The following is an excellent excerpt from the book “AFTER THE MUSIC STOPPED: The Financial Crisis, The Response, and The Work Ahead” by Alan S. Blinder from Chapter 7 “Stretching Out the TARP” on page 187 and I quote: “Redesigning the TARP – Congress, which was controlled by the Democrats, discarded the three-pager immediately and began drafting its own legislation from scratch, accepting the basic idea of giving a Republican secretary of the treasury huge discretion to buy assets but bargaining with [Hank] Paulson over several matters. Paulson got precious little support from his own party. If there was to be a deal, it would have to be cut between the Republican administration and congressional Democrats. Republicans in Congress, and especially in the House, would be a hindrance, not a help.
It was notable that Fed Chairman [Ben] Bernanke took a backseat at this point. This was a fiscal policy issue (appropriation of funds), he believed, and a highly political one at that. Bernanke was going to minimize his involvement in the to-ing and fro-ing between the administration and Congress. Though working like mad behind the scenes, he seemed to recede into the shadows, letting the political Treasury take over the job of committing taxpayer money from the nonpolitical Fed. For example, the Fed chair absented himself from the highly publicized September 25 political meeting called by then presidential candidate John McCain to address the crisis. The Fed’s vice chairman, Don Kohn, a Fed careerist, applauded the lower public profile. “As the Treasury stands up, the Fed stands down.” he thought.
This was important. The unwillingness or inability—due to legal limitations—of the Treasury to take the lead in public had forced the publicity-shy Federal Reserve to step up to the plate repeatedly and very visibly. A number of actions, though clearly legal under Section 13(3) of the Federal Reserve Act, put taxpayers money at risk—which is just one step away from spending money, a power reserved to Congress. The Fed had been pushed by necessity into the political arena, where all sorts of perils awaited it. It was rightfully eager to step out.
One political issue was particularly contentious, as Barney Frank had prophesized: executive pay. Paulson—supported by Bernanke and the New York Fed’s Tim Geithner—wanted to tread lightly on the compensation issue, if, indeed, they had to address it at all. The secretary envisioned the TARP as a facility in which banks would participate willingly, even eagerly; he knew that wouldn’t happen if bank executives were forced to take pay cuts. Democrats saw things differently. If the government was doing banks such a big favor by purchasing their toxic assets, shouldn’t bankers be willing to accept some restrictions in return—for example, on dividends and executive pay? And even if bankers objected to pay cuts, shouldn’t the public’s elected representatives demand them as a matter of elementary fairness?
Paulson pushed back hard, raising an issue on which he could fixate more than once. In his own words, “To my mind, restricting compensation meant putting a preemptive stigma on the program. And that is exactly what I didn’t want to do.” Stigma. Let’s think about that word. The basic idea was that banks would not sell their toxic assets to the TARP if doing so would label them as “weak sisters.” Taken in isolation, that sentence makes complete sense. Indeed, the Fed had run smack into the stigma problem in 2007, when it wanted to lend massively to banks. But the focus on avoiding stigma missed a larger point. At least where the big banks were concerned—and that’s where the executive pay issue was salient—the markets already knew who was strong (e.g., JP Morgan Chase) and who was weak (e.g., Citigroup). Participation or nonparticipation in TARP would tell them next to nothing new. As the accompanying box explains, signaling and stigma arise when quality differences are unobservable. In this case, they were painfully observable.
“SIGNALING AND STIGMA – Paulson’s worries about stigma were grounded in the economic theory of market signaling. But he misused the theory badly. I will use the hiring of workers to illustrate the concept, but the same sort of analysis applies to credit-granting decisions, hiring contractors, and much else—including distinguishing between sick and healthy banks.
The key ingredient in the theory of signaling is unobservable differences across people, banks, businesses, or whatever. In the labor market, there are always better and worse workers. But their superiority or inferiority may not be easy for prospective employers to discern prior to hiring. Such ignorance gives superior workers powerful incentives to set themselves apart from the rest. If they succeed, they will be hired first and at higher wages. But how do they distinguish themselves?
One way is called signaling. Suppose there are some characteristics, such as stick-to-itiveness, energy, and self-discipline, that employers want in prospective hires but that are not observable before hiring. Employers will then prefer applicants with some observable characteristics that signal the presence of these desirable traits. One such example might be completing a college degree. If so, employers will favor college graduates. From a worker’s perspective, graduating from college is a signal to prospective employers that you are a superior worker. The logic cuts the other way, too. You want to avoid signals of inferiority—like a police record or a spotty work history. Such things carry stigma.
