TARP: The Looming Debacle

On April 21, the Special Inspector General for the Troubled Asset Relief Program Act of 2009–“SIGTARP”–submitted his quarterly report to Congress on his office’s activities in relation to the TARP program. The report is a disquieting document that should be read by every American–certainly be every taxpayer.

The Inspector General’s report documents the stunning and at least partly illegal expansion of TARP from the $700 billion originally allocated by Congress to what is now a $3 trillion complex of programs. This chart shows the various programs that are now included within SIGTARP’s oversight, and how they have expanded from the initial $700 billion. Note that some of the programs are still incipient; $3 trillion is by no means a final number. Click to enlarge:


The report is valuable for a number of reasons, not least because it provides the most coherent description I’ve seen of the various programs now underway to bail out–or take over, as the case may be–the country’s financial sector. So far, the report’s most commented-upon feature is its description of the many criminal investigations that are now underway, arising out of TARP:

Both from the Hotline and from other leads, SIGTARP has initiated, to date, almost 20 preliminary and full criminal investigations. Although the details of those investigations generally will not be discussed unless and until public action is taken, the cases vary widely in subject matter and include large corporate and securities fraud matters affecting TARP investments, tax matters, insider trading, public corruption, and mortgage-modification fraud.

It is safe to assume, however, that the investigations now in progress represent not even the tip of the iceberg. The most troubling feature of the SIG’s report is its documentation of reluctance on the part of Tim Geithner’s Treasury Department to make even modest efforts to protect the interests of the taxpayers. To take just one glaring example, Treasury has refused to require banks to account for what they do with the billions of dollars they receive in TARP money:

Treasury has indicated, however, that it will not adopt SIGTARP’s recommendation that all TARP recipients be required to do the following:

• account for the use of TARP funds
• set up internal controls to comply with such accounting
• report periodically to Treasury on the results, with appropriate sworn certifications

In light of the fact that the American taxpayer has been asked to fund this extraordinary effort to stabilize the financial system, it is not unreasonable that the public be told how those funds have been used by TARP recipients. Treasury is now conducting regular surveys of the banks’ lending activities; however, with the exception of Citigroup and Bank of America, Treasury has refused to seek further details on TARP recipients’ use of funds.

Not just failed, but “refused.” The report adds:

The American people have a right to know how their tax dollars are being used, particularly as billions of dollars are going to institutions for which banking is certainly not part of the institution’s core business and may be little more than a way to gain access to the low-cost capital provided under TARP.

Later, with respect to the Capital Assistance Program specifically, the report says:

Treasury announced that it would require CAP applicants to set forth how they intend to use CAP funding. Notwithstanding this requirement, Treasury adamantly continues to refuse to adopt SIGTARP’s recommendation that it require CAP recipients (and indeed all TARP recipients) to report on how they actually used TARP funds. Putting aside the value of this recommendation in other TARP programs, SIGTARP submits that it is largely meaningless to require an applicant to report on its intended use of funds without setting up a mechanism to monitor its actual use of funds.

I don’t know of any way to explain Treasury’s position other than as a manifestation of the Democratic Party’s instinctive preference for cronyism over accountability.

The Treasury Department is now managing a vast portfolio of “troubled assets” on behalf of the American people. It has not, however, developed any plan for how to dispose of them, or how to manage them in the meantime. This may relate to the Obama administration’s failure to staff the Department:

In its Initial Report, SIGTARP noted that “[t]o date, Treasury has not fully developed significant policies or controls with respect to asset management issues,” and recommended that “Treasury needs, in the near term, to begin developing a more complete strategy on what to do with the substantial portfolio that it now manages on behalf of the American people.”

As of the drafting of this report, however, no asset manager had been hired to manage the existing asset portfolio, and no investment strategy has been developed.

The Special Inspector General’s office employs a number of people who are experts with respect to the various kinds of fraud that are invited by TARP’s manifold programs. It is obvious from his report that the SIG foresees the prospect of fraud on a truly massive scale. Yet, for some reason, Treasury does not appear to have the same level of concern about fraud that could cost the taxpayers hundreds of billions of dollars.

With respect to specific TARP programs, the report goes into considerable detail about the features of the programs that make them susceptible to fraud and manipulation. Here, the SIG discusses the “Public-Private Investment Program,” one of the most controversial aspects of TARP. PPIP is intended to form public-private “partnerships” to buy distressed assets, mostly mortgage-backed securities. But the vast majority of the risk lies with the taxpayers, while the program is rife with opportunities for connected insiders to make a fortune. The following excerpt is lengthy, but easily understandable:

Many aspects of PPIP could make it inherently vulnerable to fraud, waste, and abuse. First, PPIP deals with assets that have recently been illiquid, making valuation difficult, therefore raising the danger that the Government will overpay for the assets. Second, many of the participants in these markets, such as hedge funds, are substantially unregulated and the internal oversight and compliance capability at those institutions vary widely. Next, the interrelationships between the market participants can be extremely complex and difficult to anticipate: the same entity might buy and sell toxic assets for its own benefit and manage portfolios of toxic assets for others, all while holding or managing equity or debt securities of the banks and other institutions that have large positions in the same toxic assets. Finally, the sheer size of the program — up to a trillion dollars for the PPIFs and up to another trillion dollars for the expansion of TALF — is so large and the leverage being provided to the private equity participants so beneficial, that the taxpayer risk is many times that of the private parties, thereby potentially skewing the economic incentives.

