Beneath the TARP

When U.S. Secretary of the Treasury Henry Paulson announced his grand $700 billion plan to bail out the banks, he initially envisioned creating a fund to buy up toxic securities from bank balance sheets. "This needs to be big enough to make a real difference and get at the heart of the problem," he said at the time, telling Congress that acquiring the toxic mortgage-backed securities was one of the "single most effective things" to help the economy.

The theory: By creating a fund to buy up struggling securities from bank balance sheets, the government would help lighten the banks' load and also help create a market for the securities by setting a price for them. Market participants hope that all this will ultimately allow market distribution mechanisms to begin functioning again, and give the banks the confidence -- or the capital -- to begin lending again.

So insistent was Paulson on the need for this plan that he was even willing to get on bended knee before Speaker of the House Nancy Pelosi to save the program before its initial rejection by Congress.

But the situation has changed since the bailout bill passed. An initial $250 billion Congress doled out to Treasury is being used to inject capital directly into banks, with no mention of purchasing assets. In fact, on Nov. 12, Paulson, with about two months in office, said Treasury had for now abandoned the repurchase part of the plan. "Our assessment at this time is that this is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other potential uses of TARP resources," he said.

Still, some in the market seem to want repurchases to happen. At a New York conference two days earlier, several attendees expressed frustration at the lack of purchases. Said Greg Peters, head of U.S. credit strategy at Morgan Stanley, "The idea behind TARP is price discovery," cautioning that "direct capital injections constrain this process and just put off this price discovery ... and delay the time until these assets change hands."

RBC Capital Markets' Gerard Cassidy echoed Paulson's earlier comments by saying how "critical" that part of the plan was to getting liquidity back into frozen markets. "This is like a slow boat to China," a lawyer says. He argued that regulators seem to have decided that forcing consolidation is a better way to stabilize the situation than repurchasing assets.

Indeed, forced consolidation does seem to be the most obvious effect of the TARP program as it's been implemented. Stronger banks are receiving money; weak ones are being denied. Stragglers are left with few options beyond forced sales. Such seemed to have happened with National City Corp., which was effectively denied TARP money and then acquired last month by PNC Financial Services Group Inc. for the fire-sale price of $5 billion.

Still, Treasury may have a more considered plan at work here, though if it does it hasn't gone out of its way to tell anyone. One banker says institutions that sell troubled securities, whether to the government or anyone else, will inevitably do so at a steep discount, which will damage their capital ratios. Filling the resulting capital hole would then become the pressing issue.

"The government is giving them capital to make sure they can take the pain," says one financial services banker, who adds that TARP has only just been implemented and will take time to really get rolling.

Neel Kashkari, the Treasury official who's administering the program, himself said as much at the New York conference. "Given the complexity of executing these transactions, it will take a few months to fully execute and fund these transactions," he said.

But Treasury could also be setting itself up for more bruising political battles. As one Washington-based attorney says, Treasury has taken a very difficult route. By effectively giving itself the power of life and death over institutions that apply for TARP injections, Treasury will inevitably come into conflict with elected representatives intent on preserving hometown banks and jobs. "Buying and selling assets is less charged," he argues.