Treasury Secretary Outlines Revised TARP Strategy
By: Anthony R.G. Nolan, Laurence E. Platt
On Wednesday, November 12, 2008, U.S. Treasury Secretary Henry M. Paulson, Jr. delivered a significant speech outlining current issues regarding the implementation of the financial rescue package authorized by the Emergency Economic Stabilization Act of 2008 (“EESA”), and a revised strategy for the use of funds through the Troubled Asset Relief Program (“TARP”) to address those issues. Click here for a link to Secretary Paulson’s speech.
One of the key aspects of Secretary Paulson's speech was that the remaining funds authorized by EESA will not be used to purchase illiquid mortgage-related assets, but rather to pursue alternative strategies to refloat credit markets and to create new mechanisms to facilitate price discovery for troubled assets. The Secretary’s remarks seem to reflect a belief that it will be a losing battle to buy troubled mortgage assets in the face of deteriorating economic circumstances that are likely to cause home loan defaults to increase at a dramatic pace. This new approach appears to focus on addressing circumstances that may cause consumers to default—such as the loss of jobs—rather than on the effects of such defaults.
Secretary Paulson outlined three alternative strategies for the use of the remaining funds authorized under the EESA:
- Building additional capital in financial institutions, as has already been done with more than $200 billion of the amounts authorized under EESA.
- Supporting consumer access to credit outside the banking system.
- Further mitigating mortgage foreclosures.
Governmental efforts to support consumer access to credit outside the banking system, the second strategy mentioned above, may have profound implications for the securitization markets. In his remarks, Secretary Paulson spoke forcefully of the need to resuscitate the securitization markets because of their importance as a source of liquidity, not only to financial institutions, but also to consumers who necessarily rely on credit. His speech suggests that the Treasury is prepared to take significant steps to prime the pump for securitization activity, including a liquidity facility for AAA-rated securitizations. This is an important statement of policy in light of the views of many who have concluded that the securitization markets are permanently dead, or that securitization is an inherently antisocial activity. Paradoxically, the announcement of this strategy may actually end, for a time, the modest thawing of the securitization markets that we have recently seen for certain asset classes, as new issuances are delayed until the Treasury further elaborates its plans to revive securitization markets. Issuers may be reluctant to go forward with securitizations that might obtain better pricing in the near future if they may be backed by a Treasury liquidity facility.
The third strategy described by Secretary Paulson—additional efforts to mitigate mortgage foreclosures—may have important consequences for the ongoing struggle among mortgage servicers, borrowers, whole loan holders and investors in mortgage-backed securities as to who will ultimately bear the risk of loss inherent in loan modifications that reduce borrower payments. While the issue is difficult regardless of the type of loan or investor, it is particularly complex in the case of loans pooled in mortgage-backed securities. While servicers of securitized mortgages have been modifying mortgage loans in great numbers, there are significant obstacles to expanding the scope of modifications. Among these obstacles are investors’ reluctance to waive contractual rights in a manner that arguably shifts a social cost to them where modification costs more than foreclosure (even where the outstanding loan balance arguably represents principal that should never have been extended in the first place). Another issue, evident in the tepid reaction of consumer advocates to the recently announced mortgage modification protocol, revolves around disagreements over the extent to which modification relief should be made available to borrowers with similar loans but who are in different economic circumstances, and the extent to which relief should be made permanent.
The success of any program to expand mortgage modifications will depend not only upon Treasury’s ability to craft solutions that are perceived to be fair, but also its ability to resolve some of the deeper obstacles to broad loan modifications. Ordinarily, most borrowers could be expected to resolve the need for mortgage modifications by refinancing their homes or selling them—neither of which may be feasible given changes in the economic circumstances of borrowers following loan closing, declines in property values, and the drying up of sources of credit for borrowers with anything other than pristine credit histories. The solutions to these problems go well beyond the authority and capability of Treasury. Strategies for promoting mortgage loan modifications may include the use of TARP funds, but there simply is not enough money for this tactic alone to have a material impact on a nationwide basis.
The significance of Treasury’s shift in direction should not be overstated, as it is likely to be quickly overtaken by other events. However, it sets a new direction for the financial recovery as the transition to a new administration begins. Elements of the previously announced asset purchase program may come back in some form. More broadly, we remain in the beginning stages of what may turn out to be a massive shift of leverage from private balance sheets to the public debt.
