Tuesday I began with a simple example, which I am calling Large Bank.

Yesterday we looked at TARP I, in which the government would buy troubled/toxic assets from banks.

Today I will describe TARP II, the plan we (the Bush Administration) implemented, in which the government made direct equity investments in banks to help fill their capital holes. We called this the Capital Purchase Program.

As a reminder,we are trying to address two problems:

1. Large Bank does not have enough capital.
2. Large Bank 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.

Here is the balance sheet for Large Bank:

• Total capital: 20
• Leverage: 46:1

TARP I solves problem #2 if you buy all the bad loans, but it is extremely inefficient in addressing problem #1, the capital hole. Spending 120 from the TARP to buy the bad loans would provide no new equity capital. Spending 150 to buy the loans valued at 120 would provide a net 30 of capital for 150 outlayed from the TARP.

The constraint is not the ultimate cost to the taxpayer. It is instead the legislated limit on how much outstanding cash can be invested/spent at any one time from TARP: $700 B.

To fill the capital hole, our first choice would be for the bank to attract private capital. Bank management appears reluctant to do this, because they don’t want to dilute the value of their existing shareholders. In addition, private investors were unwilling (at least last Fall) to invest in banks that had significant downside risk on their balance sheets. So temporary public capital, provided by the taxpayers, was the only option to recapitalize the banking system.

If we take the same 120 from the first TARP I case, but instead use it to buy preferred stock in Large Bank, we end up with this:

• Total capital: 140
• Capital added by this transaction: 120
• Leverage: 7.4:1
• Risk of bad loans: still lies entirely with Large Bank
• Taxpayer outlay from TARP: 120
• Long-term cost to taxpayer: Zero if the firm remains solvent, up to 120 if the firm goes bankrupt.

Results:

1. Large […]