Repairing a Frayed TARP

October’s hasty enactment of the $700 billion Troubled Assets Relief Program (TARP) is coming home to roost. Stinging criticism of the Treasury Department’s handling of the program has come from the Government Accountability Office and from both sides of the aisle on Capitol Hill. With debate brewing over whether to block release of more TARP funds and with this week’s report by TARP’s congressional oversight panel, now is the time to focus on the deficiencies of the program and to repair the TARP. Fixing the mistakes made in the rush to enactment will be an essential part of convincing American taxpayers and markets that government intervention can help to resolve the snowballing economic crisis.

What went wrong with TARP? The GAO audit observes that Treasury has failed to track how banks are deploying their TARP dollars. Legislators argue that Treasury has undermined congressional intent by failing to use TARP funds to help stem the tide of residential foreclosures and by being too lenient on banks receiving taxpayer capital. Many also argue that Treasury should have used TARP to help rescue the nation’s automobile industry. Treasury Secretary Henry Paulson counters that TARP and other market interventions have stemmed the collapse of the banking system. Funding foreclosure relief through TARP would amount to subsidies, rather than the investments intended by Congress.

Congressional overseers are right, up to a point. Paulson and Federal Reserve Chairman Ben Bernanke argued that the financial system would collapse if Congress failed to provide billions for the purchase of mortgage-backed securities. Paulson then switched gears, using the broad language of TARP to force healthy banks to accept taxpayer cash. Congressional critics now question the terms of the capital injections, demanding better taxpayer protections and efforts to compel banks to limit dividends and bonuses. Meanwhile, despite plans for loan modifications by the Federal Deposit Insurance Corporation, Paulson has not acted.

It is easy to point fingers at Treasury given the secrecy with which it has infused capital into banks and the midcourse changes in Paulson’s tactics. But Congress also shoulders responsibility for the bailout’s fallout. Worried about voter retribution, Congress placed some conditions on the asset purchases, but did not write a playbook to guide TARP expenditures.

Congress should amend TARP in three ways.

First, openly debate a plan to inject capital in the banking and possibly other sectors, and consider whether mortgage-backed assets should be pursued. Critics charge Paulson with a bait-and-switch because there was no formal congressional debate about alternative uses of the TARP funds outside of a short House floor colloquy. Paulson even testified that injections of public capital would be seen as a sign of “failure.” With nearly $300 billion now invested in banks— including some banks that initially balked when told of the plan—and other industries lobbying for a piece of the TARP, congressional debate over the aims and implementation of the program is critical.

Second, rewrite the conditions imposed on institutions that take public capital under TARP. Micromanagement by Congress is no panacea, and in fact can harm, rather than cure, the nation’s economic ills. But securing an optimal deal for taxpayers and requiring greater transparency in how TARP is run are essential.

Third, create carrots and sticks to compel Treasury to comply with congressional aims, particularly with respect to mitigating foreclosures. Congress created multiple layers of oversight in TARP, but did so largely by imposing numerous reporting requirements. Taking a peak under the TARP is essential, but so too is creating tools to make sure it works as Congress intended.

Treasury’s implementation of TARP has had steep costs for investor confidence, contributing to the stock market’s accelerated downdraft this fall. Investor confidence has been shaken by policy makers’ failure to convey competency, to communicate effectively the steps being taken, and to act consistently with what Treasury and the Federal Reserve argued needed to be done. The chaotic drama has compounded an increasingly dire economic environment – one challenged by rising foreclosures and bank failures. The housing market will continue to deteriorate as unemployment rises, creating additional pressures throughout the financial system and economy.

Economic policy works best when markets understand what policy makers are doing. Congress can respond more effectively and can bolster public confidence in its ability to solve tough, time-sensitive economic problems by learning from its mistakes when it rushed TARP into law the first time around.