Saturday, January 17, 2009

More course correction - where is TARP headed?

What will be the final form of the Troubled Asset Relief Program (TARP) (is it still called by this name?), the $700 bn financial markets bailout plan initiated by US Treasury Secretary Henry Paulson in October 2008? This assumes significance in view of the repeated course changes that TARP has undergone since inception. The course changes are chronicled here. The original proposal of purchasing troubled assets was soon abandoned for bank capitalization in different variations, and it appears we are back to a mixture of both, with their worst elements.

The original Paulson Plan had also sought to confine government interventions to healthy banks, where the cash injections would be in exchange for preferred shares, which would pay a regular dividend and come with warrants that would allow the government to profit from increases in company stock prices. It was thought that this arrangement, instead of direct equity stakes, would enable the government to keep an arms-length distance from day-to-day management of the company. But all these now appear to be becoming difficult to hold on to, and the amounts required seem to be growing by the day, to well beyond $1 trillion.

First came the Citigroup bailout in November, which covered $300 billion in assets. Citigroup agreed to absorb the first $29 billion in losses. The Treasury agreed to take a second round of losses up to $5 billion, and the Federal Deposit Insurance Corporation agreed to take a third round of losses of up to $10 billion. The Federal Reserve then agreed to lend Citigroup money at low interest rates for the value of the remaining assets.

The latest course change concerns Bank of America (BoA), whose dramatic and rapid-fire takeover of Merrill Lynch was then seen as a testament of BoA's (and its empire-building CEO Kenneth Lewis) strength, despite the huge controversy generated by the deal. It was clearly seen as an example of one deal gone too far, and a representative of the greed and irresponsible business pratices of the era that led to the sub-prime crisis. However, it has now emerged that Merrill's balance sheet had much more losses than was originally thought, forcing BoA to plead the Treasury for a lifeline. Even though this round of assistance for BoA is being shown as an effort to help absorb losses incurred by Merrill Lynch since the acquisition was negotiated in September, it is clearly an effort to shore up BoA’s increasingly shaky balance sheet.

Accordingly, to bail out the "too big to fail" BoA, the US Government decided to supply BoA with a fresh $20 billion capital injection and absorb as much as $98.2 billion in losses on toxic assets. Under the plan, a reward for corporate greed and irresponsibility (of BoA), similar to the $306 bn bailout of Citigroup, "BoA will be responsible for the first $10 billion in losses on a pool of $118 billion in illiquid assets, including residential and commercial real estate and corporate loans, and that will remain on its balance sheet. The Treasury Department and the Federal Deposit Insurance Corporation will take on the next $10 billion in losses. The Fed will absorb 90% of any additional losses, with BoA responsible for the rest. In exchange for the new support, BoA will give the government an additional $4 billion stake in preferred stock, cut its quarterly dividend to a penny, from 32 cents, accept a loan-modification program and put more stringent restrictions on executive pay."

The second tranche of bailout assistance for Citigroup and BoA, has to be seen in the back-drop of Ben Bernanke's recent speech, where he claimed that there was a need to pour billions more in cash infusions, over and above the $700 bn already committed in bailing out the financial markets, "to stabilize the financial system and restore normal flows of credit", assumes significance. Unlike the original Paulson Plan, which sought to infuse capital only into healthy banks in return for equity stakes, Bernanke spoke of expanding the scope of bailouts by providing blanket guarantees for banks assets (as was done in case of both Citi and BoA) and by ring-fencing off the illiquid and almost worthless troubled assets (from non-performing loans to mortgage-backed securities), from the healthy ones and thereby effectively forming a Chinese Wall between a government backed "bad bank" and a "good bank"! Both these arrangements would have the effect of protecting common stockholders of the bank from being wiped out by the Government preferred shares, and thereby leaving the bank with the option, sometime in future, of going out and raising common shares from the market.

Through both these bailouts, which involve taking of preference shares, instead of voting common stock, the US Treasury wants to continue to give the impression of capital infusions without appearing to take equity positions. But that tenuous balancing act now appears to be on its final legs, as the Government now has majority stake in both the banks, thereby threatening to squeeze out the common stock holders (as "any losses would have to first wipe out common stockholders before the bank could stop paying dividends on preferred shares"). This would amount to an effective nationalization of the two largest financial supermarkets in Wall Street. But it is now being argued that this may have been a better original option, instead of the back-door capital injections, with limited control, that has been done till now and is being done now too.

The major criticism against the bailouts of BoA now and Citigroup earlier, is that instead of injecting capital and taking stakes (atleast through preferred shares), the bailout assistance also commits to absorb losses on distressed and illiquid assets by effectively underwriting them, thereby liberating the two banks from some of their most threatening assets. This amounts to a virtual blanket takeover of all the troubled assets of these two banks, effectively as an "insurance program for big bundles of the banks’ most toxic assets", with no clear idea about their risks or prices, all at the tax payers cost. As Edmund Andrews writes in NYT, "If the government-guaranteed securities turn out to be worthless, the cost of the insurance would be much higher than if the Treasury Department had simply bailed out the banks with cash in the first place."

This new bailout assistance will take the government’s total stake in BoA to $45 billion (initial $25 bn as part of the first round of bailouts), making it the bank’s largest shareholder at 6%. The similar government bailout of Citigroup had already made the Government the largest shareholder in the bank. In many respects, all this amounts to a virtual nationalization of the American banking system. And it also means that any fresh disclosures of worthless assets, a most likely possiblility, will leave the government with a fait accompli to pump more bailout cash.

The troubles facing the big financial supermarkets like BoA and Citigroup, with its attendant "too big to fail" moral hazard risks, calls to question whether such behemoths ought to be broken up or atleast tightly regulated. However, such break-up of behemoths need to go much beyond the proposed spin-off of Citigroup into two entities.

James Kwak makes excellent points all round on many of the issues mentioned above. Mostly Economics too has similarly indignant analysis of both the Citigroup and BoA bailouts, besides an excellent comparison of the two bailouts. Joe Nocera has another excellent commentary on the meandering bailout programs, and feels that the bailout money is being poured into a big pothole that keeps getting bigger and bigger and there is an urgent need for more systemic responses. As Kwak points out, the TARP is increasingly looking like a series of ad-hoc and lobbying driven pork-barrel to bailout greedy and irresponsible bankers hiding under the "too big to fail" curtain.

Update 1
Mostly Economics has this excellent post on the British version of TARP here.

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