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 […]