Donald L Kohn: Troubled Asset Relief Program
Testimony of Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, before the Committee on Financial Services, US House of
Representatives, Washington DC, 13 January 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve
System's website.
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Chairman Frank, Ranking Member Bachus, and other members of the Committee, I
appreciate this opportunity to review some of the activities to date of the Treasury's Troubled
Asset Relief Program, or TARP, and to discuss how additional funding could be used to
strengthen our financial system and promote economic recovery.
A well-functioning, stable financial system is essential for healthy economic growth.
Unfortunately, as you know, after the collapse of a credit boom that encompassed both
mortgage lending and other major credit markets, the financial systems of the United States
and of a number of other industrialized countries came under severe strain. Banks and other
key financial institutions have seen their capital depleted and their balance sheets clogged
with poorly performing and hard-to-value assets. Securitization markets have largely shut
down, and credit spreads have widened dramatically on balance. Together with the ongoing
contraction of the housing sector, the worsening of credit conditions weighed heavily on
economic growth throughout 2008.
The financial crisis intensified considerably more in September and manifested in many
countries that it had not yet touched, which led to grave concerns about the stability of the
global financial system itself. The shocks to confidence and to the availability of credit that
followed the intensification of the crisis last fall have contributed to a substantial further
weakening in global economic activity. However, although the economic impact of the
worsening crisis has been severe indeed, an international financial collapse - which seemed
a real possibility in early October - would unquestionably have led to economic outcomes far
worse even than those we are currently experiencing. The first and most urgent priority of
policy was thus to avert such a collapse. The existence of the TARP allowed the Treasury to
react quickly by announcing, on October 14, a plan to inject $250 billion in capital into U.S.
financial institutions. Although the Capital Purchase Program has been in place less than
three months, many banks, both large and small, have applied for and received capital from
this program. The Treasury's actions were complemented by the Federal Deposit Insurance
Corporation's (FDIC) expansion of bank liability guarantees and by the Federal Reserve's
measures to increase liquidity and support the functioning of key credit markets. Together,
these actions helped to bolster confidence in our lending institutions, which enabled them to
access funds and make loans. As contemplated by the enabling legislation, TARP funds
have also been used on a targeted basis to prevent potentially disorderly failures of
systemically critical financial institutions - failures that would have had highly adverse
consequences for the system as a whole.
These actions, together with similar measures in other countries, have brought greater
stability to our financial system. Moreover, injections of new capital are moderating the
powerful pressures on the financial institutions that received the injections to deleverage by
selling assets and pulling back from new lending. Stabilization and slowing the pace of
deleveraging are critical first steps toward more-normal credit conditions. The federal
banking regulators, pursuant to their joint November 12 statement, are working to help banks
ensure that they are fully meeting the needs of creditworthy borrowers.1 Bank lending to
creditworthy borrowers is good for the economy, but it is also good for the profitability of
banks and supports their safety and soundness. We have strongly encouraged our
examiners to work constructively with banks as they perform the careful analysis needed to
identify sound lending opportunities.
Regarding the future, the remaining TARP funds will play an essential role in further
strengthening the financial system and restoring normal credit flows. An important use of
these funds will be to step up efforts to avoid preventable foreclosures. Preventable
foreclosures harm not only the affected borrowers and their communities but also, through
their effects on the housing market, the broader economy and the financial system as well.
Although a number of efforts are underway to address the problem of preventable
foreclosures, more needs to be done.
Generally speaking, the most attractive approaches to reducing preventable foreclosures fall
into two main categories. The first category features highly streamlined re-underwriting
processes with the goal of modifying large numbers of troubled mortgages quickly. Based
partly on its experience working with troubled borrowers at IndyMac Federal Bank, F.S.B.,
the FDIC has proposed a plan of this type. To encourage an aggressive approach to loan
modification, the FDIC plan would provide partial insurance against the losses stemming
from borrower redefaults on modified loans and would also pay servicers $1,000 for each
loan they modify. An alternative program in this same category would have the government
share the cost when the servicer reduces the borrower's monthly payment.
