ARP has gone from being a big piece of blank canvas to something very different. But it’s still a work in progress.”

When Guy Moszkowski, managing director at Merrill Lynch & Co. Inc., uttered those words at a recent industry panel, it was with understatement.

The analogy is an apt one. Everyone from members of Congress to bankers to government leaders, to private equity capitalists to bank analysts to the man and woman on the street has an idea of what the canvas should look like. Treasury has some ideas, too, but keeps reworking the picture.

And there is very little apparent agreement on model, method, or medium. Everyone wants to get their hands on the paintbrush and everyone is also an “art critic.”

The name TARP itself is a misnomer—officially standing for “Troubled Asset Relief Program.” But in the breakneck pace that dominates official responses to the economy’s troubles, any bit of shorthand that helps one’s head stop spinning gets adopted quickly. TARP’s capital program made the fourth quarter all the more challenging for banks of all sizes. The largest banks had the capital put to them, no questions to be brooked, and have since been smacked by public opinion no matter how they use the proceeds. Representatives of the some of these institutions were haled before the Senate Banking Committee in early November to demonstrate that they weren’t using TARP money to pay executive bonuses, and such.

Many other publicly traded banks faced their own quandaries, as the Nov. 14 deadline for their participation in the capital program loomed. Go for it and risk being seen as actually needing capital? (And what if you don’t get it?) Don’t go for it and risk being seen as someone who supposedly couldn’t qualify?

Ultimately some well-capitalized banks cited their good numbers and took the money anyway. Some equally well-capitalized banks declined the offer. The exhibits nearby put some names and numbers to this.

As of late November, some smaller public banks that had applied for TARP capital and been approved by their primary regulators, had not yet received funds. And private banks only received their term sheets in mid-November, with their deadline set for Dec. 8.

With all that in play, on Nov. 23, the Citibank rescue announcement altered the TARP canvas once again. One of the original nine banks required to take capital, and thus supposedly not needing it, Citi ended up not only receiving an additional capital infusion, but entered into a troubled-asset takeout plan, as well.

What will TARP mean?
In the rush of things that today’s bankers haven’t seen in their lifetimes, the import of what the government is doing with TARP shouldn’t go unexamined. The concept itself must be considered, as well as the impact on capital in the near-term, mid-term, and, potentially, the long-term.

“The TARP Program has served to calm the financial markets and does have promise to promote renewed economic growth,” ABA President Edward L. Yingling testified at a House Financial Services Committee hearing. “However, it is a source of great frustration and uncertainty to banks. Much of the frustration and uncertainty is because of the significant and numerous changes to the program and misperceptions that have resulted on the part of the press and the public.”

 

Yingling testified further that, “To my knowledge, no one in the banking industry requested a capital program; the ABA certainly did not.” The European push to infuse capital into banks drove the U.S. shift, in part. But Yingling pointed out a critical difference not appreciated in much thinking and coverage of the so-called “bailout” when TARP CPP was unveiled.

“The announcement of the program really harmed the perception of our banking industry over the next few days,” Yingling testified. “Commentators jumped to the conclusion that many banks must be capital deficient and in trouble. They did not understand that U.S. banks were much more heavily capitalized than the European banks receiving capital, nor that about 95% of the U.S. banks were well-capitalized. … as a general rule, only strongly capitalized, healthy banks are eligible. This is the exact opposite of the capital injection programs in Europe and elsewhere; it is also the opposite of other uses of TARP and other government funds.” [Emphasis added.]

Indeed, ABA has requested that Treasury keep separate sets of numbers for TARP capital investments in healthy banks and TARP infusions into other situations, such as the cleanup at AIG.

The dirty word for what the TARP capital program has wrought is “nationalization.” Historically, the American banking system has relied on private ownership, with management whose role is increasing shareholder value, according to Peter Wallison, fellow at the American Enterprise Institute for Public Policy Research, and Treasury general counsel in the Reagan era.

“It’s a bad precedent,” said Wallison.

That said, he acknowledges that the government clearly had to do something, and took decisive action. His concerns chiefly center on any possibility that the government does not pull out of the banks with TARP capital as soon as it can.
If, for some unforeseen reason, banks and the government don’t part company on schedule or sooner, “then we will have really nationalized the banks.”

