Paulson Speech Shows Tarp Only Marginally Effective

If you listened to Secretary Hank Paulson's speach, one thing was very clear - their actions are only having a minor impact and that for the most part, a resolution to the problem is out of their control. The necessity to inject an additional $27 billion into insurer AIG (total government funding for AIG now stands at $150 billion) shows the deep hole the government is climbing into.

Paulson said:

"Our financial system remains fragile in the face of an economic downturn here and abroad, and financial institutions' balance sheets still hold significant illiquid assets. Market turmoil will not abate until the biggest part of the housing correction is behind us. Our primary focus must be recovery and repair."

To me, this says that no matter how much money we throw at this problem, nothing is going to really help the problem until the housing correction is done. That makes sense but it makes you wonder why we have been pouring billions into banks. They haven't started lending and why should they? Would you lend to someone in today's climate?

He continues:

"During the two weeks that Congress considered the legislation, market conditions worsened considerably. It was clear to me by the time the bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets – our initial focus – would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks."

Paulson and Bernanke flipped their approach and instead of buying troubled assets, took a page out of the Bank of England and began injecting capital directly into the banks. The capital injections were designed to keep the banks solvent and to get them lending again. Massive bank failures have subsided for now, but lending has not restarted - see above. This about face in itself is not a problem. We want our leaders to be flexible and to adjust their approach as new ideas gain credence. But it troubles me that they seem to be reacting on-the-fly and have no real idea of what will work and what won't. Yesterday it was asset purchase, today it's capital injections, what will it be tomorrow?

"Although this program's primary purpose is stabilizing our financial system, banks must also continue lending. During times like these with a slowing economy and some deterioration in credit conditions, even the healthiest banks tend to become more risk-averse and restrain lending, and regulators' actions have reinforced this lending restraint in the past. With a stronger capital base, our banks will be more confident and better positioned to play their necessary role to support economic activity. Today banking regulators issued a statement emphasizing that the extraordinary government actions taken by the Fed, Treasury and FDIC to stabilize and strengthen the banking system are not merely one-sided; all banks – not just those participating in the Capital Purchase Program – have benefited, so they all also have responsibilities in the areas of lending, dividend and compensation policies, and foreclosure mitigation. I commend this action and I am particularly focused on the importance of prudent bank lending to restore our economic growth."

Lending isn't going to happen right now. The government can beg banks to lend money but they're going to hang on to their cash like a baby and its bottle. The consumer is tapped out and the business climate is the worst its been in 60 years. Banks just lost a load and they're not eager to lose even more.

"We have evaluated options for most effectively deploying the remaining TARP funds, and have identified three critical priorities. First, we must continue to reinforce the stability of the financial system, so that banks and other institutions critical to the provision of credit are able to support economic recovery and growth. Although the financial system has stabilized, both banks and non-banks may well need more capital given their troubled asset holdings, projections for continued high rates of foreclosures and stagnant U.S. and world economic conditions. Second, the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Addressing these two priorities will have powerful impacts on the overall financial system, the strength of our financial institutions and the availability of consumer credit. Third, we continue to explore ways to reduce the risk of foreclosure."

Sounds to me like putting fingers in a dike. You plug one hole and the next one opens up. Until this fire has burnt itself out, the actions of Paulson, Bernanke, and others are like firefighers battling a major blaze. They can hope to steer the damage and maybe even limit it, but the fire is mostly going to take its own course.

I respect Paulson for being so candid about this today. He admitted that while they have had some modest success, for the most part the situation is still pretty bad. That $700 billion is going to be spent very quickly.