Treasury prepares for a TARP-and-switch. And it’s a good thing, too

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Did anybody else notice that when Hank Paulson was describing in his press conference today what the Emergency Economic Stabilization Act enables Treasury to do, the first thing he listed was “to inject capital into financial institutions”?

That wasn’t how Treasury initially advertised its Troubled Asset Relief Program. It was sold as a way to get the market for mortgage securities moving (or, to use the jargon, liquid). Lots of academic economists objected that liquidity wasn’t the problem, it was insolvency. What Treasury needed to do was recapitalize financial institutions and take equity stakes in return.

When members of the Senate Banking Committee pressed Paulson on this two weeks ago, he pushed back. “Putting capital into institutions is about failure,” he said. “This is about success.”

But Congress went ahead and forced on Paulson a provision that said he had to get equity or senior debt from financial institutions in exchange for taking significant assets off their hands–effectively enabling backdoor recapitalizations. Yesterday Ben Bernanke hinted that a change in emphasis might be in the offing for the TARP. And today Paulson seemed to confirm it.

None of the people asking questions at the press conference really seemed to pick up on this, of course (&%%$# Washington journalists!). Along with Paulson’s affirmation that the FDIC was going to use its “systemic risk” powers to protect depositors and unsecured creditors “as appropriate,” I take it as one more sign that we’re headed toward a Swedish solution of our banking crisis—recapitalization and temporary nationalization of much of the banking system. This is the right thing to do, I think. But I’m still a little bit confused as to why Paulson had to back into this instead of asking for it in the first place. Maybe because he thought President Bush would never sign a bill to nationalize the banks? Just a thought.

Update: I just talked to Treasury spokeswoman Michele Davis and she was a little bit cagey. “Our focus is still on buying troubled assets,” she said. “But we’re going to look at all these tools. We wanted the flexible tools to do what is necessary over the next several months.” She also pointed me to this interesting exchange from the Oct. 3 House floor debate:

Mr. MORAN of Virginia. Thank you, Madam Speaker. I won’t take that much
time. I do want to thank the chairman for his masterful leadership on
this bill, and I do want to clarify that the intent of this legislation
is to authorize the Treasury Department to strengthen credit markets by
infusing capital into weak institutions in two ways: By buying their
stock, debt, or other capital instruments; and, two, by purchasing bad
assets from the institutions, in coordination with existing regulatory
agencies and their responsibilities under this legislation, as well as
under already existing authorization for prompt, corrective action and
leastcost resolution.
Mr. FRANK of Massachusetts. Will the gentleman yield?
Mr. MORAN of Virginia. I’d be happy to yield.
Mr. FRANK of Massachusetts. I can affirm that. As the gentleman knows,
the Treasury Department is in agreement with this, and we should be
clear, this is one of the things that this House and the Senate added to
the bill, the authority to buy equity. It is not simply buying up the
assets, it is to buy equity, and to buy equity in a way that the Federal
Government will able to benefit if there is an appreciation.

Update 2: From Alec Phillips of the Goldman Sachs economics team (who, you know, oughtta know):

Now that the government has started committing taxpayer funds to stabilizing the financial system, a further assumption of risk appears quite likely. The TARP is clearly the main risk-bearing vehicle in this regard, but which of the authorities that the Treasury chooses to exercise could make a large difference. By purchasing preferred shares or other means of capital injection rather than only buying assets, the program could leverage the $700 billion at its disposal. With financial institutions levered 10 to 12 times, a dollar of direct investment can support the purchase of many more assets than direct purchase. Likewise, if the program ultimately brings in private capital alongside public capital, as is reportedly being discussed, this would add to the leverage as well.

Update 3: And now the NYT has figured it out.