After receiving initial briefings from Treasury on PPIP and discussing the issue with law enforcement partners, SIGTARP has identified three of the most significant areas of potential vulnerability to fraud and abuse applicable across the program.

The program is rife with potential conflicts of interest. Again, the explanation is lengthy but is clearly written:

The first area of vulnerability is that the private parties managing the PPIFs might have a powerful incentive to make investment decisions that benefit themselves at the expense of the taxpayer. By their nature and design, including the availability of significant leverage, the PPIF transactions in these frozen markets will have a significant impact on how any particular asset is priced in the market. As a result, the increase in the price of such an asset will greatly benefit anyone who owns or manages the same asset, including the PPIF manager who is making the investment decisions.

As an extremely simplified example from the Legacy Securities Program, assume that the fund manager of the PPIF owns 1 million bonds of MBS [Mortgage-Backed Security] X in its own account. MBS X is currently valued on the fund manager’s books at 20% of its original value, or $20 per bond, for a total of $20 million. The fund manager does an estimate and believes that, in a fully functioning market, MBS X is actually worth 30% of face value, or $30 per bond. In the absence of a conflict of interest, the fund manager, using PPIF funds, might be willing to pay up to $30 per bond in the market. However, the fund manager realizes that it can make more money for itself if it drives the price even higher. It thus uses the funds it controls in the PPIF to buy 1 million MBS X bonds from someone else at $40 per bond, or $40 million. This transaction has the potential, in the current illiquid market, of setting the market price for that MBS X at $40, even though that price is far above what the MBS is actually worth. As a result, the fund manager could sell the MBS on its own books and recognize a profit of $20 million. Over time, however, the price of MBS X declines to its actual value, $30 per bond, and results in a $10 million loss to the PPIF fund. This loss has no negative impact to the fund manager, however, because it did not have any of its own money invested in the fund. Indeed, the fund manager has made money on the PPIF, because it has received fees from both Treasury and the private investors based only on the total size of the PPIF. In other words, the conflict results in an enormous profit for the fund manager at the expense of the taxpayer.

The same incentives to overpay could exist in the Legacy Loans Program and in numerous other factual circumstances. The incentives exist, for example, even if the fund manager does not own MBS X but is merely managing other funds that hold MBS X, as the manager earns fees based on the value of that fund, a value that would, in this example, be significantly overstated (temporarily) as it can increase the value of that fund based on valuing, or “marking” the MBS X at the inflated “market” price that it set.

A second risk identified by the Special Inspector General is collusion between participants in the PPIP program–the issue that we highlighted here:

A closely related vulnerability is that PPIF managers might be persuaded, through kickbacks, quid pro quo transactions, or other collusive arrangements, to manage the PPIFs not for the benefit of the PPIF (and taxpayers), but rather for the benefit of themselves and their collusive partners. In both the Legacy Loans Program and the Legacy Securities Program, the significant Government-financed leverage presents a great incentive for collusion between the buyer and seller of the asset, or the buyer and other buyers, whereby, once again, the taxpayer takes a significant loss while others profit.

This time, consider an example from the Legacy Loans Program. Imagine that a bank owns a pool of mortgage loans that both it and the private equity firm investing in a PPIF values at $600 million. The private equity firm invests $60 million into the PPIF, which is matched by $60 million of TARP funds, and which is leveraged by a loan of $720 million guaranteed by FDIC (the 6-to-1 debt-to-equity ratio). The PPIF private equity firm surreptitiously agrees with the bank to overpay for the pool of loans and causes the PPIF to bid $840 million at auction for that pool. After the auction, the bank secretly pays the PPIF private equity firm a kickback of $120 million, or half the difference between the auction price ($840 million) and the true value ($600 million).

Although the PPIF will eventually perform poorly as a result of the overpayment, the private equity firm’s loss is relatively small. Even if the PPIF was completely wiped out, the most the PPIF private equity firm could lose is $60 million, which would still give it a guaranteed profit of at least $60 million as a result of the kickback, a 100% return. Meanwhile, the bank would have gained an illegal benefit of $120 million, all at the expense of the taxpayer and FDIC. Of course, in practice, the collusive scheme would be far more complex and would likely involve a series of affiliates and offsetting transactions, but the principle would be the same.

The same collusion could occur in the Legacy Securities Program between buyer and seller. Similarly, collusion could occur among other buyers.

