The TARP Trojan Horse

Resident Fellow
Ted Frank

In executing TARP, the Troubled Asset Relief Program, the Bush Treasury Department built off of the experience of costly mistakes the government made in the 1980s bailout of the savings and loan industry. But the lessons learned are the wrong ones, and the consequences could be dramatic.

Special interests could use Congress to demand that TARP participants engage in various forms of costly social engineering.

To induce healthy thrifts to take over troubled thrifts, the Federal Savings and Loan Insurance Corporation offered a regulatory incentive: it would permit the institutions to count intangible "supervisory goodwill" towards their reserve requirements, and amortize that goodwill over forty years. This and other favorable accounting treatments would permit the acquirer to increase its leverage and thus, hypothetically, its profits. Without this incentive, the desired mergers never would have happened: a healthy thrift plus an insolvent thrift would have equaled another insolvent thrift under the old accounting regime.

Dozens of institutions made express agreements with the FSLIC and relied upon those promises. These deals saved the government money (at least in the short run) because the failing thrifts could continue operating and the government did not have to make good on deposit insurance.

Now, one can argue that the FSLIC's policy was unwise because it distorted economic incentives and encouraged healthy banks to make themselves less healthy. Recent events have shown the problem of overleveraging. And some businesses were rent-seeking, created simply to buy failing thrifts and take advantage of the favorable regulatory treatment. But the way Congress resolved that problem was to pull the rug out from under these deals retroactively.

FIRREA, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, abolished the old regulatory regime, including the FSLIC. More importantly for the thrifts, FIRREA established capital requirements that made the deals' accounting treatment impermissible.

Profitable thrifts that had relied upon the government's promises found themselves out of compliance with the new rules, and regulators seized and liquidated them.

Many of those thrifts sued the United States for breach of contract. And the Supreme Court quickly ruled unanimously in Winstar Corp. v. United States that the thrifts had a case. Yes, Congress could change the rules; the thrifts did not claim otherwise. But the government had the responsibility to make whole those who had contractual agreements when the new rules meant the government could no longer keep its promises.

The aftermath of Winstar was disappointing, however, for those investors. The Department of Justice litigated the suits to the hilt through three presidential administrations, and the thrifts received only a small fraction of the billions they lost for trusting the government.

There are many lessons that policymakers could take from this experience. One is to avoid addressing financial problems with short-term solutions that only forestall and magnify the eventual pain. (Yet TARP also involves accounting kludges.) Another is realizing the costs to the economy when the government reneges on a deal: aside from the fundamental unfairness of a broken promise, capricious policy makes it more expensive for the government to induce trust from investors in the future. The Winstar experience is no doubt interfering with the government's plans this time around.

But the government's conclusion from its Winstar experience is the wrong one: lawyer up in advance. TARP's "Securities Purchase Agreements" each contain a Trojan Horse clause, Section 5.3, stating that Treasury may "unilaterally amend" the agreement to comply with changes in federal statutes. In short, Congress has the power to retroactively amend the terms of the bailout, and stakeholders would have even less recourse than the Winstar plaintiffs.

The provision is a blank check. Congress could raise the dividend rate without warning; it could change the repayment schedule. Congress can wipe out shareholders or subordinate debt-holders overnight. Any of a raft of special interests could use Congress to demand that TARP participants engage in various forms of costly social engineering, ranging from meddling in corporate governance to abstinence from foreclosures to favorable treatment for Democratic constituencies.

This is already more than hypothetical. During December's Republic Windows and Doors sit-in, Illinois Governor Rod Blagojevich used the fact of the bailout to mau-mau Bank of America into paying over a million dollars to the lawbreaking union, even though banks have no legal obligation to their debtors' workers.

And the "stimulus" bill included strict regulation of executive pay for bailout recipients--essentially insuring that the bailed out banks won't be able to compete in the marketplace for talent to replace the people who got them into the mess they are in.

David Baris of the American Association of Bank Directors pointed all this out in a November 3 letter to Treasury Secretary Paulson, but never received a response. Little wonder many banks are refusing to participate in TARP, and equity holders should be especially wary of the ones that do given the unbounded political risks.

This unnecessary uncertainty is almost certainly contributing to the financial paralysis that is preventing TARP from working. The Obama administration should ameliorate the damage by deleting Section 5.3 from the Securities Purchase Agreement.

Ted Frank is a resident fellow at AEI.

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About the Author


  • Ted Frank is a former resident fellow at AEI. He specialized in product liability, class actions, and civil procedure while at AEI. Before joining AEI, Mr. Frank was a litigator from 1995 to 2005 and clerked for the Honorable Frank H. Easterbrook on the Seventh Circuit Court of Appeals. Mr. Frank has written for law reviews, the Wall Street Journal, the Washington Post, and The American Spectator and has testified before Congress multiple times on legal issues. He writes for the award-winning legal blogs and Overlawyered, and the Wall Street Journal has called him a "leading tort-reform advocate."  Mr. Frank was recently elected to membership in the American Law Institute.

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