How TARP Paybacks Expose the Weakest Banks

The government has finally acknowledged something it wanted to keep secret six months ago: Which banks are in the worst financial health.

It’s now obvious that Citigroup, GMAC, Bank of America and perhaps a dozen other large banks are in rough shape, but when the Troubled Assets Relief Program went into effect last October, the idea was to mask problems at sick banks by flooding the whole financial system with liquidity. President Bush’s Treasury Secretary, Henry Paulson, famously imposed TARP bailout funds on big banks like Goldman Sachs and JPMorgan Chase, which took the money even though they said they didn’t need it.

Paulson was trying to prevent a repeat of the runs on Bear Stearns and Lehman Brothers that occurred when big, institutional clients, worried that those banks could fail, decided to pull their money out. All at once. Pumping some healthy banks with money, Paulson reasoned, would distract attention from the sickest banks, and buy time until the risk of panic receded.

[See why the banks still aren’t fixed.]

Without a doubt, the healthy banks enjoyed the government loans, which came at a lower rate than they'd have to pay in the capital markets. But the conditions—such as limits on executive pay and Congressional mob rule over certain business practices—have turned out to be too onerous.

So the banks that can pay back their TARP funds are doing so. The Treasury will recoup about $68 billion. Capitalism lives. Commence celebration.

The first set of big bailout repayers includes Goldman, JPMorgan, American Express and seven others. Two dozen or so smaller banks will also pay back their TARP handouts. It’s obviously good news that these banks can stand on their own, the feds will get out of their business and taxpayers will get some of their money back.

But the TARP paybacks by the healthy banks are also a sign of confidence in the support structure for the sick banks. Last fall, with panic intensifying, it might have spelled the Lehmanization of Citigroup et. al. if the government had singled them out as unable to survive without government aid. Yet that’s what the government has now done. Letting the healthy banks pay back their loans makes it clear who the real Bailout Babies are: At least 10 large banks, and a couple hundred smaller ones, that aren’t yet planning to reimburse the taxpayers.

[See the banks least likely to pay back their TARP loans.]

It’s notable that this is happening without any bank runs or other signs of distress. That’s partly because investors and institutional bank customers have had months to absorb bad news about big bailout recipients like Citi and BofA, and adjust. The government, for better or worse, has clearly signaled that it won’t let those banks fail.

The “stress tests” conducted by the Federal Reserve earlier this year provided greater clarity on the 19 biggest banks, which itself was reassuring, even if part of the data-dump was a signal of more trouble ahead. The markets prefer predictable bad news over uncertainty just about any day. So the de facto nationalization of Citigroup is a ho-hum event, now that we know it doesn’t signal a contagion that will spread like swine flu through the whole sector.

[Read an insiders’ take on how the federal bailouts began.]

The optimal situation, of course, is for the government to completely get out of the business of funding banks. But it’s likely to be years before the most-troubled banks work through all their money-losing loans, declare their writeoffs and get off the government dole. Some won’t survive and will be sold or liquidated by the FDIC. But the first major TARP repayments are an important pivot point on the way back to a healthy financial sector. Now we can focus on the sick banks and let the rest solve their own problems.