Category: Finance

Treasury Extends, but Limits, TARP

Well that was quick. This morning Treasury Secretary Geithner laid out the administration’s vision for TARP, answering the questions I posed yesterday.

As expected, Secretary Geithner is using his authority to extend the TARP program to October 3, 2010 (it otherwise would have expired at the end of this month). As I’ve suggested in earlier posts, I don’t see how he could have chosen otherwise. The administration is committed to programs that aren’t complete yet, and it needs to worry about unpleasant surprises. In the words of his letter to House Speaker Pelosi:

This extension is necessary to assist American families and stabilize financial markets because it will, among other things, enable us to continue to implement programs that address housing markets and the needs of small businesses, and to maintain the capacity to respond to unforeseen threats.

Second, Geithner announced that henceforth TARP will be used for only four programs: to mitigate home foreclosures, provide capital to small and community banks, additional efforts to facilitate small business lending, and, possibly, to expand the TALF program that supports securitization markets for loans to small businesses, commercial real estate, etc. Notably (and correctly) absent from this list are some of the ideas — funding for new infrastructure, assistance to state and local governments — that have been floated in recent days.

Geithner is right to draw a moat around TARP and to limit its use to specific activities, except in emergencies:

Beyond these limited new commitments, we will not use remaining EESA funds unless necessary to respond to an immediate and substantial threat to the economy stemming from financial instability.

Third, Geithner provided a new forecast of how much TARP money will eventually be used:

While we are extending the $700 billion program, we do not expect to deploy more than $550 billion.  We also expect up to $175 billion in repayments by the end of next year, and substantial additional repayments thereafter.  The combination of the reduced scale of TARP commitments and substantial repayments should allow us to commit significant resources to pay down the federal debt over time and slow its growth rate.

In short, the administration believes that at least $150 billion of TARP money will never be used. That’s great news. But now attention will turn to Congress to see whether it tries to use that $150 billion to “pay for” new initiatives. As I noted the other day, current budget rules would give Congress credit for 50 cents of savings for each dollar that’s removed from overall TARP authority. But such savings are an accounting fiction, not real, if the TARP authority never would have been used anyway.

Some Questions about TARP’s Future

As I discussed the other day, using TARP to pay for new jobs programs faces some serious practical issues. First, the administration is limited in how it can deploy existing TARP funds. It should be straightforward to use more funds to support lending to small businesses (which TARP already does to some extent), but it would take great legal ingenuity to use it to fund infrastructure projects or aid to state and local governments.  Indeed, in an article titled “Use of Cash from TARP Hits Hurdle“, the Wall Street Journal reports that top Democrats have concluded that TARP money can’t be used for either of those ideas.

Second, legislative use of TARP money are limited by budget scoring rules, which currently would attribute only 50 cents of budget savings to each dollar by which TARP’s authority might be reduced. And even then, careful budgeteers would realize that such savings are make-believe if, as seems likely, any such limits would apply only to TARP authority that was unlikely to be used anyway.

In short, the rhetoric about using TARP to finance various proposals seems to have gotten ahead of reality.

The President’s speech at the Brookings Institution today provided some additional insight into the Administration’s plans for TARP, but some important questions still remain.

Here are the President’s three forward-looking statements about TARP (he also made some comments about TARP’s origin and history, but that’s a topic for another day):

I’m asking my Treasury Secretary to continue mobilizing the remaining TARP funds to facilitate lending to small businesses. …

[W]ith a fiscal crisis to match our economic crisis, we also must be prudent about how we fund [initiatives to accelerate the pace of private hiring].  So to help support these efforts, we are going to wind down the Troubled Asset Relief Program — or TARP — the fund created to stabilize the financial system so banks would lend again. …

TARP is expected to cost the taxpayers at least $200 billion less than what was anticipated just this past summer.  And the assistance to banks, once thought to cost taxpayers untold billions, is on track to actually reap billions in profits for the taxpaying public.  So this gives us a chance to pay down the deficit faster than we thought possible and to shift funds that would have gone to help the banks on Wall Street to help create jobs on Main Street.

If I am reading that right, the President would like to (a) continue Treasury’s existing effort to support small business lending through TARP, (b) wind down the TARP program, and (c) shift funds to other purposes. That leaves me with some important questions, including:

  • Does the administration plan to expand TARP’s small business lending support or just execute the one that’s already been announced? (NB: The President also endorsed several other steps to help small businesses, including easier access to SBA loans.)
  • Does “wind down the TARP program” mean that Secretary Geithner won’t use his authority to extend the program beyond December 31, 2009? If I were him I would sleep much better at night if I had some “dry powder” in an extended TARP, just in case we have another September-October of 2008. Such a replay seems highly unlikely (knock on wood), but if that exceedingly remote event did happen, I wouldn’t want to be the Treasury Secretary who went up to Capitol Hill to ask for a TARP II.

Can TARP Be Used to Pay for a New Jobs Program?

