Potentially a Really Bad Case of “We Told You So!”

The Financial World According to Inya” Column
by Inya Ivkovic, MA

According to an independent watchdog at the Treasury department assigned to the Troubled Assets Relief Program (TARP), the bailout money that the government used to prevent the financial China syndrome from actually melting down its way to China has potentially resulted in making things much worse for the United States in the long run. PROFIT CONFIDENTIAL readers may recall that I was never quite sold on the economic stimulus for one simple reason — all that money was thrown in not to solve the problems that led to the crisis. Instead, if asked to come up with a mental image for comparison purposes, I would equate the use of TARP money with putting a band-aid on the badly leaking Hoover Dam.

I have to acknowledge that TARP did stop the global financial and economic system from throwing itself off a cliff back in 2008. However, absent consequential regulatory and other reforms, we would say we are still cliffhanging, both literally and metaphorically, while the winds are getting stronger and stronger, threatening this time to loosen our grip permanently.

Here’s the thing. Since Congress opened the Treasury’s purse and the $700-billion financial bailout was unleashed, financial institutions deemed “too big to fail” have only become larger and did little to nothing to prevent lavish compensation for their executives. In other words, big banks still have little incentive to stop taking risks. Why would they stop when the government is there to bail them out next time there is a threat to the overall financial system?

To make matters worse, the watchdog stated that the office is investigating 77 cases of alleged criminal and civil fraud. What are being investigated are allegations of tax evasions, of insider trading, concocting false financial statements, corruption, etc. One case in particular concerns self-dealing by a private fund manager that was selected by the Treasury to buy toxic assets from a bank at discounted prices. The fund manager allegedly sold a bond at inflated prices out of one of its own funds and then repurchased it at significantly lower prices for a government-backed fund. However, a rating agency recently downgraded the bond and it is now worth much less than what the government had paid for it. Obviously, the need for better controls and walls among various conflicts of interest within the financial system is greater than ever before.

The Treasury, on the other hand, while welcoming the TARP watchdog’s oversight and recommendations, seems to be against erecting additional barriers to guard against conflicts of interest, stating that more stringent rules could be detrimental at this point to the overall financial system and that compliance rules already in place are demanding and effective enough.

The TARP watchdog also focused on the growing government’s role in the real estate market, warning that all that money coming into the market could potentially create another housing bubble. For most of 2009, the U.S. government has poured billions of dollars into the housing market. Approximately 90% of all loans are backed-up by government agencies, including Fannie Mae, Freddie Mac and the Federal Housing Administration. Where the Federal Reserve comes into play is spending about $1.25 trillion on reducing, and keeping, rates for mortgages at ultra-low levels.

The government was certainly there, stepping up when nearly all private players have vanished. But if the government merely replaces one side of the housing market without fixing everything that had gone wrong with it, the risk of artificially inflating home prices in the years to come remains, as does the risk of the housing market pulling us under yet again, which, if or when it happens, could sink the global economy permanently. Simply, the government cannot be the only one supporting the mortgage market and taxpayers should no longer carry all the risk that had once been shouldered by the private lending sector.

Eventually, the uber-overextended U.S. government will have to turn off the cash tap and, when that happens, financial markets will be again vulnerable to dramatic declines. Predictably, the housing market is likely to be again in the eye of the storm. Some market analysts are forecasting the decline in national home prices between eight percent and 10% below the March 2009 lows.

The key to preventing mortgage and housing markets’ black swans that have nearly annihilated the U.S. economy in 2008 is to reform Fannie Mae and Freddie Mac; to improve loan underwriting, focusing on risk management; and to increase supervision of banks. Perhaps overhauling regulation of the entire financial system in the U.S. is not necessary, but certain segments of it would benefit very much from the TARP watchdog’s analysis and the resulting proposals.