Subsequent to our interview with Wallison, Treasury announced plans to develop a program that would encourage private capital to come forth to invest in banks, with the government making matching investments. Wallison had addressed this point, expressing skepticism about private equity funds investing in banks while federal stakes in potential targets exist. Such investors would frown on an opportunity where there is the potential for government calling at least some of the shots.

The near-term

For banks considering taking TARP capital, there’s a sticking point. “Many banks are willing to take investments, but from a silent partner, not an active partner,” said ABA’s Wayne Abernathy, executive vice-president, financial institutions policy and regulatory affairs.

TARP marks a significant change in the arrangement between the federal government and those banks that take from it, he continued. “There have been government guarantees for all sorts of things,” said Abernathy, “but this is the first time you’ve had the government investing as an earning partner.”

Abernathy said that what bankers he’s spoken with most worry about are the results of this new dimension. For instance, the TARP Capital Purchase Program’s Section 5.3 makes the federal government the ultimate control investor. It reads, in part:

“No amendment of any provision of this Agreement will be effective unless made in writing and signed by an officer or a duly authorized representative of each party; provided that the Investor [the U.S.] may unilaterally amend any provision of this Agreement to the extent required to comply with any changes after the Signing Date in applicable federal statutes…” [emphasis added].

Some bankers have taken the attitude that “the government runs my business already, so, heck, I’ll take the money.” But others fear “strings attached” to the aid, and decline to take it, seeing the TARP contract as a one-way agreement, and not in their favor.

Abernathy said that this latter group fears a future of credit allocation and other influences.

As Senate Banking Committee Chairman Christopher Dodd stated at the outset of hearings on TARP: “The acceptance of public funding carries with it a public obligation. One cannot benefit from taxpayer support in all its many forms and assume that one has no duty to serve that same taxpayer.”

Politicians have clamored for more lending, saying that was what TARP was created for. But forced lending comes with potential peril. “Capital is important,” said Eugene Ludwig, former Comptroller of the Currency and CEO of Promontory Financial Group, Washington, D.C., “but however high the capital is, poor lending will eat through that capital very quickly.”

Just where the government could go in adding conditions to money already taken boggles the imagination. There are already strong clues.

Senators Robert Mendendez (D-N.J.) and Charles Schumer (D-N.Y.) have called on Paulson to issue guidelines dealing with using TARP funds for acquisitions and dividends.

“These loans,” the two wrote in a letter, “must not be used to acquire healthy banks, hoard in their coffers, or pay shareholder dividends….Banks must understand that these funds aren’t a gift and if they don’t want to play by our rules, they don’t need to cash the check.”

This is likely just the beginning. “You will see increasing pressure to do more lending to the top extent allowed by the TARP capital injections,” predicted Randal Quarles, managing director, The Carlyle Group, Washington, D.C.

Risk of federal flip?
There’s another side to the risk of obligations not expected up front from TARP, and that is the risk of the government backing away from obligations of its own, through Section 5.3 or otherwise.

Financial history already has an example of such a shift, pointed out Thomas W. Killian, principal at Sandler O’Neill & Partners, L.P. This is the federal flip flop on supervisory goodwill that took place in the early 1990s, in the wake of government deals of the 1980s with institutions that took over ailing banks and thrifts on the strength of arrangements for that special treatment. The government reversed policy and more than 100 lawsuits bloomed.

Overall, “the markets are very nervous about the change of Administration, given the great flexibility embedded in this program,” said Greg Peters, chief U.S. credit strategist at Morgan Stanley, during a recent industry conference.

Raising private capital in TARPtime
The presence of government investment in privately owned banks begets faith in those banks, in the federal view and the view of some private parties.

“We view TARP very favorably in that it is going to strengthen the U.S. banking system,” said Gerard S. Cassidy, managing director, equity research, at RBC Capital Markets Corp., Portland, Maine.

But there is substantial concern that the opposite effect will be seen.

The federal actions in the Fannie-Freddie takeover present a stinging example where many banks of all sizes, but especially community banks, were burned. And there’s more of that.

“Having the government out there and active and obviously willing to hurt private investors—there has to be a degree of uncertainty,” said Emory Ireland, partner at Foley & Lardner LLP, Milwaukee. He points out how some private equity investors were badly hit in some of the large failures of autumn 2008.

