Newsmaker interview: Bailout watchdog warns of "doomsday cycle"

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The government watchdog who oversees the $700 billion Troubled Asset Relief Program (TARP) said on Tuesday that the massive bailout fund had likely prevented a larger financial crisis, but that in doing so, had sown the seeds for a future crisis and potential “doomsday cycle of boom, bust, and bailout.”

In an hour-long interview with journalists at the Center for Public Integrity, Neil Barofsky, the inspector general of the controversial TARP program, said that the financial market believes some U.S. banks remain too big to fail despite the Dodd-Frank financial reform law.

“The market does not believe the government when it says it will not bail out banks,” he said. “It’s the same toxic cocktail that was mixed of implicit guarantees and the distorted market that gives the [big] banks such an advantage over their smaller counterparts.”

Barofsky added: “In a way, what we’ve done is we’ve created this doomsday cycle of boom, bust, and bailout.”

The government rescue program launched in late 2008 helped Wall Street, but failed to assist many homeowners facing foreclosure, Barofsky said. The Treasury Department, which administers TARP, has failed to do anything more than merely encourage loan servicers to modify the loans of homeowners in trouble.

Barofsky, who has been a persistent critic of how the Treasury has handled TARP, is due to testify Wednesday morning before the House Oversight and Government Reform Committee.

The hearing comes on the same day he delivers his quarterly report to Congress. It is the first hearing called by the panel’s new Republican chairman, Darrell Issa of California, who has promised to be a tough critic of Obama administration policies. The TARP program was created during the final months of President George W. Bush’s administration and largely carried out by Obama’s appointee, Treasury Secretary Tim Geithner.

In some respects, Barofsky acknowledged that the TARP program has been a success. The financial sector didn’t collapse, and it appears that taxpayers will recover most, if not all, of the $700 billion allocated for the program. The Congressional Budget Office estimated in November that TARP would end up costing taxpayers about $25 billion.

But the program has failed to meet its goals in fundamental ways, he said.

Under Dodd-Frank, the Federal Deposit Insurance Corp. has new authority to break up mega-banks if so ordered by a new oversight council made up of the heads of Washington’s largest regulatory agencies. Barofsky said if the law is used to simplify and shrink big banks as necessary, and regulators exercise their new authority, future financial crises could be mitigated.

“They have to use the regulatory authority that they are given. And there’s a question of whether there will be the political will as well as the regulatory will to do that,” he said.

Noting that the major financial institutions are 20 percent larger than they were before the financial crisis, Barofsky said that the financial markets simply don’t believe that the government will allow one of these biggest banks to collapse, regardless of what they say will happen. Those big banks enjoy access to cheaper credit than smaller institutions, based on that implicit government guarantee, he said.

As evidence, he cited the ratings agency Standard & Poor’s, which recently announced its intention to add the prospect of government support into its calculation when determining a bank’s credit rating.

TARP has also failed to keep Americans in their homes, Barofsky said.

The Treasury Department’s initial prediction was that its Home Affordable Modification Program, or HAMP, would allow three to four million Americans avoid foreclosure by reducing their monthly payments.

But with as many three million foreclosures expected in just 2011, the number of permanent modifications under HAMP remains “anemic,” he said. There were just under 522,000 ongoing permanent modifications as of Dec. 31, 2010, with approximately 238,000 of those funded by and attributable to TARP.

If current trends hold, HAMP will result in 700,000 to 800,000 permanent modifications.

“Treasury refuses to acknowledge that the program is not working,” Barofsky said in the interview.

One of the problems he cited was the lack of cooperation by loan servicers. Treasury officials “have no stick,” he said, and are unable to force the loan servicers to make the loan modifications permanent or to crack down on abusive practices. Treasury has also refused to adopt meaningful goals and benchmarks for HAMP despite “consistent and repeated recommendation,” he said.

Asked why he hasn’t taken his concerns directly to Geithner, Barofsky said that he hadn’t spoken to the Treasury chief since November 2009.

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