would constitute a curious addition to the political contract if we did not recognize the dilemma inherent in a legislative bargain that had attracted so little Baptist sympathy. After all, no prior study had found an empirical link between executive pay and the excessive leveraging of risk responsible for the downturn. Fahlenbrach and Stulz (2011), in fact, report that not only was there no correlation between CEO compensation and negative stock performance (relative to average market return) in the wake of the crisis, but also that companies with CEOs whose incentives were more aligned with those of shareholders fared worse. Indeed, the inclusion of constraints on executive compensation was not necessary for stability in financial markets but represented an attempt to help legitimize an un-Baptized political transfer from taxpayers to Bootleggers.
Another stipulation geared toward limiting the amount of pork, thereby placating the electorate, involved insuring full recovery of taxpayer dollars. The Emergency Economic Stabilization Act ((H.R. 1424 2008), sec. 134) requires the president to submit “a legislative proposal that recoups from the financial industry an amount equal to the shortfall in order to ensure that the Troubled Asset Relief Program does not add to the deficit or national debt.” The means by which these funds would be secured were not specified, though the language of the bill indicated that this would take place within five years of the initial TARP disbursements.
TARP was capable of providing enormous short-run benefit to Bootleggers, but in exchange, lawmakers demanded discretion over the market practices of participating companies. The lawmakers’ demands were necessary, at least in part, because of the missing Baptist component. In effect, the lawmakers made themselves TARP nannies in an effort to mitigate public disapproval,
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as reflected in the low polling figures cited previously. Playing to the public’s rational ignorance, the nanny oversight signaled to the electorate that these Bootleggers could not simply take the money and run but would be held accountable in the public forum.
TARP Evolves into a Versatile Pork Barrel Mechanism
With TARP firmly established, the Treasury Department’s first action was to distribute $250 billion in subsidies to nine large banks and financial institutions by purchasing preferred stock and warrants.
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Government documents show that Treasury Secretary Henry Paulson had a closed meeting with CEOs from these nine institutions, most of which were financially strong and needed no government assistance. Paulson warned the assembled bankers that noncompliance with his plan “would leave you vulnerable and exposed” and threatened further regulation (CEO Talking Points 2008).
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This strong-arming of major financial institutions ostensibly occurred so that Paulson and his advisers would not have to identify to the public the weakest major banks in the financial system. By bundling the banks, he prevented a potential run on the few banks that actually needed the assistance. Furthermore, by setting up contracts with nine of the largest investment banks in the country, he paved the way for subsequent TARP disbursements.
Although this initial disbursement greatly benefited several cash-hungry firms, a case could be made that this Faustian bargain actually delivered pork not to the nominal recipients but to their creditors. Indeed, law professor J. W. Verret (2010) claims that the TARP mechanism represents an innovative type of extraction that indirectly funnels resources to companies tied to TARP-supported firms. Put another way, all the TARP recipients had debt on their books involving other financial institutions and transaction counterparties. Funds distributed to the TARP recipients could be extracted by anxious creditors, some of whom fully recouped their money.