There is also the feeling that the presence of TARP will diminish the face of banks in the capital markets somewhat.

 

There are multiple facets to this argument. One is voiced by Rick E. Maples, co-head of investment banking and head of the financial institutions group at Stifel Nicolaus, St. Louis:

“Raising capital in either a public offering or in a private placement will be impacted by the company’s ability to participate in TARP. Receiving approval effectively provides the Good Housekeeping stamp of approval on the institution and its ability to raise additional capital should be enhanced by easing any potential concerns that the investor group may have on the long-term viability of the company. And it is important to note that the receipt of approval,  not necessarily the acceptance of funding, is the key factor for many banks.”

More broadly, “the fact that the government felt the need to intervene in the banking industry to the extent it has will likely change in a negative way the market’s evaluation of the banking industry as a comparatively safe and conservative industry in which to invest,” said William Isaac, former FDIC chairman and chairman of The Secura Group, Washington, D.C.,

And Promontory’s Eugene Ludwig worries that stressing only TARP equity injections  “diminishes the strength of the capital markets, because instead of a free markets solution, it is in essence nationalizing the problem.”

Are you wheat or chaff?
In the matter of PNC’s pending acquisition of National City Corp., PNC was granted TARP capital while National City was turned down. Many see this as only the beginning of a government winnowing.

“You really have opened the door to picking winners and losers,” observed ABA’s Wayne Abernathy.

“The Capital Purchase Program effectively separates the wheat from the chaff,” said Stifel Nicolaus’ Maples. “We expect a wave of forced mergers to result from the rejection of TARP funding, and these mergers will likely be financed through TARP funding obtained by the buyers. This form of consolidation will come in advance of certain banks entering into receivership by the FDIC and preserving dollars in the insurance fund.”

RBC Capital’s Gerard Cassidy thinks the market will concentrate in the near term on those institutions who clearly don’t meet regulators’ approval for TARP, buying some time for borderline cases.

Among banks under $500 million in assets, the trend may be a bit different. Attorney Walter Moeling IV of Powell Goldstein LLP, Atlanta, thinks there will be a lot intermarriage among these players in an effort to bulk up in the face of today’s markets. Further, he sees takeovers for many of the de novo banks founded over the last decade. In part that will be driven by the changing markets they serve—they can’t live off booming commercial real estate lending anymore—and toughening regulatory attitudes towards brokered deposits.

Mark-to-market’s ongoing impact
Tussling over mark-to-market accounting continues, and with related issues, will continue to influence current industry affairs.

ABA has called for the congressional banking committees to address mark-to-market in 2009’s regulatory restructuring legislation.

“Since TARP is now focused on creating additional capital,” testified Ed Yingling, “it must be noted that the misapplication of mark-to-market accounting in today’s situation, when there is no functioning market, has unnecessarily destroyed billions of dollars in capital.”

The issue really is timing. “The abandonment of mark-to-market accounting is not going to helps banks if they made bad loans,” said RBC Capital’s Cassidy. But for many players, mark-to-market was never the appropriate treatment.

 

“In a downturn, many banks would be insolvent,” said Cassidy. Traditional treatment, he continued, permitted lenders with some bad loans the time to bleed out losses, like air in a home radiator. This is a benefit of TARP capital, he believes, in that it will give qualifying banks some time and some room to “clear up the mess as quickly as they can.”

The mid-term

We are only seeing the initial stages of a long association between banks that take TARP capital and the government. With a maximum ten-year term, the TARP CPP will span the terms of at least three presidents, if one thinks in terms of George Bush, Barack Obama, and the  next leader.

Retiring TARP obligations
Analysts have mixed feelings regarding what will happen as the time comes for TARP capital to be retired, either under the government’s standing schedule, or earlier, if circumstances enable TARP banks to do this.

Some banks regard the ability to get out early (subject to contractual terms) as a given. For instance, attorney and bank consultant Jeff Gerrish, whose Gerrish McCreary Smith LLP, Memphis, Tenn., works with community banks, cited one client who was well-capitalized who opted to apply for TARP capital. The client saw the government funds as a timely assistance to help the strong bank grow larger, through expansion. Gerrish said that the bank also tended to see the relatively cheap capital as a hedge against a difficult economy. Other institutions seem to fit this mold, as well.

