Of Course There's a Profit on the Bank Bailout

This week the bank bailout officially became a profit center for the U.S. government. Troubled Asset Relief Program (TARP) repayments on Wednesday put the government in the black for the first time -- on the bank portion of the bailout. This tally doesn't include American International Group's (AIG) massive bailout, the automaker bailouts, or the mortgage program costs that also received TARP funds. But the bank portion is profitable. The only surprising thing about this news is that anyone finds it surprising.

It Could Only Turn a Profit

To understand how the bank bailout managed to turn a profit, you need only understand its structure. Back in 2008, when the financial crisis was at its climax, the market was very worried, because it thought lots of big banks might fail. But then, the U.S. government stepped in and said that it would not let them fail -- it bailed them out. This cured the panic that had gripped the market.

At the time when the bailout occurred, the government gave banks a deal that they literally couldn't refuse. While some were happy to take bailout funds, the government force-fed money to others. And in return, the government demanded equity at very low prices -- which took all that uncertainty and panic into account.

So the government cured the panic, while simultaneously coercing banks to provide it fire-sale prices on equity. How could the government lose? The only way the banks' stock prices wouldn't have rebounded is if the market had no faith in the U.S. government's ability to stand behind the banks. And if that were the case, then taxpayers would have bigger problems than a bailout liability.

Not as Originally Intended

Some might find the news of a profit surprising if their understanding of the bailout reflects its original purpose. Back when former Treasury Secretary Paulson announced the initial plan, the government hoped to purchase toxic assets from the banks. Those assets may have very well been undervalued due to panic and uncertainty -- just like the bank's stock. But the government presumably would have paid a premium over the market prices at that time. Otherwise, the banks would have had to realize huge losses, which would have hurt their stability.

If this plan had been adopted, the government would have been stuck with a reeking pile of trash securities for which it had overpaid. Then, it would have been far less likely that taxpayers would have made a profit on the bailout. In fact, there probably would have been a significant loss. This is similar to what happened with Fannie Mae and Freddie Mac -- and helps to explain why taxpayers will lose more than $150 billion on their bailout. Instead, the government just gave banks cash in exchange for debt and cheaply-priced equity.

Treasury Isn't Winning Yet

It's important to keep in mind that this profit is only on the bank bailout portion. The U.S. may still lose money on the entirety of TARP, if you include AIG, the auto company bailout, and the foreclosure prevention provisions. Though, in its press release the Treasury says that even if you include these additional pieces of the puzzle, TARP will result in "little or no cost to taxpayers."

Of course, TARP was never designed to provide a lifeline to the auto industry or struggling homeowners. Instead, it was meant to stabilize the financial sector. So in regard to the goal it was created to achieve, the program will likely provide taxpayers with a windfall. Unfortunately, some or all of those profits will be eaten away by those other bailouts, which were added in for political reasons.

Finally, we need to be careful about equating a profit on TARP with success. Now that the government has stepped in to rescue the financial system, a great deal of additional moral hazard has entered the U.S. economy. If banks and investors believe that the government would behave the same way in the future, then future financial crisis and additional bailouts will follow in coming years. But if they believe that some aspects of recent financial regulation -- like the new resolution authority -- will succeed in ensuring that no bailouts will occur again, then this moral hazard may be avoided.