Healthy banks may be allowed to pay back TARP - but at what cost?

Treasury Secretary Tim Geithner signaled this morning in a New York Times op-ed that he will allow banks that pass the stress tests to pay back the Troubled Assets Relief Program (TARP) money that Hank Paulson forced on them.

There's just one more test they'll need to pass -- a debt stress test, about which I posted yesterday. This means that Goldman Sachs Group (GS) and JPMorgan Chase (JPM) may soon pull way ahead of their peers, and that could help accelerate the demise of those laggards.

Since last fall, the Treasury, through TARP, has bought about $640 billion of preferred stock in U.S. banks, boosting the equity side of their balance sheets. But it has done far more for the debt side -- as I posted, the banks that are getting $200 billion in TARP money from the Treasury are also getting $336 billion in cheap loans from the FDIC and another $1 trillion in emergency loans from the Fed. Goldman got $10 billion from TARP and $22 billion in debt with help from the FDIC guarantees. Now all Goldman needs to do to get out from under the government's control is to prove it doesn't need that FDIC money anymore -- but it's unclear how it would do that.

Geithner expects more than $25 billion of TARP money to be repaid. Why is the U.S. doing this? The politics look favorable because there is no public appetite for another $750 billion in TARP money. The U.S. considers the political risk of a systemic collapse as a result of the failure of the banks that can't repay the TARP money to be less than that of failing to convince Congress to provide more bailout money for them. So how big is the risk that stress test flunkers Bank of America (BAC) -- which needs $34 billion more capital -- and Citigroup (C) -- which may need $10 billion more -- will fail?

In the short run, the risk does not appear to be that great. That's because a little accounting trick -- of converting the government's preferred shares into common ones -- will give those banks most of the additional capital they need. And the remaining TARP money can fill in the gaps. But Treasury will force them to sweat before they get the money, giving them a month to assemble a capital raising plan and to defend their management teams.

Over the longer term, however, the banks that are still under government control will lose their talent to banks that throw off the TARP yoke. That's because the winners -- Goldman and JPMorgan -- will be free to pay as much as they need to siphon the talent from those banks that can't pay limit up. This reshuffling of the talent deck will gradually weaken the stress test losers whose revenue will slump -- eventually encouraging more and more clients to take their business to the healthier banks.

This probably means that the U.S. can forget about getting back its money from those banks now deemed too big to fail. The question is not whether those banks will fail, but when and at what cost to the taxpayers who did nothing to cause the failure and everything to pay for it.

Peter Cohan is president of Peter S. Cohan & Associates. He also and is the author of You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He owns Citi shares and has no financial interest in the other securities mentioned.

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