 

“I think most will refinance it within a five-to-nine-year time frame,” said Gerrish. “At the end of five years, that will be a time of refinancing.”

ABA’s Wayne Abernathy, who logged time with the Senate Banking Committee and the Treasury Department, isn’t willing to consider the game as remaining the same as it began. As if to underscore his comment, the Citigroup rescue offered yet another variation of what TARP is.

The TARP documentation allows federal capital to be retired if a bank’s regulator gives approval to do so, Abernathy noted. But, he added, “Who knows what future regulators would condition their OKs on?”

Others think, in the words of Powell Goldstein’s Walter Moeling, that the “government will be thrilled” to redeem its preferred stock and buy back its warrants.

Rising capital requirements
Regulatory discretion is a significant factor, too, in how capital will be viewed in the future. As ABA’s Yingling noted in his testimony, referred to earlier, examiners have already been asking for higher levels.

“My general view is that regulators aren’t familiar with the term ‘excess capital’,” said Philip Smith, president, Gerrish McCreary Smith, PC, Memphis, Tenn.

This is still a matter of individual cases, and analysts debate whether officials will, between such demands, and the overlay of TARP capital, come to feel comfortable with higher ratios. Abernathy said that regulators have assured the association that they won’t let current conditions permanently raise regulatory capital requirements.

Secura Group’s Isaac thinks raising mandatory levels would be a bad idea. “We need to get out of the economic hole we have dug for ourselves,” he said.

On the other hand, RBC Capital’s Cassidy said that, “we fully expect the banking system to have to be forced to raise the level of capital in the system. The system can’t handle mark-to-market accounting.” Unless officials back off from these requirements, there will be the need for either more capital or less leverage, he said. Cassidy also thinks the current Tier I capital level mandate of 6% could be raised to 8% or even 10%, through permanent regulatory action.

The long-term

For most people contacted, the issue of whether federal capital intervention will “taint” U.S. banking is a far-off matter. Attorney Jeff Gerrish of Gerrish McCreary is one who does not expect to see lingering effects.

“It depends if  you are an optimist or a pessimist,” said Gerrish, a self-described optimist. Of course, he added, the definition of an eternal optimist is someone who expects to see pooled trust preferred capital return in time to take the government out. Gerrish isn’t betting on that.

Moral hazard has increased
A significant worry going forward for both the industry and the economy is the issue of “moral hazard.” This is the concept that an individual, executive, or company will behave differently when insured or protected from the results of risk taking, versus how they would have behaved in the absence of protection. The resulting misbehavior is the moral hazard.

“We’ve created increased amounts of moral hazard,” said Eugene Ludwig. He said it was not anticipated by backers of the original TARP legislation that the government would wind up nationalizing banks with direct capital injections. “This will have clear, lasting impact.”

Peter Wallison said he’s confident that the temporary investments in banks under TARP are truly that, and not a permanent fixture. “But I’m worried about the moral hazard of the government having made the investment in the first place.”

In his term as FDIC Chairman from 1978-1985, William Isaac did much to stress the importance he placed on “market discipline,” that is, discipline imposed by the market’s reactions to a banking company’s actions and decisions. Facets of the federal rescue efforts concern him.

“We have done some serious damage with respect to moral hazard,” said Isaac. “Guaranteeing the funds in money market funds was huge and has almost gone unnoticed. The FDIC guaranteeing not only bank debt, but holding company debt—including the debt of newly formed holding companies of investment banking firms—was something I never thought I would see. We had counted on holding company shareholders and creditors to keep a watchful eye on the risks being taken in subsidiary banks.”

Continuing his reasoning, Isaac said, “Now we don’t have any meaningful discipline at the bank level or the holding company level in large firms.”

Legislative legacy
The impact of TARP capital must also be considered in the bigger picture, with a new legislative season imminent. After an unusually active lame-duck session and transition period, Congress and the incoming Administration are primed for major-league revamps. And the top regulators who will fill the seats of supervisory agencies will have their own agendas, as well as congressional marching orders.

“This is my third financial crisis,” said attorney Tom Vartanian. “Regulators will write regulations that go deeper into the business,” he predicted. “Capital will be king in the new regulatory regimes,” he added, and bankers can expect statutes that allow regulators less discretion.

