Today, the Congressional Oversight Panel, established by Section 125 of the Emergency Economic Stabilization Act of 2008, released its April Oversight Report entitled “Assessing Treasury’s Strategy: Six Months of TARP.” The report was adopted by the panel by a 3-to-2 vote, with panelists disagreeing about whether it was appropriate for the panel “to present alternatives to Treasury’s strategy.”

The report identifies “three fundamentally different policy alternatives” for dealing with a troubled financial system: (i) liquidation; (ii) reorganization through receivership or conservatorship; and (iii) direct or indirect subsidization. Looking to historical examples, both domestically and internationally, for comparative purposes, the report discusses the advantages and disadvantages of each policy.

  • Liquidation. Drawing on examples from the 1980s savings and loan crisis and the creation of the Resolution Trust Corporation, the report details the process by which the U.S. government liquidated troubled financial institutions. The report states that this process can involve “considerable political barriers” and that “a surprise or poorly-explained liquidation” reduces market confidence and creates high levels of uncertainty regarding future government intervention in the financial markets. One advantage, however, is that liquidation does not pose the same risk of creating open-ended commitments presented by a subsidization strategy and may restore market confidence in surviving financial institutions. The report notes that the liquidation process “can potentially accelerate recovery by offering decisive and clear statements about the government’s evaluation of financial conditions and institutions.”
  • Reorganization through Receivership or Conservatorship. Using historical examples provided by the government’s rescue of Continental Illinois in 1984 and the financial crisis in Sweden in the 1990s, the report notes that reorganization protects depositors and some bondholders and permits an institution to emerge from the process with a healthier balance sheet. According to the report, reorganization “also offers clarity to markets about the balance sheets of the reorganized financial institutions and encourages capital investment” in the reorganized entity. The primary disadvantage to this process is the drain on government capacity and resources.
  • Direct or Indirect Subsidization. The report uses the Japanese government’s use of direct and indirect subsidization of financial institutions during the 1990s as a guide in discussing the pros and cons of subsidization. Although cash assistance can serve as bridge capital necessary for financial institutions to survive economic downturns, the report states that subsidizations could serve to obscure the true value of recipients to the market. As noted above, subsidization of financial institutions “also carries a risk that it will be open-ended, propping up insolvent banks for an extend period and delaying economic recovery.”

The report suggests that a successful resolution of the financial crisis will involve four elements. First, the resolution process must ensure the integrity of financial institution accounting to enable regulators and investors to accurately value the institution’s assets and properly assess bank solvency. Second, early aggressive actions must be taken to either allow irreparably insolvent financial institutions to fail or to improve capital ratios of financial institutions that can be rescued. Third, management of troubled financial must be removed or otherwise held accountable for the decisions that led to the failure. Finally, there must be “[t]ransparency in the government response with forthright measurement and reporting of all forms of assistance being provided and clearly explained criteria for the use of public sector funds.”

In addressing each of these issues, the report notes that a key assumption underlying Treasury’s current approach is that “the system-wide deleveraging resulting from the decline in asset values … is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets.” Couched in these terms, the debate then turns on whether prices are based on fundamental values or “are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.” If Treasury’s assumptions are correct, its current approach may be reasonable. If not, and “the economic crisis is deeper than anticipated,” the report concludes that Treasury will need to take different action to achieve financial stability.