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What $700 billion buys

Anthony Randazzo
October 12, 2008, 2:43pm

Meet Neel Kashkari, 35 years old and the interim head of TARP–the Troubled Asset Relief Program. Kashkari is a former vice president at Goldman Sachs, Treasury Secretary Paulson's old firm. It is Kashkari's job to administer the TARP, a protective blanket that is to be cast over the nation's financial system, and guide the Treasury Department in their effort to "save" the financial sector. A little over a week after President Bush signed the Emergency Economic Stabilization Act of 2008 that created TARP and the Financial Stability Oversight Board (FSOB) to make sure it stays within the bounds of the bill, Treasury's plan has begun to take shape. At this point it looks like they will be doing a little more than just buying securities. Buying ownership stakes Claiming Congress gave it flexible authority under the terms of the EESA, Secretary Paulson has decided the Treasury Department will buy equity shares in "healthy" banks, mirroring actions that European nations are taking. England has nationalized almost all of Britian's top banks–including Royal Bank of Scotland–and France, Germany, Austria, the Netherlands, Portugal, and Spain have allocated $2.3 trillion dollars to take equity stock in banks to guarantee interstate loans. While there is still some apprehension in the Treasury Department towards complete nationalization of banks, they, and the Fed, have determined the credit crisis requires increased government intervention. By buying up equity, basically buying stocks and investing in banks, the government will be injecting capital into the system. The government won't forcibly buy up anything, and will require firms to voluntarily offer equity stakes. The goal is to inspire new confidence in the market, and it seems to have worked as of today as Wall Street recovered half of its losses from the past week with a 11% gain across the board of indicies. By only buying from solvent firms the Treasury will avoid a moral hazard with this stock buy, though it is stepping way outside the role of government in buying into companies. If all that was needed was the hope for more capital to flow into the market, the government could have created a tax holiday for all returns on money invested between now and Dec. 31. Or they could have given tax breaks on repatriated funds or funds invested from overseas. Any or all of those efforts could have achieved the same confidence result while keeping the taxpayer off the hook for potential losses on the Treasury's equity investment. Buying mortgage backed securities Beyond partially nationalizing banks, Kashkari will direct TARP in buying up troubled mortgage-backed securities that banks can't get off their books. There are three options on the table for liquidating the toxic MBSes according to Kashkari: "One, an auction purchase of troubled assets; two, a broad equity or direct purchase program; and three, a case of an intervention to prevent the impending failure of a systemically significant institution." In English, those options are an auction, where banks would offer their assets at whatever price they want and the Treasury Department would start by buying the lowest priced MBSes. This would keep banks from overpricing their assets and provide clear signals to the government as to which assets are unwanted. The second option would involve the government going over the books of various firms and spot choosing which assets they wanted to buy, however this might target some assets firms want to keep and miss some that are creating problems for financial balance sheets. The third would involve more nationalization under the "too big to fail" philosophy that has troubled politics for decades. Kashkari says that TARP is in the process of selecting firm managers to handle this process, which would then clarify which option the government would choose to pursue. The Treasury's "master custodian" will be announced sometime tomorrow to serve as the prime contractor, though the Treasury has already given TARP roles to the law firm Simpson Thacher & Bartlett LLP and investment consultants in Chicago-based Ennis Knupp & Associates. Buying your home On top of this, the Treasury will also use its "flexible powers" to purchase whole loans. Some subprime mortgages were not securitized, but are still dragging down bank finances. Homes that banks have not been able to sell will be purchased by the Treasury to get them off financial balance sheets and free up that capital. Though we don't know how the government will value the toxic mortgages that are worthless now (though have great value potential in the future), it is likely that they will hire a firm to manage and refinance the loans it buys. Fannie Mae and Freddie Mac may become involved as well. In general, this is what McCain has proposed, though he suggested last week that $300 billion more be allocated for just this purpose alone. The rationale is that stability in the housing market is the silver bullet to the whole crisis and that fixing home values would bring balance to the chaos. The rest of the story The EESA bailout also created compensation rules for executives that TARP will have to define and FSOB will have to enforce. And Kashkari is also leading the effort to establish and insurance program for mortgage-backed securities that The Bailout required, hoping it would give the MBSes some foundation for value.

Anthony Randazzo is Director of Economic Research


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