The heart of the response to the U.S. financial crisis last fall was the $700 billion TARP program. The on again, off again program was to buy bad assets from banks and free them up to lend again and reinvigorate the economy.
A few weeks after arguing that this program was essential to saving the world economy, the Treasury and Federal Reserve backpedaled and decided to use the money to inject equity directly into the banks.
While that was a worthy objective and essential to enabling the banks to resume lending, it left the financial markets puzzled. What was the Treasury really thinking and did they know what they were doing? If the bill was named the Troubled Assets Relief Program, why wasn't it dealing with troubled assets?
Dealing with an unprecedented crisis strains, the financial markets were panicking and the critical thing in shortest supply was confidence. Treasury's flip flopping and floundering squandered whatever confidence was left.
In reversing its decision to purchase bad assets, the Treasury cited as their biggest obstacle figuring out how to price assets. That's a question that Treasury and the Fed had danced around during Congressional testimony in September and later.
The problem in a nutshell is this. Because no one wants to hold illiquid assets now, prices have plunged. In a few years, when institutions are more willing to assume normal risks, these assets may rebound significantly if their intrinsic value remains the same. The Federal government can add these assets to its balance sheet now and wait a few years for the increase in price and an expanded number of buyers.
But which price should the Government pay? The current low market price, the expected higher future price or something in between?
The answer is critical because the idea is to help these financial companies recover so they can provide the wherewithal to get the economy moving again. If the Government pays too little, it won't help the banks. If it pays too much, it will feel like a chump and taxpayers will be taken for a ride.
The real answer may be that the Government should inject money now and worry about the price later.
Here's how that would work. Think options. The Government would pick an arbitrary middle price and pay the banks that money now. That would help the banks get back to work, lending money to sound borrowers. The Government would sell the assets it is acquiring over a period of years. If the Government got good prices, it would split the upside with the banks. If it realized lower prices, it would collect some of the difference from the banks.
This would accomplish three major things. It would help repair the balance sheets of the banks now and restore confidence. We would avoid the thorny problem of pricing for now but a market-based mechanism would be used in the future. This would avoid the problems and possible corruption of arbitrarily setting prices. Finally, this would bring transparency to the process and boost investor confidence which is a critical step toward recovery.