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Plugging the Leak

*Rather than Quenching the Industry’s Thirst, Did TARP Trickle Away Needed Funds—Making Matters Worsex*
Rome may not have been built in a day, but it certainly didn’t take long for its empire to decline and fall. That’s a lesson many investors were quick to recall last autumn, when they watched a tightly wound economy suddenly unravel under the weight of loan defaults and corporate write-downs. Faced with an existential crisis fit for Caesar—$8 trillion in losses, a year of declining home prices, and the rapid-fire demises of big firms from Bear Stearns to Lehman Brothers—the federal government devised a novel plan to rebuild the financial empire: the Troubled Asset Relief Program (TARP). ""I believe we have taken the necessary steps to prevent a broad systemic event,"" Treasury Secretary Henry Paulson told Congress in November.  
The program’s birth last October seems like eons ago. That’s because pop icon Madonna has undergone fewer reinventions since her ""Material Girl"" days than TARP has in the past half year. And Madonna’s makeovers have probably had a more positive effect on the economy: In its evolution, the government’s showcase economic rescue plan has wobbled drunkenly through an identity crisis and done little to soften blows to the lending industry.
Now, government officials are reinventing the program again—this time, to focus on homeowners in danger of foreclosure. While it may be a good theory, loan servicers and other REO professionals have cause to be wary of the plan’s promises. The Obama administration’s TARP-based anti-foreclosure plans only reach a fraction of the nation’s homeowners—and even then, the programs are legally hamstrung from making meaningful modifications to toxic loans. If Rome is to be rebuilt, a new blueprint may be needed.
*Goodbye, Wall Street
Paulson and former President George W. Bush assured investors that TARP’s $700 billion fund would be spent to flush the economy of its ""toxic"" assets, including mortgage-backed securities whose values plummeted when home prices fell to earth and foreclosure rates rocketed. But within a month, TARP had became a catch-all ""bailout"" fund, tossing bundles of cash at undercapitalized banks, insurers, and auto makers.
So what happenedx Almost immediately after TARP’s creation, the Dow Jones Industrial Average posted its biggest weekly loss ever. Paulson, faced with daily doom and gloom, decided bank capitalization was a more pressing need than taking toxic assets off the market. Showering dollars on banks for preferred stock, Paulson told reporters, would ""provide liquidity to markets, strengthen financial institutions, protect savers, and enforce investor protections."" By October’s end, TARP had already doled out $110 billion to institutions it deemed to big to fail, including Citigroup (Citi), Bank of America (BofA), JPMorgan Chase, Wells Fargo, and Goldman Sachs.
That opened the bailout floodgates. Regulators made an exception for American International Group (AIG), whose trade in collateralized debt obligations had nearly sunk the insurance giant. Then Paulson announced consumer credit companies, like American Express, would receive funds as well. By December, with rumors swirling that Chrysler and General Motors might go bankrupt, then President Bush flexed his executive power, saying he’d use TARP money on any endeavor he considered necessary to the economy’s health. The auto companies quickly received $9 billion in TARP funding.
Meanwhile, with few other alternatives, Citi, BofA, and AIG recieved second, third, and fourth rounds of cash. However, executives at these companies came under criticism for continuing to spend money on lavish retreats, corporate jets, and salary bonuses. Also under critisim were aspects of TARP that did not regulate where the money could be spent. Citi and BofA lent $15 billion to business entities in Dubai and China, according to a House Oversight and Government Reform subcommittee report. ""The transactions are not illegal,"" a BofA spokesman responded, saying TARP legislation ""was mostly silent on prohibited transactions, and the funds provided . . . were made without conditions.""
When the Bush administration sold a bailout to lawmakers and their constituents, officials said failure to act would result in frozen credit, failed businesses, and unemployment. Billions of dollars later, those conditions still exist. And some have argued that without the bailout, we’d be closer to finding bottoms in home prices and mortgage assets.
About that time, lawmakers complained the plan they’d approved bore no resemblance to the current TARP cash cow. It had done nothing about toxic assets or runaway foreclosures. And according to a bipartisan Congressional Oversight Panel, ""[The] Treasury paid substantially more for the assets it purchased under TARP than the market value of those assets at the time the deal was announced."" For every $100 Treasury had spent, the panel said, it had received about $66 in value. That translated to a government loss of $78 billion—more than most countries’ annual budgets—on its first quarter-trillion-dollar spending spree. Rome was burning, and the government appeared to have tossed $254 billion on the flames.
*From TARP to TALF
On top of all this, a new program devised soon after TARP is about to kick in. That’s TALF, the Fed’s Term Asset-Backed Securities Facility, which is prepared to lend up to $1 trillion to investors so they can buy up securities backed by consumer lending instruments—chiefly credit-card, auto, and student loans. Its scope is limited—the Federal Reserve Bank of New York is only lending to purchase top-rated AAA securities, which are a rarity since ratings companies like Standard & Poors have upped their criteria.
Because of the quality of the securities covered under TALF, it might actually help loosen up consumer credit and leave TARP to do what it was meant to—buy mortgage securities. But there aren’t many high-quality securities to be had—possibly not enough to move loan markets. And the more toxic securities tied to property lending are the ones that have the biggest potential effect on banks.
