We have so far:
- created our example of Large Bank;
- described TARP I, in which the government would buy bad assets from banks; and
- described TARP II, in which the government made direct equity investments in banks.
The Bush Administration implemented TARP II as the $250 B Capital Purchase Program (CPP), although less than $250 B has been allocated to specific banks.
Today I would like to describe TARP III, the Geithner plan now being implemented by the Obama Administration. I should warn you that this is more complex than TARP I and TARP II.
Here is the summary:
TARP III = (TARP II + stress tests + more capital targeted at big sick banks) + ( TARP I with private sector participation and more money through the Fed & FDIC)
Let us begin with the Obama Administration’s expansion of TARP II. They have:
- Left the Capital Purchase Program in place.
- Stress tested the 19 banks that have more than $100 B. Based on those stress tests, regulators will require some of these big banks to raise more capital.
- These banks “will be given a six month period to raise any additional capital needed to establish [a] buffer from private sources.” If the bank cannot raise this capital privately, then Treasury will provide it from the TARP.
The Administration calls (2) + (3) their Capital Assistance Program. It is an expansion of the Capital Purchase Program, targeted at filling the capital holes of big sick banks that cannot or will not raise funds from private investors.
Now let us turn to the Administration’s new plan to address the downside risk that Large Bank has on its balance sheet, what they call their Public-Private Investment Program.
It comes in two parts, one to help Large Bank sell its loans with downside risks, and the other to help it sell those securities with downside risks.
I will start with the Legacy Loan program, which is a little easier.
Large Bank shows their 120 of bad loans to the FDIC. The FDIC evaluates those loans and sets a ratio and a price. The ratio can be as high as 6:1. Let’s assume for these loans that the FDIC will go up to 5:1. I will describe the price in a moment.
Let’s also say that your friend Fred runs Fred’s Hedge Fund.
- Fred puts up 10 of investment capital.
- Treasury matches Fred with 10 of capital from the TARP.
- FDIC uses its 5:1 ratio to match the 20 of capital with 100 of guaranteed debt. Technically, FDIC only puts up the guarantee, while the actual funds come from other private lenders.
- Fred now has 120 (his 10 of capital + 10 from Treasury + 100 of FDIC guaranteed debt). He uses this to buy the 120 of bad loans from Large Bank.
Fred is in a great position. If these loans are actually worth 180, then he makes 60 of profit which he splits 50/50 with Treasury. He invested 10 and made 30 in profit. Not bad.
If these loans are actually worth 60, then he loses his 10 of investment. Treasury loses 10, and FDIC covers the other 40 of losses.
I said earlier that the FDIC sets a ratio and a price. The price is the amount FDIC will charge for the guarantee. This is a key variable to watch. If FDIC charges an actuarially fair price for their guarantee, then that will eat heavily into Fred’s profit. I presume that FDIC will charge less than an actuarially fair price to encourage buyers to purchase these bad loans. By lowering the guarantee price below that which is actuarially fair, the Administration and FDIC Chairman Sheila Bair have a dial they can turn to encourage buyers of bad loans and drive up the prices paid to banks for those loans.
Assuming that the guarantee price is inexpensive, this would be a great deal for Fred’s hedge fund if he had it all to himself. His upside risk is much greater than his downside risk. In fact, he would be willing to pay more than 120 for these loans that Large Bank has been valuing at 120. Other investors will recognize this opportunity and compete with Fred to buy these bad loans from Large Bank. We would expect Fred and other investors to compete away the “rent” by bidding up the price of these bad loans until they are receiving a competitive return.
The Administration looks to be throwing this process wide open, to encourage lots of buyers. The winners will be the banks with the bad loans. By subsidizing the private purchasers with debt guaranteed by the FDIC for a cheap guarantee fee, the Administration can encourage private bidders to bid up the price of these bad loans until they expect to receive a return commensurate with the risk they are taking. Since FDIC bears much of the downside risk, the price should rise.
The Administration emphasizes that private bidders will be establishing the price paid for these bad loans. This program appears to be a clever way to “overpay” the banks more than current market prices for these loans, while being able to politically say that prices were set by market forces rather than the government. They can leverage private capital and especially FDIC’s balance sheet to buy more legacy loans than if they had used TARP funds alone, and they can recapitalize banks at the same time by setting up a mechanism that should bid up the sales price for these “legacy loans.” Given that for the loan program, you have up to 11 government dollars for each dollar of private capital, I think they are overselling the private sector involvement. I think they think it helps them with their optical challenges.
The legacy securities program is similar but not identical. It works through the Federal Reserve. It is not open to as wide a range of purchasers, so some of the benefits should (I think) go to the buyers, rather than having all the rents accrue to the sellers.And it works through leveraging a separate program, called the TALF, rather than through the FDIC’s guaranteed loans. I don’t think that walking through all the mechanics of the securities program adds a tremendous amount of value, because I want to get to the conclusions.
Results (if it works):
- They fill capital holes in a broad array of banks through the Capital Purchase Program (aka TARP II).
- They supplement CPP by finding and filling capital holes in the sickest big banks through the stress tests plus targeted capital investments, aka the Capital Assistance Program.
- They buy bad assets from Large Bank and others, leveraging FDIC (for loans) and Fed (for securities) balance sheets, plus a little private money, to make TARP dollars go farther and buy more bad assets. This is good because it helps them solve more of the downside risk problem, but bad because they are exposing taxpayer to more risk.
- By subsidizing the guarantee fee and taking a lot of the downside risk, purchase prices (at least for loans) should allow banks to get more than current market prices for those assets (at least for the loans). This helps those banks dump their bad risks on the government and gives them a bit more capital.
- The FDIC and Fed bear the downside risk associated with these bad loans and securities. Ultimately the taxpayer bears the downside risk carried by the Fed. It is unclear who bears the downside risk carried by FDIC — the taxpayer or the banking industry. FDIC is supposed to be self-financing through fees on insured institutions.
- The Administration has political cover if and when market prices for these assets are above current market prices.They will continue to hide behind “the private sector choosing the prices,” even though they have distorted those prices through subsidized loan guarantees.
With TARP III the Obama Team has figured out a way to make TARP dollars go farther. They are using this extra room to try to address both the banks’ capital holes and the downside risk / bad assets problems. I hope it works.