Monday, December 1, 2008

The different iterations of TARP

Thus far, we have seen three versions of the TARP. Every iteration has been a case by case reaction to the adverse environment of the moment. But since the financial markets continue to be roiled, and we have as yet to see a version that works, let’s review the versions we’ve seen so far.

TARP 1: Purchase bad assets. This was the original plan. The plan calls for the government to set up an entity that will take out the toxic CDOs from the books of the financial institutions, warehouse these securities while the banks re-build their balance sheets and start lending again, and at some point in the future, resell the CDOs to the market. With CDOs no longer in banks’ books, they will no longer have an asset class with a continuously declining value. They can then focus on re-building their asset base, confident of the stability of their remaining assets.

Worst case scenario – Treasury misprices the toxic assets, and overpays for the assets. This would have proven a bad deal for the taxpayers. Or it underpays for the assets, and ends up destroying bank capital.

TARP 2: Re-capitalize the banks. Because an unintended consequence of underpaying for bank assets is that unless the government’s capital injection is sufficient to provide adequate capital cover for the banks, these banks will have to operate either at sub-standard capital ratios, or start providing loans at more prohibitive rates, to earn back their lost capital. The next iteration, therefore, was to purchase bank equity instead of purchasing bad assets. This iteration would have solved the banks’ equity problem.

Worst case scenario – Since the bad assets in this option remain on bank balance sheets, their continual decline results in further deterioration of bank capital, and the government ends up re-capitalizing the banks repeatedly. Government would have ended up taking over the banks.

TARP 3: Guarantee bank debts. This was the Citibank deal. Government does not buy bad assets, nor does it nationalize the bank. But in return for a guarantee amount that would otherwise have necessitated a full takeover, government acts as a backstop to the bank’s liabilities.

Worst case scenario – Since the bad assets remain on bank balance sheets, their continual decline will result in further deterioration of bank capital, with the government ending up paying for the bank’s liabilities. Government would have to put up the funds, either depleting Treasury funds, or printing more money. By printing money, currency loses value, and results in inflation in basic commodities.

What would have been the best option? Given that all options would have had serious consequences, it’s a tricky question to answer. But a hyper-inflation coming right out of a debt deflation environment would have catastrophic results to those worst-hit during the deflation. Option 3 should not be pursued going forward. Option 2, complemented with a little of Options 1 and 3 could be best. It calls for acquiring stakes in the banks, in exchange for taking bad assets out of their books. But it will be for a price that re-capitalizes the banks adequately. If it turns out nationalizing the banks completely, then so be it.

When the crisis has been contained and people are investing again, banks that are able to raise private capital can get out of outright government ownership. Wasn't this the original intent after all?

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