The 111th Congress convenes tomorrow and repairing the damage left by the financial crisis of 2008 will be at the top of the agenda. The early talk and action will center on what President-elect Obama has dubbed the "American Recovery and Reinvestment Plan (ARRP). Even the pronounciation of the acronym tends to draw a connection to "TARP"—the $700 billion package Congress passed and the Treasury reinvented in the fall and early winter of 2008.

The two packages are tied beyond just their rhyming acronyms. Discussions within the Obama transition team—and between the team and Congressional leaders—over the size of the recovery package are pivoting on the question: "Can the recovery plan for Main Street be smaller than the bailout plan for Wall Street?" House Speaker Nancy Pelosi (D-CA) has indicated she is pointed at a $600 billion program, smaller than the TARP. However, the Obama transition team appears to be aiming at a target of $775 billion and the nation's Governors have been pushing for a number above the TARP number. Our sense is the ultimate proposal from the Obama team and Democratic Congressional leaders will be closer to the $775 billion number, so more for Main Street than for Wall least for now.

The TARP may also affect the timing of the economic recovery plan. Before the holidays, Congressional leaders pledged to have a stimulus bill ready for the president immediately after he took the oath of office on January 20; however, President-elect Obama has indicated that he wants strong bipartisan support for his economic package. This was evidenced over the weekend as he released the first details of his plan which included $300 billion worth of tax cuts likely aimed at attracting Republicans and moderate Democrats. Obama also wants to head out across the nation to sell his recovery plan directly to the American people which signals that the timing of the economic recovery bill is now more likely to be mid-February. One variable that may force a change in the schedule is the release of the remaining $350 billion in the TARP. Treasury Secretary Hank Paulson has said he plans to leave the remainder of the TARP funds for the new administration.

So all of this leaves us with a few questions. Will the Obama Administration and Congress be willing to release the remaining TARP money prior to passing an economic recovery package? How would doing so impact their ability to gain bipartisan support for the recovery program? Will the commitments made by the Bush Administration force the release of TARP funds prior to the mid-February timeframe? As our readers can see, while the TARP may not be at the forefront of the debate on economic recovery , it continues to play a major role behind the scenes.


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Will Smith - April 16, 2009 5:06 PM

The TARP Program was originally passed with the intention of fixing the problems with banks, namely the "toxic assets/legacy assets" or debt securities that many of these banks are stuffed to the gills with. Because of the way many of those assets were packaged, it is nearly impossible to determine what went into making them and so it is likewise almost impossible to determine the riskiness of assets since you don't know the riskiness of those fundamental components. As such, you can't determine the potential losses you might suffer if individuals or businesses started defaulting on their debts, the debts that provides the cash streams which supports most of those toxic assets. So, until people stop defaulting on their mortgages and stop not paying their bills, or at least until the number of people doing so starts to decrease the fundamental values of most of those "toxic assets" will remain indetermenant. Given that, as the market has witnessed increasing levels of foreclosures and the worsening economic conditions have made it more likely that people will default on debt, the insecurity associated with those "toxic assets" has also increased, forcing the market to push down the expected values of most of those assets. Because these "toxic assets" make up a significant portion of the portfolios of many banks, as the market values of those assets drop, the equity value of the banks also gets dragged down. However, since it's incredibly difficult to get some idea of the true value of these assets and the market expects their book values to continue to drop, the banks which own the "toxic assets" are unable to sell them to anyone else.

This was where the TARP was supposed to come in. Secretary Paulson was going to use the $700 billion to buy up "toxic assets" for something like 20cents on the dollar and then keep them in some entity for a few years to let the market calm down. This would also have given us time to determine something of the true value of most of those assets. The treasury, though, didn't want to pay more than just a few cents on the dollar because there is the possibility that many of these assets are worth less than what the banks say they are. So paying the bank's asking prices significantly increases the chances that the Government would get seriously burned, while paying only 20cents or so would go a long way toward limiting its exposure to risk. Banks, however, couldn't be expected to sell those assets at such low levels, even if these prices might be above what some of the assets are worth. With the current situation, banks are continuously cutting the book values of these assets, pulling down the value of the corporation as a whole, but the banks are doing so in steps. True, they may eventually cut them all down to 20cents on the dollar, but something might happen before that which would make it unnecessary for them to cut values to those levels. On the other hand, if banks were forced to knock the values of these assets down to 20cents on the dollar all at once, they would see an instantaneous evaporation of all the equity they were trying to save, and many of those banks would subsequently go bankrupt. Also, until the banks sell those assets, their losses are essentially only book losses, but when they do sell them, the banks will realize in real terms the true financial pain. So the Treasury didn't want to buy the stuff for more than a few cents on the dollar but banks didn't want to sell it for much less than book value. Doing either of those things would result in one of the parties getting burned, badly.