Washington is abuzz with the idea that Congress, the White House, or both may try to use unspent TARP funds as a way to promote job creation (see, e.g., this WSJ story and this WaPo story). Over the past two days, many reporters have asked me about the mechanics of this idea–can the government really use unspent TARP money this way? Here’s my best answer (given what I have learned so far).

There are two basic ways that our leaders could try to use TARP money to pay for new initiatives: through executive action or through new legislation.

Executive Action

Treasury Secretary Geithner has the ability to use TARP funds largely as he sees fit, as long as those uses are within the boundaries set out by the original legislation. As you may have noticed, the exact location of those boundaries–well, even the rough location of those boundaries–has been a topic of great debate during TARP’s existence. But the basic idea is that TARP can be used to purchase troubled assets, which the bill defines as follows:

(A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and

(B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.

If our leaders want to use TARP through executive action, they will have to come up with programs that fit within these limits. Additional support for small-business financing or home mortgages could certainly be structured to fit within these parameters; indeed, TARP already has programs for both of those. It would require substantial ingenuity, however, to figure out a way to support some of the other ideas being floated (e.g., aid to local governments).

New Legislation

The second approach would be for Congress to enact legislation that would increase spending on various programs and then pay for it, at least in part, by reducing the amount of money in the TARP program.

There have already been at least two pieces of legislation that have taken this approach:

Continue reading “Can TARP Be Used to Pay for a New Jobs Program?”

Capital One Warrants Bring in $146.5 Million

Yesterday the Treasury auctioned off its TARP warrants in Capital One. Treasury sold the warrants for $11.75 a piece, well above its $7.50 reserve price, but below some private estimates of $19.00 or more. I wouldn’t have gone as high as $19.00 myself, but I would have ended up a winner in the auction if I had found a broker with access. Oh well, maybe I can pick some up when they start trading on the NYSE (ticker COF WS) in the next week or two.

Disclosure: I have no position in any Capital One securities.

TARP Warrants: Let the Bidding Begin

Thursday is a nice milestone in TARP’s history: with the help of Deutsche Bank, Treasury is auctioning off the warrants it received when it invested in Capital One. The company has already paid off the preferred stock that the government purchased last fall, and will now be free from TARP oversight once the warrants are in private hands. Or, perhaps, in its own hands. Although Capital One declined to purchase the warrants from Treasury at a negotiated price (as had other firms that repaid the government’s TARP investments), it can still bid in the auction.

A few months ago, I pointed out many benefits from auctioning the warrants rather than selling them back to the companies at negotiated prices. To my mind, the biggest benefits are transparency and the fairness of market pricing. Everyone—including, at least in principle, small investors—can bid in the auction.

If you are interested, here’s the prospectus, which includes (pp. S-15 to S-16) a list of participating brokers. I don’t see my broker on the list, which is disappointing, but maybe others will be luckier.

For a nice discussion of the auction mechanism (a modified Dutch auction in which all winning bidders pay the market-clearing price, very similar to the method used to sell Treasury bonds) and some estimates of the warrant values, see this Seeking Alpha piece by Linus Wilson.

Disclosure: I have no position in Capital One and, apparently, no way to bid on the warrants. If I find a way, I might do it for fun.

Deja Vu All Over Again?

Earlier this week, the Treasury released its quarterly update about its borrowing requirements and its strategy for meeting them. I haven’t had time to review all the documents, but I did skim through the minutes of the meeting of the Treasury Borrowing Advisory Committee (TBAC), which was held on November 3.

This pair of paragraphs particularly caught my attention (my emphasis added):

The Committee then turned to a presentation by one of its members on the likely form of the Federal Reserve’s exit strategy and the implications for the Treasury’s borrowing program resulting from that strategy.

The presenting member began by noting the importance of the exit strategy for financial markets and fiscal authorities. It was noted that the near-zero interest rates driven by current Federal Reserve policy was pushing many financial entities such as pension funds, insurance companies, and endowments further out on the yield curve into longer-dated, riskier asset classes to earn incremental yield. Treasury securities have benefitted from the resultant increase in demand, but riskier assets have benefitted even more. According to the member, the greater decline in the indices for investment grade and high-yield corporate debt relative to 10-year Treasuries and current coupon mortgages display this reach for yield. A critical issue will be the impact on the riskier asset classes as market interest rates move away from zero.

Yes, our old friend the reach for yield. Back in pre-crisis days, the reach for yield would often be viewed as evidence that the monetary transmission mechanism was working well, with low short-term rates providing a real boost to the economy. Now, however, we are all-too-familiar with the downside of the reach for yield: unsustainable booms in longer-term assets.

Is this deja vu all over again? I don’t know. But those paragraphs certainly didn’t make me feel more comfortable about our recovery.

P.S. I should also note that the TBAC endorsed greater reliance on Treasury Inflation Protected Securities (TIPS), as well as moving from 20-year TIPS to 30-year TIPS. These recommendations paralleled some similar ones released back in September by the GAO.

