Banks Now Rejecting Government Funding Through TARP and PPIP, Ahead of the “Stress Test” Announcement

ATLANTA— According to MarketWatch.com, “more than 250 institutions receiving preliminary approval to receive funds from the Treasury’s Troubled Asset Relief Program, or TARP, decided against taking the money.”   Separately, Jamie Dimon, CEO of J.P. Morgan said during the first the bank’s first quarter earnings release conference call, “”[We have] no intent on using PPIP. We have our own assets, if we want to sell them, we’ll sell them… and we’re certainly not going to borrow from the government, because we’ve learned our lesson about that.”  Others in the banking industry have recently expressed deep concern about too much government involvement in private financial institutions. They warn that it could distort competition because government-backed institutions can offer tax-payer subsidized interest rates and it could exacerbate the current issues, as the government could pressure the industry into making more bad loans in order to pump liquidity into the economy.  We predicted banks would soon turn against government funding three months ago, when Barack Obama first announced government restrictions of executive pay at TARP-funded institutions.

This is all extremely relevant, because on May 4th, the government is set to announce the preliminary results of the Federal Reserve’s bank “stress tests,” the intent of which is to determine whether major U.S. financial institutions have sufficient capital to weather another severe market downturn, should one occur.  It is highly likely that the Federal Reserve will determine one or several major institutions are not sufficiently capitalized, and will use the “stress tests” as cover to inject them with more capital.  It is also likely they will convert their current preferred shares into common shares, to give the U.S. Treasury Department the legal voting power necessary to influence the direction of these “undercapitalized” banks.  Inevitably, one or several major bank CEO’s will be forced out of office, much like Richard Wagoner at General Motors. 

The Federal Reserve and Treasury Department will have to do these things for several reasons.  First, they will have to fail at least one bank, regardless of the actual outcomes, to lend credibility to these “stress tests” and to the competence of Timothy Geithner.  If they pass every institution, then it will beg the question of whether the “stress tests” were done properly, given all the hoopla the government and many private economists have made about the health of the financial sector.  Further, it would virtually negate the need for Mr. Geithner’s Public-Private Investment Program (PPIP), the purpose of which was to use taxpayer money to incentivize members of the private sector to buy bad assets from banks, thereby capitalizing them.  If all of the banks passed, people would question why the hoopla about under capitalization – and why is Mr. Geithner wanting to stuff more taxpayer dollars into these institutions.  People will begin to question if he truly understands what he is doing.

Second, since the government will have to fail one or several institutions, they will then need to act.   Action will likely take the form of converting their shares to common shares, and removing the current leadership- to give the impression that the government is in charge of the circumstances and has punished those who put the insitution in the bad financial position.   Whatever actions the government takes after this, who knows?   Likely, they will dither over how to handle bad assets and will institute all manner of regulations over the institutions’ lending policies, the goal of which will be to flood more credit into the market.  In my view, this will all lead to bumbling failure down the road and immense controversy, on par with the AIG bonus controversies from a few short weeks ago.

But the reason I am interested in the events documented in the first paragraph of this missive is that financial institutions are growing extremely apprehensive about the continued government encroachment into their industry.    The turning point of their opinions was clearly the announcement of Barack Obama’s pay restrictions on executives.  This has only been pushed further by the AIG bonus snaffoo and the confiscatory tax on those bonuses that the House of Representatives tried to pass.  The firing of Richard Wagoner and the threats by Administration officials to replace bank executives were also unhelpful.

In the end, I am not surprised banks are turning away from the government intrusion.  Private markets always resist regulation- or find ways to creatively get around it.  If the web of regulation becomes too tight, then the Great Depression showed us that private capital generally retreats, with lasting and brutal effects on the economy.

I am actually glad the banks are resisting and hope they continue to do so.  I would be pleased to hear more about private inititatives to remedy bad assets and recapitalize banks.  For instance, I was happy to learn that Goldman Sachs has been considering a stock offering to raise capital and pay back their TARP funds sooner, so that they can get out from under the government’s thumb. 

Haters of free markets probably do not like these moves by the banks to get out from under government control, but I love them.  They are incredibly less expensive to the taxpayer and I think will benefit the long-term health of the economy because the financial markets will be allowed to weather the storm of their own mistakes on their own, learning valuable lessons.  This should also reduce the likelihood of future moral hazard being spawned by the perception that government will always bailout institutions deemed “too big to fail.”

But if I am wrong- and if government recapitalization is what is needed- then I stand by my previous argument that one of Barack Obama’s worst moves yet was to announce the pay restrictions on banking executives.  It is only going to make his Administration’s efforts to recapitalize the system that much more painful and difficult.   I have not read enough about it, but I have got to imagine participation in PPIP is less than stellar to this point.  Regardless of what happens with the stress tests, Tim Geithner is going to get his competence questioned even more, if PPIP fails to pan out.