The second category of foreclosure prevention plans takes a less streamlined but more
deliberate approach, with the goal of increasing the proportion of loan modifications that
borrowers will be able to sustain over the longer term. The tradeoff is that the more
deliberate approach would likely result in relatively fewer mortgages being modified. One
example of a plan that puts greater emphasis on achieving sustainability would have the
Treasury use TARP funds as working capital to buy delinquent mortgages from lenders and
investors at steep discounts to their remaining balances, through negotiations or through
reverse auctions. The acquired mortgages would then be re-underwritten and modified as
appropriate to meet the criteria for refinancing into Hope for Homeowners (H4H) or other
government programs. Especially if the Congress moves forward on a plan of this type, it
should examine the possibility of enhancing the H4H program to make it a more effective
vehicle for this effort.
A second broad use of new TARP funding, besides foreclosure mitigation, would be to
support programs to help restart key credit markets. The Treasury and the Federal Reserve
recently announced such a program, the Term Asset-Backed Securities Loan Facility, which
is designed to stimulate securitization activity in the market for asset-backed securities
collateralized by a range of consumer and small business loans.2 Under this program, which
is expected to begin operation next month, the Federal Reserve will lend for up to three
years on a nonrecourse basis against asset-backed securities. By providing this financing,
the program should increase the availability of credit to households and small businesses.
The Federal Reserve will be protected from credit losses by lending amounts less than the
market value of the financed security - that is, by applying a "haircut" - and by the $20 billion
of capital provided by the TARP. If the program is successful, the program could be
increased in size or expanded in scope to provide financing for additional types of securities,
such as commercial mortgage-backed securities, for which the markets are currently
distressed.
Finally, I would expect the bulk of the remaining TARP funding to be devoted to
strengthening financial institutions, thereby supporting the normalization of credit markets
and the flow of new credit. Some of this support might take the form of additional capital
injections, both to offset additional credit losses and to further expand lending capacity.
Consideration should be given to whether it is feasible for some capital injections to be made
on a matching basis with private capital raises, thereby providing a market test for those
injections. In addition, prudence requires that funds be held in reserve as needed to address
urgent contingencies, such as averting the disorderly failure of a systemically important
financial institution.
A continuing barrier to private investment in financial institutions is the large quantity of
troubled, hard-to-value assets that remain on institutions' balance sheets. The presence of
these assets significantly increases uncertainty about the underlying value of these
institutions and may inhibit private investment and new lending. The Treasury may thus wish
to consider whether to supplement injections of capital with steps to reduce the uncertainty
about the values of assets held by financial institutions. This objective could be accomplished
in several ways, including by directly purchasing troubled assets, by setting up and
capitalizing special banks that would purchase assets from financial institutions in exchange
for cash and shares of capital in the special bank, or by making available to banks insurance
that would pay off under very adverse conditions. Each approach could build on the
infrastructure that the Treasury developed when it was planning to purchase troubled assets
directly. Moreover, as I noted earlier, purchases that include residential mortgages could be
combined with steps to restructure some mortgages as needed to avert preventable
foreclosures.
As you know, the ultimate cost of the TARP program to the taxpayer is likely to be far less
than the total amount allocated, because the funds are not simply spent but are used to
acquire financial assets, such as preferred shares in banks. Even so, the public is
understandably concerned about the cost of this program, particularly as most other
industries experiencing distress are not receiving comparable assistance. History clearly
shows, and recent experience confirms, that - because of the dependence of modern
economies on the flow of credit - serious financial instability imposes disproportionately large
costs on the broader economy. The rationale for public investment in the financial industry is
not, therefore, any special regard for managers, workers, or investors in that industry over
others, but rather the need to prevent a further deterioration in financial conditions that would
destroy jobs and incomes in all industries and regions. That said, the public is entitled to
demand that policymakers take near-term, concrete actions to ensure that we do not face a
similar crisis in the future. An important part of those actions should be to create a stronger
supervisory and regulatory system in which gaps and unnecessary duplication in coverage
are eliminated, lines of supervisory authority and responsibility are clear, and oversight
powers are sufficient to curb excessive leverage and risk-taking, particularly in systemically
critical institutions. The Federal Reserve stands ready to work closely with the Congress to
achieve meaningful and effective regulatory reform.
Thank you. I would be pleased to take your questions.