By William Isaac for Forbes’ Blog

The government and AIG announced an agreement to unwind the government’s ownership of AIG acquired under the Troubled Asset Relief Program (TARP). It’s unclear how long the unwinding process will take or how much taxpayers will ultimately lose.

The AIG announcement spurred a good many comments in the media proclaiming that TARP was a necessary program that will cost far less than anticipated. With a very important election around the corner, it’s important that we assess the TARP program objectively so we can evaluate the politicians who voted for and against it.

The purpose of the TARP, as peddled to Congress by then Treasury Secretary Henry Paulson, was for taxpayers to purchase $700 billion of “toxic assets” from large financial institutions. Paulson theorized this would relieve firms of the burden of carrying the toxic assets and inspire them to lend again. This rationale was having trouble passing the collective smell test, so Paulson added that the program would calm customers of money market funds who were beginning to panic and bank depositors who might also panic.

In truth, customers of money market funds had already been calmed when Treasury issued a 100% guarantee of their money – before TARP was enacted. The FDIC had the authority to reassure depositors under existing law, as was in fact done shortly after the TARP was enacted.

Two weeks after the TARP was enacted, Paulson abandoned the toxic asset plan and announced that the money would instead be used to shore up the capital of banks. I had argued against the TARP in part because I believed capital infusions would support much more new lending than would the purchase of toxic assets. Moreover, I believed capital infusions would be far less costly to taxpayers.

However, the TARP was not needed for capital infusions because the FDIC had existing authority to provide capital to banks. I preferred strongly that the FDIC manage a capital infusion program rather than the highly politicized program Treasury implemented.

Treasury made two egregious mistakes on the capital program and many smaller ones. The first blunder was to order nine large financial institutions – CitiGroup, JPMorgan Chase, Wells Fargo, Goldman Sachs, Bank of America, Bank of New York/Mellon, Merrill Lynch, Morgan Stanley and State Street – to accept $125 billion of taxpayer money that most of them did not need or want.

The second blunder was to announce in February 2009 that 19 large financial institutions would undergo “stress tests” to determine their viability. Just as things were beginning to stabilize for banks, the Treasury destabilized the system with this announcement. Bank regulators were appalled – one large bank executive publicly called the announcement “asinine.”

The Dow Jones Industrial Average stood at 8,200 prior to the stress test announcement and fell to just over 6,500 the following month. The KBW Bank Stock Index dropped nearly 50% during this period.

Forced to do damage control, the government declared that none of the 19 large banks would be allowed to fail no matter what the stress test results. Imagine how that action sits with smaller firms competing with the 19 banks.

The selling of the TARP to a doubting Congress and public was highly destructive to public confidence. Our national political leaders were in the media continuously during the TARP deliberations using highly inflammatory terms like “financial Armageddon” to describe the conditions we were facing. They panicked the public, wallets slammed shut, and the economy still struggles to recover from the damage. Moreover, the TARP created a political firestorm that will have hugely negative consequences for our financial system and economy for years to come.

The FDIC through its special guarantees of bank debt and the Federal Reserve through its creative and ambitious liquidity programs calmed the markets. The TARP was not needed for them to do what they did.

Rubbing salt in the wound, the Treasury decided to loan TARP funds to Chrysler and General Motors and their finance arms. The chances that taxpayers will recover in full the funds invested in AIG and the auto industry are extremely remote.

Proponents of the TARP warned that if Congress rejected the program, the Dow Jones Industrial Average would drop by 1,000 points. Once the bill passed, the markets sobered up to the fact that Congress just authorized $850 billion (counting the pork added to buy votes) the Treasury did not have to pay for a bill that would do no good. The Dow plunged from 10,831 on October 1, 2008 to 8,175 on October 27. It continued its downward spiral to a low of 6,547 on March 9, 2009. It is difficult to imagine how rejection of the bill could have produced worse results.

Objectively, the TARP did nothing to stabilize the financial system that could not have been done without it. The negative aspects of the TARP far outweigh any possible benefit.

William Isaac’s Blog for Forbes is located here.