There’s that word. Paulson’s worry was that coming to the TARP would be seen as an act of desperation. If, for example, taking the TARP money required a bank’s executives to accept pay restrictions, asking for the money would carry such a stigma. The point was conceptually correct. But it ignored the critical adjective mentioned earlier: for the theory to apply, the bank’s weakness must be unobservable; and in this case, it was painfully observable.
Markets had numerous ways to distinguish between strong and weak banks: stock prices, credit ratings, CDS spreads, analysts’ reports, market chatter, and so on. No one had to watch TARP take-up rates to judge whether JP Morgan Chase was stronger or weaker than Citigroup, or whether Goldman Sachs was stronger or weaker than Morgan Stanley. And if they needed any help, the strong banks were eager to provide it. To take just one concrete example, Goldman was not worrying about stigmatizing itself when it became the first user of the FDIC’s guarantee program for corporate debt. Goldman was the fastest antelope in the herd, and everyone knew it.”
However, the big political issue was not any debate over correct application of the economic theory of stigma, but rather over simple notions of fair play. Ordinary Americans, and therefore their elected representatives, saw that greedy and irresponsible behavior by bankers had created a financial calamity that put the whole country at risk. Now they, the taxpayers, were being asked to pay for the sins of the bankers, who would continue to earn staggering sums. Try playing that in Peoria—or anywhere else. One Republican congressman from North Carolina illustrated the public’s attitude by reading from a letter from one of his constituents: “The bailouts should be about as welcome as malaria.” To which he added, “They do not see why we have to be bailing out those people whose greed. . . got them into trouble.” It was a fair question. Unsurprisingly, public opinion polls ran solidly against the bank bailout.
After much wrangling, Paulson got away with surprisingly mild restrictions on executive pay in the final TARP legislation. The law disallowed golden parachutes and capped severance payments at three times base salary. (Stan O’Neal would have been appalled!) It banned giving top executives pay incentives that encouraged “unnecessary and excessive risks,” but it left that determination to corporate boards, not to the Treasury. There were also clawback provisions in cases in which bonuses were “based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.” All in all, it was hardly Draconian.
But Paulson’s victory was pyrrhic. The pay issue would come back to haunt him and his successor, Tim Geithner, time and again. Ironically, the TARP’s seemingly relaxed attitude toward executive compensation created a much more damaging kind of stigma. Never mind weak versus strong banks. In the eyes of the public, it helped stigmatize the entire TARP as a giveaway to greedy bankers, some of whom were Paulson’s friends. Later, when Geithner took over the top job, the view persisted that he was an alumnus of Goldman Sachs! This was entirely fictitious and unfair: Geithner had never worked for a private bank a single day of his life.
Paulson later admitted, “I was wrong not to have been more sensitive to the public outrage.” He sure was, and it should have been obvious at the time.
Numerous other changes were made on the bumpy road toward ultimate passage of the bill. Normal judicial review was, of course, restored. The TARP money was appropriated in tranches, not all at once, with some clearly set aside for the next administration. An option to insure (rather than purchase) troubled assets was added to appease certain House Republicans. (It was never utilized.) Language on using the TARP to mitigate foreclosure was added throughout the bill—including in the definition of “troubles assets.” There could be no mistaking congressional intent: Members wanted some of the bailout money going to distressed homeowners, not just to distressed banks.
Multiple layers of oversight were added, including the Congressional Oversight Panel, which wound up being headed by Elizabeth Warren, and the Special Inspector General for the TARP, who wound up being Neil Barofsky. Both proved to be zealous guardians of the public purse and thorns in the side of Secretary Paulson and later Secretary Geithner. I remember saying at the time that the TARP law created so many layers of oversight that the next secretary of the treasury would want to give away the extraordinary powers it gave him. That proved to be a bad prophecy. But I wonder if, in retrospect, Geithner wishes he had done so.
