U.S. headed for another bubble: TARP watchdog

WASHINGTON -- With the spotlight on U.S. President Barack Obama's proposed bank reforms and record-setting deficits it's easy to forget that tackling the root causes of the financial crisis remains unfinished business.

Mr. Obama has proposed a series of bank reforms aimed at reining in risk, including a tax on big banks, a ban on their proprietary trading, and a limit on their liabilities.

But these measures are overshadowing a key problem, some critics say. The incentives for both banks and homeowners to pile on risk are as strong as ever.

In a sobering 224-page report this week, the federal watchdog responsible for overseeing the $700-billion (U.S.) Troubled Asset Relief Program argued that failed reform could put the United States on course for another bubble - and crash.

"Even if TARP saved our financial system from driving off a cliff in 2008, absent meaningful reform, we are driving on the same winding mountain road, but this time in a faster car," said Neil Barofsky, TARP's special inspector general.

The U.S. Federal Reserve, along with government-backed lenders Fannie Mae and Freddie Mac, continue to prop up the housing market by guaranteeing or insuring virtually all new mortgages and mortgage-backed securities.

Americans also enjoy a tax system that pushes them to max out their credit limit on first and second homes because mortgage interest is fully deductible. Congress recently boosted those generous incentives with an $8,000 credit for first-time home buyers.

And so far, none of the proposed financial reforms addresses the critical problem of banks that are so large they endanger the financial system, according to Mr. Barofsky.

He warned that all the "money, moral hazard ... and government credibility" will be wasted if the U.S. sinks into an even deeper crisis in the next decade. "It is hard to see how any of the fundamental problems in the system have been addressed to date," he wrote bluntly.

And reform won't get any easier from here on in, now that the Democrats have lost their veto-proof 60-40 vote margin in the U.S. Senate.

Even Mr. Obama's call last week for a ban on proprietary trading at the country's big banks is running into stiff resistance in Congress, which must pass legislation to make it happen.

The result, critics said, is likely to be a further watering down of an already ineffectual financial reform package.

"Unfortunately, for whatever reason, the Obama administration remains convinced that merely tweaking our existing regulations is the only responsible way forward," said Simon Johnson, a senior fellow at the Washington-based Peterson Institute for International Economics and a former top economist at the International Monetary Fund.

Mr. Johnson echoed Mr. Barofsky's warning that the United States has not dealt with the problem of banks that are too big to fail.

"We are smack in the middle of a doomsday cycle of repeated boom-bust-bailout," he cautioned. "If anything, as these banks have increased in size, the problem is now worse."

Mr. Barofsky, a lifelong Democrat and former drug fighting prosecutor appointed by former U.S. president George W. Bush, also complained there has been "little fundamental change in the excessive compensation culture on Wall Street."

Perhaps most ominously, Mr. Barofsky warned that the government's multiple efforts to bolster home prices may be reinflating the bubble that caused the crisis.

"Between net mortgage lending and existing mortgage management, the Federal Government now completely dominates the housing mortgage market, with the taxpayer shouldering the risk that had once been borne by the private sector," he pointed out.

Mr. Barofsky has been a thorn in the side of both the Obama administration and Congress for months, pursuing allegations of misuse of TARP funds as well as the events that led to the bailout of failed insurer American International Group.

Mr. Barofsky acknowledged that many of TARP's stated goals have not been met. Bank lending continues to contract and home foreclosures remain at record levels and mortgage modifications haven't worked.

Whatever leverage the government had to push banks to change their ways was lost when most of the large banks repaid their TARP loans, according to Mr. Barofsky.

In a recent New York Times interview, Mr. Barofsky said he was stunned when he arrived in Washington to take up his post to discover billions of government dollars flying out the door, with so few controls.

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KEY DATES IN THE U.S. MORTGAGE INDUSTRY

1989-92: U.S. government steps in during the savings-and-loan crisis, to help make up for the loss of lending capacity in that sector.

1990s: Private lenders account for approximately half of net mortgage borrowings in the U.S.

2003: Government-backed lending begins to drop, reflecting a surge in private mortgage lending, particularly that related to mortgage-backed securities (MBS).

2003-04: Government-backed share of net new mortgages decreases significantly.

2005: MBS activity accounts for majority of new loans.

2008-now: Private sector sheds more than $1.5-trillion (U.S.) of mortgage assets. Government share rises again; it now guarantees or issues almost all net new borrowing for mortgages and mortgage-backed securities.

Source: Office of the Special Inspector General for TARP, January 2010 quarterly report to Congress