Intro to TARP — TARP I: Buying bad assets

Yesterday we created a simple example of Large Bank, which made some bad loans and now has two problems:

  1. It doesn’t have enough capital.
  2. It has downside risk on its balance sheet due to the uncertain value of these bad loans. That downside risk makes the firm’s value uncertain and scares away investors.

Today we examine “TARP I,” the first plan for how to address these problems.

(One commenter pointed out some oversimplifications in my example. I will continue to oversimplify. These are imperfect teaching tools designed to illustrate the conceptual differences among TARP I, II, and III.)

I am again indebted to Donald Marron for his examples and help.

As a reminder, here is the balance sheet for Large Bank:

Assets Liabilities and Equity
Good loans 800 Deposits 600
Bad loans 120 Debt 300
Equity 20
Preferred 0
Total 920 . . . . . . . Total 920
  • Total capital: 20
  • Leverage: 46:1

Congress has now passed and the President has signed the TARP law. The Treasury Secretary (and, practically speaking, Federal Reserve Chairman, and FRBNY President) have a big pot of money to help Large Bank and others.

Suppose the government bought those bad loans from Large Bank for the same value that Large Bank was carrying for them:120. The balance sheet of Large Bank would now look like this:

Assets Liabilities and Equity
Good loans 800 Deposits 600
Bad loans 0 Debt 300
Cash 120 Equity 20
Preferred 0
Total 920 . . . . . . . Total 920
  • Total capital: 20
  • Capital added by this transaction: 0
  • Leverage: 46:1 (Caveat: This depends on whether “cash” is actually cash or something safe like Treasuries. In practice, real leverage ratios are risk-weighted. Even if we only count the loans it is 40:1, which is still very high.)
  • Risk of bad loans: cleared from Large Bank
  • Taxpayer outlay from TARP: 120
  • Cost to taxpayer: Whatever the losses are on the bad loans.

This is just a swap on the asset side of the balance sheet. Large Bank traded 120 of bad loans for 120 of cash from Treasury.The results are:

  1. Large Bank’s capital problem is unaffected. It still has only 20 of capital, and still has a very high leverage ratio.
  2. The downside risk associated with the bad loans has been eliminated from Large Bank’s balance sheet. This should presumably make it easier for Large Bank to attract private capital.
  3. The government has spent 120 of the TARP pool.
  4. The taxpayer now bears the downside risk associated with bad loans for which it paid 120. The expected cost to the taxpayer is less than 120. This is an investment, and we are buying something of (uncertain) value.

Now let’s look at an important variant of this plan. Suppose we do the same thing, but the government pays 150 for the bad loans which the bank had been valuing at 120. Large Bank’s balance sheet would now look like this:

Assets Liabilities and Equity
Good loans 800 Deposits 600
Bad loans 0 Debt 300
Cash 150 Equity 50
Preferred 0
Total 950 . . . . . . . Total 950
  • Total capital: 50
  • Capital added by this transaction: 30
  • Leverage: 16:1 (with the same caveat as above)
  • Risk of bad loans: cleared from Large Bank
  • Taxpayer outlay from TARP: 150
  • Long-term cost to taxpayer: Whatever the losses are on the bad loans

The bank trades 120 of bad loans for 150 of cash from Treasury. The results are:

  1. Large Bank has 30 more capital from the government. It now has a more reasonable leverage ratio.
  2. The downside risk associated with the bad loans has been eliminated from Large Bank’s balance sheet. This should presumably make it easier for Large Bank to attract private capital.
  3. The government has spent 150 of the TARP pool.
  4. The taxpayer now bears the downside risk associated with bad loans for which it paid 120.
  5. Elected officials and the press scream about the government “overpaying” for these bad loans and shafting the taxpayer.

We are now addressing both problems: Large Bank’s capital hole, and the downside risk of the bad assets. The downsides are that we are consuming more of our TARP pot to do so, and we have an optical problem in that we are paying banks more for these bad assets than the bank thought they were worth. Large Bank will also report a profit of 30 from this transaction, further compounding the optical challenge.

The logic of “overpaying” for bad assets becomes a little easier if we instead imagine that these are mortgage-backed securities (MBS) rather than loans. If the bank had to value these bad securities at their market value, you could end up with the following scenario:

  • The bank thinks that if it held these mortgage-backed securities for the long run, the underlying mortgages would pay out and they would collect 160. This is the bank’s estimate of the “hold-to-maturity price.”
  • But since the market is so nervous about the downside risk, the current market price is 120.

If the government pays 150 for these securities, is it overpaying for them? If the bank is right (or the government analysts who say they are willing to value it at 150), then the taxpayer can buy it at 150, hold it for a long time until the mortgages mature, and make 10 in profit. We would be taking advantage of the fact that the government is willing to be far more patient than private investors, and therefore willing to buy and hold these securities.

This was the argument that Secretary Paulson and Chairman Bernanke made in September of last year when they were testifying before Congress on the need for TARP legislation.

TARP I as originally conceived, buying bad assets from banks and paying prices that would partially recapitalize those banks, was aimed at addressing both problems of Large Bank. It runs into the problem of using TARP funds inefficiently. In the first example, we spent 120 from the TARP and created no new capital for Large Bank. In the second example, we spent 150 from the TARP and only created 30 of new capital for Large Bank. To the extent you are concerned with problem #1 (the capital hole), you would like to use TARP funds more efficiently. That is the principal reason we pivoted away from buying these assets (at whatever price) and toward direct equity investing in banks. Remember, that in making these choices, you don’t know how big either problem really is.

As a more general matter, the three different TARP approaches can be understood as different answers to two questions:

  1. What is the relative importance of filling the banks’ capital holes versus removing the downside risk from banks’ balance sheets?
  2. How can we use a large but limited pool of TARP funds most efficiently?

Tomorrow I will explain TARP II: Direct equity investment in banks.

By | 2017-12-09T18:57:06+00:00 Wednesday, 29 April 2009|