So Henry Paulson abandoned the asset purchase program and instead began injecting capital directly into the banks, taking equity stakes in all the big banks. This was to give the banks the money they said they needed to start lending to each other, but it's not how they spent it. Most of these banks non-government equity was still tied up in those "toxic assets", something which was still continuing to shrink. So, what would incentivize you to lend money when the money you're lending is the only cash you have that's not evaporating at an accelerating rate. You wouldn't lend it, you'd keep it and cover your butt. Also, why would you lend it to the guy next door when you know the ground under him is crumbling away at least as fast as the ground under your own feet. How is he going to pay you back when the "toxic assets" on his books give way and he falls into the upper reaches of Hell? He's not, and if you had lent to him, you would also have soon found yourself down there with him, tied to a spit being slowly turned over some brimstone coals. The underlying lesson is that unless you can get those "toxic assets" off the bank's books, banks won't lend to each other and that makes it very unlikely that they will start lending to us anytime soon either.

So how do you get the "toxic assets" off of the bank's books? You do almost exactly what Henry Paulson was going to do, offer banks 20cents on the dollar or something of that sort for each of those "toxic assets", but you then make one little change. In addition to giving those banks 20% of the original value of the security, you also give them a free option or warrant that allows them to repurchase that security 3-5 years down the road at either 40-60% of the then market value or at the government's purchasing price compounded forward at the average rate of inflation over that period. Whichever is higher. This way, the government can limit its exposure to risk by limiting its purchase price, and banks won't walk away from the deal facing prospects of bankruptcy because they'll be leaving with more than just 20cents on the dollar. They'll also have the value of those options to hopefully fill up at least some of their balance sheets. And if those toxic assets are worth anything, then 3-5 years down the road, when the value of those securities can be determined, the banks can recapture a significant portion of it. On the other hand, if the assets weren't worth above 20cents on the dollar, the government's investment and losses will have been limited and the banks will have avoided a total loss on the instrument. This is unlikely to be a common occurrence though because most of these assets are probably worth a measurable degree above 20% their original value. In fact, depending on what interest rates are when the options mature in 3-5 years, some of these securities could be worth more than their original book value. The majority however will probably worth somewhere between 30-70% of original book value. By going this route the banks will probably suffer some losses, but it'll be better than the 80% loss associated with Henry Paulson's original plan and it'll be better than the 100% loss they can expect if the market were allowed to continue devaluing those assets to nothing. Also, the government WILL make money from this.

So as to avoid having to go to congress to ask for the money needed to put down 20% for each security, since we've already spent what they've given us so far, the treasury could compel banks that have taken bail out funds to surrender these securities, valued at 20% of original value, and the total discounted value of the aggregated securities could be subtracted from the governments prior investments in the company. The government gets these assets at no additional cost, and the banks will have a net gain to book value because while they loose equity when they surrender the "toxic assets", this is completely offset by the canceling of part of their obligations to the government. The banks get the positive gain when you add to this transaction the options to repurchase that banks receive. Those derivatives are likely to have significant value in their own right given how their price is determined. They cover an extremely volatile instrument (+value), they have a very long period (+value), and if the instruments value is anywhere above 20% of the original face value, a likely outcome, they will generate value (+value).

If fact, if the government wanted to expand this program to an international scale, maybe offering less favorable terms yet still quite acceptable, to foreign businesses and governments that have heavily invested in these instruments, the US government could potentially recapture a great deal of value from the rest of the world. Just a thought though, have to get back some of the dollars we've sent to China and the Middle East somehow.

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