Counterintuitive Accounting: Ambac Edition

Earlier today, Ambac Financial Group (a big bond insurer) reported that it earned more than $2 billion in the third quarter, or $7.58 per share. As reported over at Marketwatch, these must be among the lowest quality earnings in accounting history:

Ambac Financial Group reported a $2.19 billion quarterly profit Wednesday as the company got a big accounting boost from deterioration in the perceived creditworthiness of its main bond insurance unit. …

Most the gain came as credit spreads widened on Ambac Assurance Corporation, the company’s main bond insurance subsidiary. When credit spreads widen, that implies investors are more concerned about a company not being able to meet its obligations. However, when this happens, it reduces some of the insurer’s liabilities. For example, if the insurer is deemed to be less capable of standing by its derivatives-based guarantees, the value of those liabilities falls. That results in a derivatives gain.

In short, earnings skyrocketed because investors became even more doubtful about Ambac’s ability to pay its future liabilities. I see many benefits in mark-to-market accounting generally, but this treatment of liabilities is counterintuitive to say the least. There must be a better way.

Ambac shares closed at a lofty $1.50 per share, up 35% on the day. It’s not often that you encounter a stock that trades for less than one-fifth of its quarterly earnings …

Disclosure: I have no investments in Ambac or any bond insurer.

Booms, Busts, and the Leverage Cycle

Over the Wall Street Journal, Mark Whitehouse has a nice piece on John Geanakoplos, a finance guru in the worlds of both academia and Wall Street. Over the past ten years, he’s been exploring how leverage and the value of collateral can drive booms and busts in financial markets.

His research was sparked by the challenges his investment fund faced after the demise of Long-Term Capital Management in 1998:

A lender to the fund where Mr. Geanakoplos was a partner abruptly demanded more margin on a loan. The event, which nearly toppled the fund as the partners scrambled to raise cash by selling securities, drove home to Mr. Geanakoplos how margins could work two ways — stimulating asset buying as they go lower, but forcing fire sales as they rise.

In a 2000 academic paper, Mr. Geanakoplos offered a theory. He said that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them “natural buyers.”

Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.

“It was evident to me that there was a cycle going on, not just in my little market, but all over the world,” says Mr. Geanakoplos, who is still a partner at Ellington Capital. The “leverage cycle,” he called it.

Well worth a read.

The GM (er, Motors Liquidation) Anomaly

A few months ago, I wrote a series of posts about anomalies in the pricing of Citigroup common and preferred stock (see here for the final installment). At the time, Citi’s common stock traded at prices that appeared to be way too high relative to the preferred stock (which has since converted into common).

Limits on short-selling appeared to be the best explanation for that anomaly.

In today’s New York Times, Floyd Norris notes that the same thing is happening to shares of Motors Liquidation Company (symbol MTLQQ). Motors Liquidation is what remains of the bankrupt General Motors. It has no ownership in the new, post-bankruptcy GM and, a (see correction below). As far as I can tell, everyone believes that ML’s common stock is worthless. Yet, as Norris shows in an accompanying chart, the stock has persistently traded above $0.50 per share:

(One nit: I don’t think the top chart should be labeled “General Motors stock price …”; it should be “Motors Liquidation stock price …”)

Norris argues, correctly I think, that the difficulty of shorting ML common stock is why it trades at a positive price. Potential sellers have been unable to drive the price down where it belongs (close to zero) and, indeed, are occasionally forced to buy back shares to close their positions. Thus, the stock trades around $0.60 per share, and the number of shorted shares has been declining.

As a contrast, Norris points to Delta Airlines which went through bankruptcy back in 2006-7. In that case, short sellers increased their positions over time, and the stock price worked its way down to zero.

Correction (11/3/09): An astute reader points out that I was wrong to say that Motors Liquidation has no ownership position in the new GM. According to the investor FAQs for Motors Liquidation:

As part of the consideration for the acquisition of substantially all of the assets of the old General Motors Corporation, 10% equity in the new GM, as well as warrants for an additional 15%, will be provided to Motors Liquidation Company which is still in Chapter 11. Distribution of this equity to unsecured bondholders and other claim holders will be determined through the court process and will not occur until a plan of reorganization is submitted, accepted and implemented. It is too early to tell how long this may take.

If I am interpreting that correctly, it means that Motors Liquidation is, in essence, the conduit by which unsecured bondholders and other claim holders will eventually receive their equity stake in the new GM.

Another useful item on the Motors Liquidation web site is this warning to investors in common stock:

Management continues to remind investors of its strong belief that there will be no value for the common stockholders in the bankruptcy liquidation process, even under the most optimistic of scenarios. Stockholders of a company in chapter 11 generally receive value only if all claims of the company’s secured and unsecured creditors are fully satisfied. In this case, management strongly believes all such claims will not be fully satisfied, leading to its conclusion that the common stock will have no value.

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