The Goldman Exit

The Goldman Exit
April 16, 2009

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com. He may be reached at Bob.Eisenbeis@cumber.com.
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Goldman Sachs’ ability to raise capital on Tuesday and its announced desire to pay back the funds obtained from the TARP program is forcing the administration and banking agencies to rethink how they plan to deal with the results of the stress tests they have been conducting. Initially, institutions were instructed not to disclose the results of the tests. The logic was essentially the same as the logic to provide TARP capital support to the major banks and investment banks. That is, if certain firms were singled out to take TARP funds and others declined because they didn’t need them, then the concern was that those firms that got the funds would be stamped as weak or fragile. As a consequence, they would have trouble obtaining or retaining their funds, and customers would be reluctant to do business with them. By forcing all large institutions to accept TARP funds, the belief was that this would blunt or eliminate any stigma that might be associated with the program.

However, it has turned out that TARP funds came with what have proved to be unanticipated and costly strings attached.1 They include not only warrants and the interest costs of the subordinated debt issued to the government, but also restrictions on executive pay, increased pressure to expand lending and to engage in mortgage foreclosure mediation, government involvement in boards of directors meetings, and other micro-management initiatives that seem to be expanding in scope as time goes on.

The original TARP program did not contemplate early repayment of the funds. Recipients would have been required to keep the funds for three years. However, the plan has been modified to permit early repayment, and several smaller banks have redeemed their preferred shares. But the exact conditions for repayment by the nation’s largest banks are still murky. Speculation has it that a successful stress test and the demonstrated ability to generate private-sector capital to replace the government capital are likely to be preconditions. Goldman’s efforts to repay the funds on a timetable shorter than had been anticipated will force the Treasury’s hand. If Goldman gets out from under the TARP program, its exit may signal to the market that it not only has passed the stress test but is deemed to be financially viable. But this could stigmatize those firms that are either unable or unwilling to also exit the program, facing the administration and regulators with a critical dilemma.

Not releasing the stress test results threatens to stigmatize the remaining TARP recipients, particularly if Goldman is allowed to leave the program. Furthermore, other firms not needing the support will have the incentive to rush to execute a Goldman-like exit, leaving only the weak behind. In finance, we would term this a separating equilibrium.

Should the government now releases the stress test results, this would simply serve as another explicit way to separate the weak from the strong. Release of the results might dampen incentives for stronger institutions to rush to leave the program, but the risk that the weaker institutions would be stigmatized could be heightened.

So, what should the administration and agencies do? First, we need to recognize that it was a mistake to have set up the program in such a way that participants were not first required to write off their bad assets before government funds were supplied. Weak institutions can’t be permanently insulated from market discipline by allowing them to hide among a group of healthy institutions. There is simply too much information being required of publicly traded firms for this to be a longer term or viable solution.

Second, as has already been noted, the costs to healthy institutions of participating in the program seem to clearly outweigh the benefits. Third, the solution does not lie in disclosing only aggregate or summary stress test results, because healthy institutions will have strong incentives to make themselves known, either through strategic leaks or through other revealing signals in their financial reports and disclosures.

All of this suggests that the agencies should release not only the results of the tests but how they were structured, implemented, and scored. Doing so would actually constitute a significant and tangible de facto strategy for weaning of our largest financial institutions from government support and be a baby step retreating from both the too-big-to-fail policy and the moral hazard risks that accompany government support.

The public benefit from Goldman’s exit may be that it jump-starts a return to reliance upon market incentives to do what the regulators have been reluctant to do. That is, to confirm what TARP participants’ financial disclosures are already likely to suggest about the relative health of the largest banks. This will be a good result and will hopefully accelerate a healing process that is long overdue.

1These were not anticipated in our previous commentaries on the TARP rescue program.

Bob Eisenbeis, Chief Monetary Economist, email: bob.eisenbeis@cumber.com

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