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Robb: Democrats poised to make financial mess worse

The Bush administration clearly botched the effort to shore up the country’s financial institutions.

Unfortunately, the Obama administration and the Democratic Congress have not learned the mistakes that were made and are poised to make the situation worse, not better.

The problem the Bush administration purported to be addressing was the uncertain value of certain assets held by financial institutions, mostly mortgage-backed securities, due to the burst of the housing bubble. As a result, the capital against which they lent declined and became shaky.

To address that problem, the Bush administration asked Congress for up to $700 billion to buy those assets and take them off the books of the financial institutions. Congress agreed, set up the Troubled Asset Relief Program, and released the first $350 billion.

But instead of using the money to buy up the distressed securities, the Bush administration decided to inject public capital into the banks.

In fairness to the Bush administration, the consensus among economic experts at the time was that injecting public capital was preferable to buying distressed securities. But it turned out to be a colossal mistake.

The TARP investments increased the capital of the financial institutions, but made it no more certain. Moreover, it put the federal government into the banking business, and that scared off private capital.

Ideally, the existing capital for financial institutions would become more certain and they would be recapitalized with private investment. But no sensible private investor wants Uncle Sam as a senior partner.

When injecting public capital, the federal government gave itself a preferred position, with a 5 percent to 9 percent return off the top. It also assumed the right to tell the financial institutions how to run their business, how much they could pay their executives and what they could distribute to other investors in dividends.

Uncle Sam is, of course, ultimately a political beast, with an army of regulators and bureaucrats and 535 would-be CEOs in Congress. Reports are beginning to trickle out about members of Congress trying to influence the allocation of TARP monies and the decisions of the financial institutions that received them.

Moreover, Uncle Sam has treated shareholders roughly in previous bailouts, requiring that shareholder equity be severely diminished or extinguished in the forced sale of Bear Stearns and the takeovers of Fannie Mae, Freddie Mac and AIG.

Now the market fear is of a more formal nationalization of the banks. Given the situation and the track record, private capital is going to stay on the sidelines so long as Uncle Sam haunts the boardroom.

The Obama administration and the Democratic Congress want to make the situation worse. Members of Congress are clamoring for more lending at the same time as the regulators are urging greater cushions due to the continuing uncertainty about capital.

The Obama administration says any additional TARP investments will come with more strings. The House passed a bill that contained several, including diversity monitoring in management, employment and business activities.

A sensible approach would be designed to increase the likelihood of new private capital flowing into the country’s financial institutions.

This would require, first of all, a firm commitment to unwind the federal government’s current position in these institutions, including selling its preferred stock at a loss if necessary.

While being unwound, the stock should be turned over to a trustee with instructions not to interfere with the management decisions of the institutions in the interim.

Second, the federal government should guarantee, for a premium, the value of mortgaged-backed securities held by financial institutions.

About 90 percent of all mortgages remain current. Even two-thirds of subprime mortgages are still current. A guarantee of somewhere between 65 percent and 75 percent of face value should provide a floor on the value of these securities without taxpayers running great risks.

I am loathe to suggest special tax breaks. But in this circumstance, freeing new investments in financial institutions from capital gains taxation for a period of time would be less offensive and far more effective than what the federal government is doing and contemplating.

This is a way out, if anyone in Washington is truly interested in one.

Robert Robb, an Arizona Republic columnist, writes about public policy and politics in Arizona. E-mail: robert.robb@arizonarepublic.com

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