Indeed, the specter of credit allocation under Democratic leadership, with TARP investments as the lever, worries many. “Bankers aren’t stupid,” said ABA’s Wayne Abernathy, and they’ll make loans that they see as reasonable. But credit allocation may lead to their lending to riskier ventures. Abernathy points to directed lending in other countries that hasn’t turned out so well. In China, where banks have been forced to make many commercial loans that haven’t performed, this has interfered with the ability to float the yen.

Could such things happen here?

“You’d have to work up to it,” said Abernathy.

Future mindset in Washington
Much has been written of the differences between generations that knew the 1930s Depression and those that came later. How will the challenge of 2008 color things?

TARP has the potential of being a major factor. “It creates a precedent, that legislators and regulators of the future may follow if they see problems,” said attorney Emory Ireland. “Hopefully, they’ll look back with 20-20 hindsight.”

However, Ireland adds a philosophical consideration.

“People are still fighting today about the causes of the Great Depression,” he said. That was about 80 years ago. BJ

 

 

Asset relief or capital infusion? Debate rages on

The original idea behind TARP—“Troubled Asset Relief Program”—was to take bad assets out of the banking system. While the Treasury Department’s fledgling implementation steps after passage of the Emergency Economic Stabilization Act involved the original TARP, by mid-November, after much delay and much rumor, Treasury Secretary Henry Paulson had put the original concept on the backest back burner. It’s all but off the stove, now.

Or is it?

The Citigroup rescue plan announced Nov. 23 would have $277 billion in toxic assets covered by several government banking agencies if and as they go bad (Citi covering the first $29 billion). In other words, asset relief on a more targeted basis than originally proposed.

There is a range of opinion about Treasury’s decision to emphasize the capital program and eschew the original asset-purchase and asset-guaranty programs.

Better to remove the toxic stuff
“I’m not a fan of that as a comprehensive solution,” said former Comptroller of the Currency Eugene Ludwig, now CEO of Promontory Financial Group, LLC, Washington, D.C., referring to the capital plan, “but I understand they made tough calls at the outset in a tough time; however, to make the CPP exclusive and comprehensive goes too far.”

Continuing, Ludwig draws an analogy. “The toxic paper in the financial system is like having a tumor,” he explained, “and the right answer is removing the tumor. But the medicine has been used for other things.” In November, with the initial outlays of funds under the Treasury plan made, Paulson announced intentions to reserve the remainder for the future use of the incoming Administration and the next Treasury Secretary.

Fresh capital is more effective
While Ludwig favored the original idea, another former regulator is happy that the concept was pushed aside in the capital plan’s favor.

“The notion of taxpayers buying bad loans from banks was a very bad idea which I opposed from day one,” said William Isaac, chairman of The Secura Group, Washington, D.C., and former FDIC chairman. “The Treasury would have paid too much for the assets and would have sold them for too little, which would have created huge losses for taxpayers.”

 

Isaac presented some math to back up his point. “It would have done almost no good to purchase $700 billion in bad loans from a $15 trillion financial system,” said the former regulator. “At most, it would have freed up $700 billion for new lending. Putting $350 billion of fresh capital into the financial system creates over $3 trillion of new lending capacity. So we will get much more bang for the dollar, and the taxpayers will likely make a pretty good return on the investments.”

We’re just feeding the termites
Occupying more of a middle ground is former Reagan Administration Treasury General Counsel Peter Wallison, who is now fellow at the American Enterprise Institute for Public Policy Research. He preferred the asset-purchase concept, though not the way Treasury appeared to be headed—specifically, the original reverse-auction plan.

“Asset purchase, the original idea, made an awful lot of sense,” said Wallison. Getting the toxic paper off banks’ balance sheet would have freed up the capital that they are now holding against such assets, he argued.

Now, worried Wallison, banks holding bad investments or credits will wind up eating through their TARP capital. He agreed that the situation is somewhat akin to putting fresh plywood down on a floor with a termite infestation.

“It does not come anywhere close to solving the problem that we have in the banks,” said Wallison. This is because simply injecting capital into the system fails to reassure investors that the banks’ assets are worth investing in.

 

 

One of the trickiest things about evaluating the TARP capital investment program has been sorting out the politics from the economics.