The third broad area of risk identified by SIG is money laundering:

Because of the significant leveraging available and the inherent imprimatur of legitimacy associated with PPIP and TALF, these programs present an ideal opportunity to money-laundering organizations. If a criminal organization can successfully invest $10 million of illicit proceeds into a PPIF, not only does the organization enjoy the possibility of profiting through the Government-backed leverage, but any eventual distributions from the PPIF are successfully laundered because they appear to be PPIF investment gains rather than drug, prostitution, or illegal gambling proceeds.

Are you confident that Tim Geithner’s Treasury Department is up to dealing with these issues? No, neither am I. But it gets worse. Because Treasury has now announced that Public-Private Investment Fund money will be available to purchase mortgage-backed securities under the Term Asset-Backed Securities Loan Facility program. This makes the Special Inspector General distinctly unhappy:

In announcing the details of PPIP, Treasury has indicated that PPIFs under the Legacy Securities Program could, in turn, use the leveraged PPIF funds (two-thirds of which will likely be taxpayer money) to purchase legacy MBS through TALF, greatly increasing taxpayer exposure to losses with no corresponding increase of potential profits. By way of example, a PPIF manager could raise $500 million of private equity, which would be matched with $500 million of TARP funds, and a loan of an additional $500 million from TARP funds (according to the term sheet, loans will only be given up to 50% of the total equity if investments will be made through TALF rather than 100% otherwise). The PPIF could then take the total $1.5 billion, bring it to the TALF window, and effectively use that money as the “haircut” amount in a TALF financing to purchase legacy RMBS [Residential Mortgage-Backed Securities].

Assuming that the haircut will be 20% (larger than any existing haircut), the PPIF will be able to receive a non-recourse loan from FRBNY [the Federal Reserve Bank of New York] for an additional $6 billion, enabling the PPIF to purchase $7.5 billion in legacy RMBS. The private investors would thus enjoy 50% of the profits from this enhanced buying power, but only be exposed to less than 7% of the total losses if the fund were wiped out.

Aside from potential unfairness to the taxpayer, this leverage upon leverage on legacy RMBS raises other significant issues. First, it only magnifies the dangerous incentives discussed above (the conflicts of interest and collusion issues), because the fund manager now has up to five times the buying power than it would if it participated in the Legacy Securities PPIF alone. Moreover, it severely undermines the validity of the methodology that the Federal Reserve has used to build the haircut percentages in TALF thus far. The Federal Reserve has told SIGTARP that it has determined its haircut percentage based at least in part on the fact that the haircut represents a TALF borrower’s “skin in the game” — someone’s own capital at risk — that incentivizes appropriate due diligence on the borrower’s part. If leveraged PPIFs are permitted to participate in TALF, that effectively lowers the private equity’s skin in the game by at least the amount of money borrowed from TARP, materially diminishing the incentive to do due diligence. Put in simpler terms, an investor who is funding 100% of the haircut amount with his own money (as is typical in TALF) can logically be expected to be far more careful than one only putting up 33% (as would occur under this example).

It strikes me as a deep irony that the Treasury Department is creating perverse incentives similar to those that plunged the country into a financial crisis in the first place.

Surely that must be the end of the bad news? No. We haven’t yet gotten to the government’s Mortgage Modification Program, which bails out individual homeowners. Here, the Special Inspector General brings considerable expertise to the table:

SIGTARP’s recommendations were made in the context of the Special Inspector General’s prior experience as the founder of the Mortgage Fraud Group in the United States Attorney’s Office for the Southern District of New York and after consultation with and advice from mortgage fraud experts at the Federal Bureau of Investigation. The recommendations address some of the patterns of the rampant mortgage fraud that contributed to the current financial crisis, including corruption of many of the potential gatekeepers who were supposed to limit such fraud: attorneys, appraisers, notaries, mortgage brokers, title insurance agents, and insiders at banks and mortgage originators.

Recognizing that many of the most prevalent frauds had common characteristics, SIGTARP’s recommendations reflected an attempt to shield the program from such schemes before they could be adapted to the mortgage modification plan.

Is the Treasury Department heeding the experts’ warnings about how to avoid fraud in the mortgage modification program? The short answer is No. Read the report for the details.

What conclusions can we draw? 1) The government’s $3 trillion and counting TARP program represents the greatest opportunity for sharp operators to profit at taxpayer expense in history. 2) The Obama administration is either in favor of giving Wall Street sharks this opportunity or, at a minimum, doesn’t much mind doing so. (If this seems odd, remember where Obama got the biggest chunk of campaign contributions in 2008.) 3) It may be that the TARP complex of programs is the beginning of a national-socialist type takeover of the financial services industry by the federal government. Thus, 4) we can only hope that this turns out not to be the case, and TARP is only the biggest–and perhaps, by the end of the day, the crookedest–waste of taxpayer money in history. Finally, 5) so far the only person or organization who appears to be looking out for the taxpayers is the Special Inspector General. We will be reading his future reports with great interest.


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