29 April 2009 
Yesterday we created a simple example of Large Bank, which made some bad loans and now has two problems:
- It doesn’t have enough capital.
- 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:
- Large Bank’s capital problem is unaffected. It still has only 20 of capital, and still has a very high leverage ratio.
- 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.
- The government has spent 120 of the TARP pool.
- 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:
- Large Bank has 30 more capital from the government. It now has a more reasonable leverage ratio.
- 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.
- The government has spent 150 of the TARP pool.
- The taxpayer now bears the downside risk associated with bad loans for which it paid 120.
- 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:
- What is the relative importance of filling the banks’ capital holes versus removing the downside risk from banks’ balance sheets?
- 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.
“That is the principal reason we pivoted away from buying these assets (at whatever price) and toward direct equity investing in banks.”
“Pivot” does seem a most diplomatic way of expressing, “We went to Congress and to the people pledging to do X but decided to do Y instead.”
Love the blog though.
Agree with Thomas L. Treasury (and the Fed) still haven’t figured out how to value these assets, in part because it has proven very difficult to figure out what these assets are. The government’s various efforts to induce the private sector to buy these mystery assets at inflated prices also have so far fallen flat. Thus, the “pivot” from buying (or bribing others to buy) paper whose worth no one knows at a rate that will advantage the banks to just lending the banks money outright. That, in turn, has mutated into a strategy to partially nationalize certain banks that are “too big to fail.” Citi was the first to fall into this category with taxpayers (or, technically, the federal government with money borrowed largely from the Chinese) now owning the largest chunk of their common shares. With the results of the stress tests now in, we can expect announcements in the coming days of other banks that the government will partially nationalize, with Bank of America likely leading the way. (Wonder if President Obama will fire that CEO, as he did with GM’s, once the government converts its TARP “loans” to BofA into equity.)
In short, the TARP has been a disaster. It was poorly thought-through, it could not be executed as originally conceived, its unworkable design forced a pivot to a plan to pump capital directly into the largest banks, which, in turn, gave the new Administration that doesn’t scruple over government ownership of anything (think of it as the “Ownership Society 2.0″) the opportunity to embark on a nationalization campaign of the nation’s largest banks and unprecedented regulation of the financial services sector.
Meanwhile, every provisional rationale for the TARP has proven ephemeral. Its passage did not stop the stock market’s slide. Remember when the Dow dropped after the House defeated the package and the Administration complained that people’s 401(k)s had lost value, implying that if TARP passed we would save those 401(k)s? Well, the market opened at 11,200 that day. A month-long market rally has brought the Dow north of 8000. How are those 401(k)s looking?
It still has not achieved its originally-stated purpose, as discussed above.
And its revised purpose — lending the banks money — didn’t achieve its aim of stimulating the banks to start issuing loans again. Remember when the Administration said that by infusing $250 billion in the biggest banks, it would result in them lending $2.5 trillion to individuals and businesses? Didn’t happen.
And remember that list of 100 banks that senior Administration officials showed skeptical lawmakers in lobbying for TARP’s passage — banks that were at risk of failure, they said, unless Congress enacted the bill? The list of banks that FDIC has shuttered since passage of the TARP continues to grow. According to the agency’s website, the feds have closed 43 banks since TARP’s enactment and the pace has not slowed, with 8 of those banks having been shuttered in April alone. And that doesn’t include zombie banks like BofA and Citi.
So we are left with the one durable defense of the TARP — things would be worse if we hadn’t done it.
These posts will be required reading for at least one Money & Banking class in the fall.
Keith, thanks for the post. I hope it clears up some confusion of those who do not distinguish between a liquidity problem and a solvency problem and why “overpaying” had to be a feature of TARP (even before you get to any issues of the government’s ability to negotiate against the holders of the “bad” assets, and fraud and collusion in the sales process).
A question about the balance sheet pre-TARP. The bad loans are over-valued at 120, right. They are implicitly valued at 0 as made clear in post-TARP.
In which figure on the liabilities side is this accounted for. How is the “imbalance” off-set. And why doesn’t that figure have to change post-TARP? As you can tell, I am not an accountant.
K Stephenson
A question about the balance sheet pre-TARP. The bad loans are over-valued at 120, right. They are implicitly valued at 0 as made clear in post-TARP. this right