“This program is intended to fundamentally and comprehensively address the root cause of our financial system’s stresses by removing distressed assets from the financial system.” Treasury Secretary, Hank Paulson, October 2008.

Until they finally create an entity to bundle toxic and mostly illiquid assets, the credit crisis will continue. Thus far, the Treasury has simply handed out tens of billions of dollars directly to banks whom remain reluctant to lend as the economy heads deeper into the financial abyss.

Back in October 2008 – at the height of the global crash – Treasury boss Hank Paulson provided hope that he would finally tackle the clogged mortgage-backed securities crisis affecting global capital markets. Investors demanded the creation of an entity to place bad assets under one roof. But the Treasury has since made a U-turn, changing its original plans.

Mortgage securitization is largely responsible for this crisis. Since 2001 Wall Street spearheaded a bull market in residential lending through the creation of mortgage-backed securities. Indeed, Wall Street – and not traditional banking – was indirectly responsible for more than 70% of all real estate loan origination.

Under TARP’s (Troubled Asset Relief Program) original mandate, the Treasury would apportion a sizable share of the original $700 billion dollars of tax-payer funds to place busted mortgage-backed assets into a separate entity, similar to the 1989-90 Resolution Trust Corporation (RTC) vehicle created to bundle bad loans. The RTC worked to help banks and Savings & Loans to finally separate bad loans and clear the way for economic recovery following the last real estate bear market.

But since October, Paulson has backtracked. Instead of dealing with the crux of the current credit crisis affecting counter-party trust and bank balance-sheet transparency, or the lack thereof, Paulson decided instead to disperse TARP funds directly to banks. Now most banks that have tapped into TARP won’t lend capital to a credit-starved economy. And in some cases, this has resulted in widespread hoarding whereby financial institutions are using TARP money to boost their balance sheets capital ratios. That’s not what the original plan sought to achieve.

Toxic assets include bonds backed by mortgages, including complex mortgage-backed securities, auction-rate securities backed by student loans and potentially a blizzard of other securities tied to commercial mortgages, credit card loans and auto loans. The size of these bad loans continues to grow, compounded by rising defaults made worse by an economy that is rapidly contracting since September.

Meredith Whitney, who ranks as the most accurate bank analyst predicting this credit-inflicted deluge since 2007, predicts banks will be required to fork over even more capital as loan-losses continue to rise. This will only delay any recovery in battered bank balance sheets since the initial TARP objective has been changed.

To be sure, several segments of credit have markedly improved since late November, including the TED Spread, LIBOR, investment-grade corporate bond spreads and even a series of new corporate investment-grade and junk debt issuance since December. But the bad assets still plaguing the American and European financial systems have not been addressed.

Bad assets must be segregated, identified and isolated from the financial system in order to improve institutional counter-party confidence and transparency. The credit crisis remains alive until this primary objective is tackled, if at all, by the next Treasury Secretary.

Source: TARP’s Original Mandate MUST be Executed