A primer on TARP and some political commentary:

With all the brightest minds in finance and politics focused on this one problem, why could they not find a better name? TARP, the Troubled Asset Relief Program, is not exactly a bailout nor is it a plan to fix the U.S. economy. It is a program that creates a new “superbank,” designed to take on risk along with the prospect of a profit or loss, and solidly address a gaping chasm in our financial system. Let me explain.

The dysfunction that we have seen over the past three weeks highlights a basic collapse of the capitalist model and its reliance on the concept of a rational agent. The belief was that greed, the primary motivation of people and the stewards of business, was so truthfully efficient that in the end you had only the best, most productive organizations flourishing in the economy. Starting in the 1970s, a form of hypercompensation, stock options, was layered onto this model to provide the ultimate reward for the best performers. To a certain degree, it worked for a number of decades.

It turns out the system had at least one major flaw. While the individuals running these companies acted to improve their fortunes, their actions became more and more short-sighted. This myopic view was driven by two primary forces: the introduction of stock option compensation that could improve one’s fortune in just a few short months, and the wild volatility made possible by electronic trading. With short-sighted fortunes to be gained came short-sighted decisions.

Additionally, the innovations brought by financial engineering such as fancy mortgage products and the ability to ship those obligations around the globe allowed financial institutions to gorge themselves and literally grow 100-fold in a very short time. Add to this the lack of regulation during the past ten years and what we had was unchecked gluttony.

Here we are today: with obese financial organizations ready to burst, we need to find a home for the billions in mortgage-based assets that were engineered this decade. Not to say that the assets are worthless. In fact, they are probably worth about 60 – 80 cents per dollar on average. The issue is that with some worth a lot and others worth close to nothing, no one is willing to take a bet on them today. With no buyers, there is no market. And with no market, the holders of these assets are forced to value them as worthless, even the good ones. It is a cascading problem when combined with accounting rules that leads to one conclusion – any institution holding a large number of these assets are forced to replace them with good assets or fail. That replacement game takes an awful lot of money and after a year of this scramble the money has run out.

Rather than continue to find money to throw at the institutions, the TARP plan is going to address the root problem – find a value for the mortgage assets. By entering as an unlimited buyer of the assets, the government has now created a new market in which the price for these assets will be readily determined – basically whatever the government is willing to pay. Set the price high enough, and all these institutions are now solvent again. Set it too high, however, and the government ends up overpaying for assets that are worth less.

If this is done correctly, the loss to the US government is minimal, and is equally likely to be a profit. Remember, these assets on average are valuable in the long-run. Hold enough of them long enough, and you’ll get that value. How much value is there? Tough question. It depends ultimately on the fate of the housing market.

The subtle twist here is that TARP does not need to buy all the assets, just enough to convince the market of their current and stable value. If TARP is too small, the market will fail to believe the determined value is stable. TARP is, in effect, a program designed to transfer risk away from financial firms to a new institution, allowing the financial markets to continue to do what they do and give us a chance to recover as an economy.

That is my objective commentary. Here comes my not-too-subtle biased commentary.

First off, this could have been avoided six months ago. As you read in my last Market Update, Treasury Secretary Paulson (arguably the most powerful person in America at this moment) made a series of bungled steps in his attempt at the children’s game of “Whack-a-Mole.” With a personal fortune of $800 million, he seemed little concerned about common investors when forging solutions to the crisis du jour each weekend. The intended effect lasted for about six minutes while the unintended effects increased risk-taking (a result of the Bear Stearns bailout), elimination of the preferred stock market (created by the Fannie Mae and Freddie Mac takeover), credit insurance failure (from Lehman Brothers’ failure), and consumer bank failures (triggered by all the above plus losses from the AIG bailout). There seemed to be no end in sight.

TARP should end this cycle. Being a government program, however, it is faced with a far greater foe. A foe that for centuries has scourged the planet, brought tears to grown men, forced women to question humanity and left children screaming in their sleep–politicians.

Leave it to the politicians in Washington to turn a crisis into personal gain. After two days of hearings last week, it became increasingly clear that few Congressmen had the slightest idea what a bank is, much less how one actually functions. Nonetheless, the core of the plan looked intact, with a number of feel-good measures thrown on top to satisfy the national obsession with sound bites. Executive compensation caps, homeowner protection and other measures were routinely thrown in and out of the plan to give politicians their moment in the spotlight. In the end, it was still about restarting the credit markets.

Then came the crusaders. Let’s put aside the fact that deregulation and corporate greed have been core tenets of the Republican platform since Reagan (along with small government and balanced budgets – seems someone forgot to read that memo). On Thursday, McCain and his merry men tried to turn TARP into SMAFED, “Save My A** From Electoral Defeat.” The Republicans proposed to replace TARP with a self-paid insurance program in an attempt to give the Republicans the chance to claim they saved the American taxpayer $700 billion. In fact, it was insurance that exacerbated the financial meltdown and did nothing to re-establish a market for these assets. It would be a disaster from the start. Whack-a-Mole redux.

As I write this article, reports are circulating that we are close to an agreement that would maintain the core of the plan as designed by Paulson and Bernanke. Irrespective of the political tinkering, this should work to restart the credit market with little long-term damage to the Federal budget. Should this crisis pass, we will still have many months to sort out the damage from this near-collapse. Higher unemployment, lower profits and slower growth are all here for the near term. We have a long road ahead to address the core problems with the system. It will take a form of basic capitalism with a socialist twist to solve this – regulation of the financial system layered on top of the free market principles that we know still work. We can no longer rely on greed to motivate business leaders to serve the public good. From the fate of the environment to the financial system, we have seen first-hand that overriding self-interest does not translate into collective prosperity.

Regards,

David