Worse still, external forces—including TARP’s many reinventions—could work against TALF. Investors who have adequate capital or access to it are unlikely to dip into the TALF trough. That could include major and mid-size banks that benefited from TARP’s largesse. And there’s an issue with demand for credit, too: As unemployment hovers around 10 percent and personal wealth continues to shrink, consumers aren’t likely to jump at a car loan just because the borrowing rates move down a smidge. With only about $1.9 trillion left in its coffers, the Fed has to think long and hard about throwing water on its smaller fires.
*Hello, Main Street
After the populist anti-bailout backlash, the Obama administration moved quickly to redirect TARP’s spotlight from Wall Street to Main Street. Congress approved the release of the fund’s remaining $350 billion in February, with the caveat that at least $40 billion go to distressed homeowners. Legislators also demanded greater pressure on corporate TARP recipients to modify the mortgages in their portfolios. The administration responded with a Homeowners Affordability and Stability Plan, which expands refinancing opportunities for eligible holders of Fannie Mae and Freddie Mac loans. It relies on TARP to seed its $75 billion budget—above and beyond an additional $200 billion to buy more preferred stock in Fannie and Freddie.
By refocusing on distressed mortgages, TARP is shifting its attention where some argue it probably should have been in the first place. ""To address root causes, public policy must focus on homeowner assistance and finding equilibrium in home prices,"" wrote the analysts at Declaration Management and Research last November. ""Once people see that the contours of the mortgage problem are known and are being dealt with,"" wrote Peter Ackerman of Rockport Capital and John Vogelstein of Warburg Pincus last October, ""consumer confidence will return, leading, in turn, to profound improvements in the stock and corporate credit markets.""
Part of the problem is that TARP’s ill-equipped to tackle bad mortgages: It has the power of the purse, but it lacks legal teeth and skirts issues of basic fairness.
Another issue is a mortgage market that’s still structured for growth, not recession. ""A series of impediments now block the negotiations that would bring together can-pay homeowners with the investors who hold their mortgages,"" the Congressional Oversight Panel wrote in February. ""They include fallout from securitizing mortgages, the arrangements with mortgages servicers that encourage foreclosures over modifications, and severe understaffing of workout departments.""
One of the biggest obstacles to the Obama plan is that it lacks ""safe harbor"" protections for servicers. According to the Wall Street Journal, roughly $1.9 trillion in mortgages are bundled into nongovernment securities, and investors in the securities could sue servicers of those loans if they make modifications that violate their pooling and servicing agreements.
Congress is considering new legislation to reduce servicers’ legal exposure for modifying securitized mortgages. But the investors are loath to let that happen. ""Investors are given rights through the contracts in the securities, and we expect those rights to be honored,"" said Jeffrey Gundlach, CIO of TCW Group Inc. Until some middle ground can be reached, the TARP-based housing rescue won’t apply to many securitized loans.
Even if all those groups of homeowners could be reached, there’s no guarantee they’d put in the hard work required to receive assistance. When TARP was born, Congress used it to set up a foreclosure-relief program under HUD known as HOPE for Homeowners. That program was intended to save 400,000 homeowners, but by 2008’s end, only 312 mortgage holders had even applied for relief. Plenty of homeowners who are underwater would rather walk away from their devalued properties than continue spending money to save them.
The Obama plan does address some underwater owners—indirectly—by advocating cramdown measures that would permit bankruptcy judges to reduce principal payments. Cramdowns are politically touchy, could be bad news for servicers and investors alike, and would represent yet another radical change in TARP identity. But without such measures, the panel wrote, the plan ""does not deal with mortgages that substantially exceed the value of the home, which could limit the relief it provides in parts of the country that have experienced the greatest price declines.""
Perhaps the harshest criticism of a bailout for homeowners, though, is the apparent unfairness of the plan. According to RealtyTrac, two-thirds of all foreclosures in the United States occur in only nine states; that means taxpayers in the Heartland will be helping to pay for the legendary volatility of housing markets in California, Florida, and Nevada. Cries of unfairness are especially ""compelling,"" the Congressional Oversight Panel says, because 105,484,000 out of 110,692,000 occupied housing units in the United States—or 95.3 percent—are not delinquent on a mortgage. And when you subtract speculators, flippers, and rental-unit owners from the 5 percent who are in arrears, the pool of truly distressed and well-meaning homeowners becomes smaller still.
""In light of these statistics,"" the panel wrote, ""an essential public policy question that must be asked regarding the effectiveness of any taxpayer-subsidized foreclosure mitigation program is: ‘Is it fair to expect 19 out of every 20 people to pay more in taxes to help the 20th person maintain their current residencex’""
Concerns like these make TARP a blunt weapon for attacking the mortgage crisis. After throwing billions indiscriminately at every sector in the economy, the government may have found the right place to focus its energies. But at this stage, foreclosure mitigation will require more than a Band-Aid—even if it’s a diamond-encrusted one. It’s time for regulators to go back to the drawing board and take some time constructing a new plan for the housing recovery. Even with all the Treasury’s resources, Rome won’t be rebuilt in a day.
-- _A_ DS News_ magazine exclusive, from the April 2009 issue_

About Author: Jacqueline Gilbert


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