Thursday, February 12, 2009

TARP 3.0 or FSP 1.0!

In its most definitive signal of intent to shore up the frozen financial markets, the Obama administration has announced a sweeping Financial Stability Plan (FSP), which includes changes to the administration of the remaining $350 bn of the Bush admionistration's $700 bn TARP. As Treasury Secretary Tim Geithner said, the new plan is intended to "help restart the flow of credit, clean up and strengthen our banks, and provide critical aid for homeowners and for small businesses" and will contain "new, higher standards for transparency and accountability" and limits of executive compensation. This would be the latest in a series of course corrections, chronicled here and here, that the TARP has undergone, since its launch as a program to buy the distressed assets of financial institutions.

With the "bad bank" idea and nationalization anathema to the policy makers in Obama administration, the Treasury is now hoping that a combination of private investors (private equity, hedge funds, and other assets) and government guarantees will help the government reduce its exposure to losses and avoid the problem of having to place a value on assets that the institutions have been unable to sell. The Obama administration is also pinning its hopes on drawing in "vulture" investors, who specialize in buying up distressed assets in the cheap with the hope of making a killing when the markets bounce back. Under the revised proposal, private investors will be incentivized by government commitment to absorb some of the losses from any assets they purchase, should their values continue to decline. The government would define a floor value for all these assets.

The new plan is similar to the deal in July 2008 when Merrill Lynch sold $31 billion in securities, mainly CDOs, for 22 cents on the dollar to the Lone Star group of private equity funds, by putting down only one-quarter of the purchase price and with the right to walk away, forfeiting only the down payment, if it later turned out the securities were worth even less than it had agreed to pay. The buyer stood to receive the upside profit if the securities prove to be more valuable, but has only a limited downside risk if they do not.

Acknowledging the actions taken so far were "inadequate", "not comprehensive and quick enough", and "policy was always behind the curve, always chasing the escalating crisis", he said that the priority would be to "mobilize and leverage private capital and ... government investment when necessary... (but) to be replaced with private capital as soon as possible". The government has so far, including the FSP, committed $8 trillion in propping up the financial markets, of which it has spent $ 2 trillion. The FSP would have four components

1. Financial Stability Trust.
A comprehensive stress test for major banks so as to have a more objective, consistent, realistic, and forward looking assessment about the risk on balance sheets and greater disclosure standards by the co-ordinated action of all regulators - SEC, Fed, FDIC etc. This test will measure whether they have enough resources to weather a continued economic decline, and then decide the extent and terms of the assistance required. This would be mandatory for all banks with assets above $100 bn. These institutions will be provided "capital buffer" from the TARP account to help absorb losses and serve as a bridge to receiving increased private capital. The capital buffer, in the form of convertible preferred shares that can be converted into common equity if needed to preserve lending in a worse-than-expected economic environment, will act as a form of "contingent equity" to ensure firms their capital strength. The investments by the Treasury in the capital buffer will be made and kept in a Financial Stability Trust. The Plan does not contain any specific limits on the amount committed under this.

2. Public Private Investment Fund (PPIF)
This will provide government capital and government financing to help leverage private capital on a massive scale (of more than $500 bn and even a $1 trillion) to help get private markets working again. This fund, targeted at distresssed assets, will facilitate private capital regenerate the frozen market for the real estate related assets, thereby creating a market-based valuation mechanism for them.

3. Consumer and Business Lending Initiative
This would involve an expansion of the $200 bn credit line under TALF announced in November, by including the markets for small business lending, student loans, consumer and auto finance, and commercial mortgages, besides the residential mortgages. The Treasury proposes to draw funds from TARP and the Fed balance sheet to leverage upto $ 1 trillion, and resort to "quantitative easing" by purchasing securities issued against packages of the aforementioned loans. This is expected to encourage banks to make such loans, because they know they can securitize them. In order to limit tax payer losses, this lending will be limited to only AAA rated loans.  

4. Housing support and foreclosure prevention
In addition to the $600 billion already committed for purchasing of GSE mortgage-acked securities and GSE debt, the new plan commits another $50 bn to prevent avoidable foreclosures of owner-occupied middle class homes by helping to reduce monthly payments. The details to be announced separately later.

The stock markets gave a clear thumbs-down to the FSP, with the DJIA falling 4.6% and S&P 500 fell 4.9%. In the absence of details on the central concern of all bailouts - removal of bad assets while protecting the taxpayer - many of the critical components of the Plan appear a re-hash of the failed Paulson plan. The valuation of distressed assets re-appears in a a new avatar under the FSP - if regulators impose loose standards for the test, banks that might not otherwise survive could receive a lifeline, and if they take a harsher stance, it could lead to another wave of takeovers and failures!

The FSP's objective to encourage private investors to buy up banks’ distressed assets, with the promise of lucrative returns once the economy mends and limited downside risks by way of floor insurance, may remain unfulfilled since it is subject to the same valuation problem - banks may not sell at low rates, investors may not buy at higher prices, and government may end up pledging too much of tax-payers money.

The plan does not make it mandatory for banks to include their off-balance sheet derivative exposures, thereby leaving the process of cleaning up of balance sheets incomplete. Ironically, the stress test coupled with the increased disclosure and reporting requirements, could leave the regional and smaller banks, sitting on a ticking timebomb of commercial real estate loans whose value is eroding rapidly, vulnerable to collapsing.

The FSP leaves open the door for nationalization by enabling the government to convert the warrants for preferred stock it has already received from many institutions into common stock, thereby leaving open the possibility of swapping debt for equity, if the need so arises. This possibility assumes greater significance in view of the fact that many of these institutions will need large capital infusions, leaving open the strong possibility of huge write downs, thereby forcing the execution of warrants and attendant dilution of the existing shareholder equity. Further, those banks failing the stress test (found to have negative net worth), could end up being nationalized.

In fact, the PPIF would be a virtual "bad bank", buying up hard to sell assets by suing TARP money and Fed balance sheet to leverage private investments. In the absence of details, the ability of PPIF to enable price discovery for distressed assets, leave alone mobilize private investments, is suspect. The $50 bn committed to prevent home foreclosures, with details to be specified later, is too meagre to make any dent on the fundamental problem that triggered this crisis. More analysis of the FSP is available here, here and here.

In many ways, Dean Baker sums it up the best, "The basic point here is the banks are insolvent. They’re bankrupt. They’re doing an elaborate charade to avoid coming to grips with that fact. The obvious thing to do would be to take them over like we did with banks in the savings-and-loan crisis, reorganize them, and sell them to the private sector."

And Nassim Taleb writes, "I don’t understand 1) why we need to force people to borrow more when, if anything, we need to de-leverage by turning debt into equity or restructuring existing debt — it is like giving more cocaine to an addict experiencing withdrawal symptoms and calling it a "solution"; 2) it does not do what to me is the essential need of the system: nationalize the banks and snatch control from the bankers because they have vicious incentives to take risks at society’s expense — and proved it with the first plan. In short: it has already failed"

There is already criticism that the Paulson Treasury overpaid for the purchase of distressed assets in the first round, with the Congressional Oversight Panel of TARP reporting that in the 10 largest transactions made with TARP funds, for every $100 spent by Treasury, it received assets worth, on average, only $66, thereby translating into a $78 billion shortfall for the first $254 billion in TARP funds that were spent.

Update 1
Anil Kashyap, Douglas Diamond and Raghuram Rajan analyze the TARP 3.0 here.

Update 2
Details of the stress tests and the opposition to it.

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