No better case in point exists than the issue of making loans with the proceeds of Treasury’s TARP investments. Playing to Main Street, members of Congress in hearings and elsewhere have chastised Treasury officials and the banking industry for not making loans, or enough loans, with TARP funds. This was going on even when only a handful of institutions had received any TARP funds at all.

“Get with the lending”
On one hand, Treasury has stressed the importance of the investments from the viewpoint of getting lending going, to help stimulate the economy.

“We have seen that capital purchases are clearly powerful in terms of impact per dollar of investment, which is a major advantage under the current circumstances,” testified Treasury Secretary Henry Paulson in mid-November. “More capital enables banks to take losses as they write down or sell troubled assets. And stronger capitalization is also essential to increasing lending which, although difficult to achieve during times like this, is essential to economic recovery.”

Indeed, at an industry conference, Neel Kashkari, Interim Assistant Secretary of the Treasury for Financial Stability, refuted those who claimed that banks receiving TARP money wouldn’t put it to use.

“A bank’s return on capital will decrease if it simply hoards the capital,” said Kashkari. He said he expected shareholders, over time, to insist on the deployment of capital.

Lending amidst mixed signals
And there is plenty of evidence that lending has been going on, on Main Street and elsewhere.

“Banks are lending,” ABA President and CEO Edward L. Yingling testified in mid-November. “In fact, many banks have said they are seeing borrowers that used to rely on nonbank financing or Wall Street coming to their doors. This would be expected with the severe problems in credit markets, including securitization. Thus, many of the stories about the lack of credit are due to the weakness of nonbank lenders.”

Yingling added this caveat: “Naturally, banks are following prudent underwriting standards to avoid losses in the future. But even with more careful underwriting, only 6% of small businesses … reported problems in obtaining the financing they desired. Borrowers are also being more careful, and the overall demand for loans is declining, although this varies by market.” (That 6% figure comes from an October National Federation of Independent Business survey.)

What has concerned ABA are reports from banks that examiners have said that their capital ratios should be increased above current regulatory requirements.

“While that may be appropriate in individual circumstances, a general move in that direction will negate the [TARP] CPP program,” Yingling testified. He pointed out the government has been sending contradictory signals, urging lending on one hand with the new TARP capital, and cautioning about credit risk on the other.

Indeed, the banking regulators, in their November joint “Interagency Statement on Meeting the Needs of Creditworthy Borrowers,” walked a fine line. This is seen in a key paragraph:

“It is essential that banking organizations provide credit in a manner consistent with prudent lending practices....

 However, if underwriting standards tighten excessively or banking organizations retreat from making sound credit decisions, the current market conditions may be exacerbated. ...”

Doubts about the octane
There is a fair amount of skepticism about how much “oomph” TARP capital will provide on the lending front.

“I don’t think that TARP as it is being used is going to give rise to the lending that has been talked about,” said Eugene Ludwig, CEO, Promontory Financial Group, LLC, Washington, D.C. “That’s good political rhetoric.” Ludwig doesn’t think there is that much potential for massive new lending at this point in the economic cycle given the utilization of government mechanisms to date.

Indeed, concerns go still deeper in some quarters. Basel II’s influence worries William Isaac, chairman of The Secura Group, Washington, D.C., and former FDIC chairman.

“Basel II, like mark-to-market accounting, is highly pro-cyclical,” Isaac said. “The models used to determine capital levels look backward. If you looked backward prior to 2006, you didn’t see any losses worth noting, so the models indicated little need for capital. That helps stoke the economic engine. But if you look backward in 2008 and 2009, you will see enormous losses so the models will demand increasing amounts of capital. I am not sure how we get banks to loan money when the Basel II models demand more and more capital.”

Time to cool down a bit?
On the other hand, there is also a belief in some quarters that some “deleveraging” is necessary, perhaps even inevitable, for the economy’s long-term benefit.

“The goal here is to avoid the contraction of credit,” rather than to encourage a huge spurt of increased credit, according to Randall Guynn, partner and head of the Financial Institutions Group at the law firm of Davis Polk & Wardwell, New York.

The moderator at the same conference, T. Timothy Ryan, Jr., president and CEO of the Securities Industry and Financial Markets Association, posed the question: “If the country is overleveraged, and the Treasury Department wants banks to lend, who are they supposed to lend to?”

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