The bill that ultimately passed Congress, the Emergency Economic Stabilization Act of 2008, ran to 451 pages, of which 261 dealt with the TARP, making that part of the Act (Title I) 87 times Paulson’s original length. But nowhere in those 261 pages is there a single word about using TARP money to inject capital into banks. Nowhere. Instead, there is a catch-all phrase under which the secretary of the Treasury was authorized, after “consultation” with the chairman of the Fed and a written explanation to Congress, to purchase “any other financial instrument that the Secretary . . . determines the purchase of which is necessary to promote financial market stability.” [Footnote: Notice that the law did not require the Fed chairman’s approval, only that there be consultation.] That language allowed pretty much anything.
The road to passage proved rocky. Although the House leadership thought they had the votes on September 29, the membership surprised them by rejecting the TARP the first time around, in a 205-228 vote. Opposition came from both the Republican Right and the Democratic Left, though for starkly different reasons. The Right was the bigger problem; more than two thirds of House Republicans voted no. Apparently, Bernanke and Paulson hadn’t quite “scared the shit out of them.” But the stock market soon did. The S&P 500 fell almost 9 percent the next day—destroying about $1.25 trillion of wealth, almost twice the TARP request, in a single day. That made believers out of enough House members to pass the bill by a comfortable 263-171 margin just four days later—after adding a few sweetners to a piece of legislation that no politician could love.
As this political drama played out in Congress, something else was brewing behind the scenes—something that would make the TARP even more reviled. Paulson came to believe that capital injections were a better route than asset purchases after all, just as Bernanke had said. Some observers say the secretary, too, had believed all along but squelched the idea because of politics. Regardless, his timing was awful—right between the two House votes.
Why? It seemed that Treasury staff work was convincing him that designing a program to purchase toxic assets was fraught with difficulties and would take too long. It would be simpler and, more important, faster for the government just to buy equity stakes in the banks. Doing so might even net a profit for the taxpayers in the end—which, in fact, it did. Never mind the fact that buying toxic assets near their lows would probably have netted the Treasury even larger profits.
When Paulson informed his top press officer, Michelle Davis, of his decision, she reacted with disbelief. “We haven’t even gotten the bill through Congress. How are we going to explain this? We can’t say that now.” And Paulson didn’t. As a result, in early October 2008, the United States Senate and House Representatives voted to inject capital into banks while thinking it was voting to purchase “troubles assets,” including lots of home mortgages. As if the TARP needed even more political handicaps, it would soon look like a classic case of bait and switch.”
(WITH THE INVESTMENT BANKERS AND WALL STREET GETTING IN TROUBLE WHEN PRESIDENT GEORGE W BUSH WAS IN OFFICE, IT EVENTUALLY LED TO THE 2008 $700 BILLION TARP BANK BAILOUT BECAUSE OF BANK DEREGULATION, I CAN EASY UNDERSTAND WHY SENATOR BERNIE SANDERS DECIDED TO RUN FOR PRESIDENT ON THE DEMOCRATIC TICKET FOR 2016. THE REPUBLICAN CANDIDATES RUNNING FOR PRESIDENT IN 2016 DON’T SEEM ANY SMARTER THAN REPUBLICANS, BUSH-CHENEY WERE WHEN THEY WERE IN OFFICE. I CAN EASY UNDERSTAND WHY THE BOOK HERE TALKED ABOUT DEMOCRAT ELIZABETH WARREN BECAUSE SHE UNDERSTOOD THE BANKING PROBLEM CREATED BY PAULSON, BERNANKE AND OTHERS. WHILE PRESIDENT OBAMA DID A LOT BETTER THAN PRES BUSH DID IN TRYING TO REINSTATE SOME REGULATIONS WITH THE DODD-FRANK BILL, AS WELL AS THE VOLCKER RULE, THE REPUBLICANS, ALONG WITH THEIR LOBBYISTS, WORKED JUST AS HARD TO GET RID OF ANY REGULATIONS BECAUSE THEY LIKED GIVING THE CEOs HUGE SALARIES AND BONUSES, EVEN THOUGH THEY WERE THE ONES THAT CAUSED THE 2008 FINANCIAL CRASH. SO VOTERS SHOULD REALLY OBSERVE WHO IS GOING TO PROTECT OUR BANKING SYSTEM, SO WE DON’T END UP LIKE 2008 OR EVEN WORSE, LIKE THE 1929 STOCK MARKET CRASH.
LaVern Isely, Progressive, Overtaxed, Independent, Middle Class Taxpayer and Public Citizen and AARP Members