Friday, October 3, 2008

TARP: Totally Aggravating for Reasonable People

Today, Congress affirmed the behemoth economic stabilization bill (TARP) with a House majority vote: 263 to 171. The bill - in its current 451-page form – incorporates all of the previous TARP provisions, plus a slew of unrelated expenditures. The Congressional Budget Office (CBO) estimates quite vaguely the costs associated with TARP; pick a number between $0 and $2 trillion, and that would be more concrete than what I see here.

The plan is broken down into three sections: Division A – the TARP program; Division B – Energy Improvement and Extension Act of 2008; Division C – extended tax provisions and relief. The plan in brief: (below ( +$) means the provision would increase the budget deficit and (-$) means that it would reduce the budget deficit):

Division A – TARP
1. (+$) Deposit insurance for each applicable bank account increased by $150,000 to $250,000 until December 31, 2009.
2. (+$) and (-$) Purchase of troubled assets with a limit of $700 billion: $250 billion upon enactment (could be today) plus an extra $100 billion if President supports the Secretary of Treasury’s decision, and $350 billion if Congress approves. The CBO believes the full amount will be distributed. The assets will then be sold on the open market when the Treasury sees fit.
3. (+$) and (-$) Enables the Secretary to insure troubled assets and collect premiums.
4. (-$) If in five years, there is a net-loss on the portfolio, the President it required to submit a proposal to recover the losses from those firms benefitting from TARP.
5. (+$) Administrative costs are not included in the $700 billion.
6. (+$) Change in tax treatments for certain incomes, losses, or corporate deductions.
7. (+$) Firms must meet limitations on executives’ compensations.
8. (+$) Fed allowed to pay interest on the banking system’s reserves that are deposited at the Fed beginning on Oct. 1, 2008.
9. Regulatory agencies should take measures to help suppress foreclosure rates.
10. (+$) Congressional oversight will be established to monitor the reporting of portfolio transactions and implementation of program.
Net cost of the TARP program: “That net cost is likely to be substantially less than $700 billion but is more likely than not to be greater than zero.” RW: ?????

Division B – Energy Improvement and Extension Act of 2008
- (+$) 2009-2013 – projected deficits increase by $7 billion.
- (+$) 2009-2018 – certain provisions would reduce deficits by less than $0.1 billion.
Net cost: $6.9 billion

Division C – Tax Incentives and Alternative Minimum Tax Relief
- (+$) 2009-2013 – projected deficits increase by $112.3 billion.
- (+$) 2009-2018 – projected deficits increase by $107.1 billion.
Net cost: $219.4 billion

I start to feel slightly queasy when I eye this list. TARP is inter-generationally hazardous, where the debt incurred by this program will most certainly be paid for by more than one generation. The total explicit tally is: $700 billion + $219 billion + $6.9 billion, which is just shy of $1 trillion. The gains from selling those assets will offset the $1 trillion, but there are many question marks that remain as to how much gains will offset the $1 trillion. And further, numbers 5.-10. list additional costs that are not given an explicit price tag due to the vagueness of the bill.

Some of the costs in the CBO report are missing or understated. I have the following problems with the Division A cost assessment (will refer to them by their associated number in the list above).

1. The net-cost of the TARP program is still too vague. I really don’t see how those concerned with the ambiguity of the previous drafts can stomach this one: The pricing mechanism outlined in the CBO report is unspecified, and therefore, the ultimate cost of the program is impossible to determine.

My favorite line in the CBO document is: “Although it is possible that future increases in asset values would generate gains even on assets for which the government initially overpays, an overall net loss is more likely if the government initially overpays.” Duh!

2. Added FDIC insurance premiums. In June 2008, insured deposits amounted to $7 trillion, while uninsured deposits totaled $2.6 trillion. The CBO estimates that the new program will extend coverage by roughly $700 billion of currently uninsured deposits (hence an additional cost), leaving $1.9 trillion still uninsured. However, what the CBO does not account for is a potential influx of funds due to the change in banking structure.

By changing the incentive to save in the federally-insured banking system – raising the deposit limit – the government inherently changes saving behavior. The new limit reduces the opportunity cost of saving in the U.S. banking system (however slight this may be), which will result in an increase in the total of insured deposits relative to the amount under a lower debt limit. Therefore, the overall costs will rise beyond what the CBO suggests.

One could argue that the $1.9 trillion in largely institutional and uninsured funds will flee without a U.S. blanket guarantee. I don’t think so. The U.S. banking system – under the new TARP bill – looks a whole lot better than any system in Europe, and investors will keep their funds tied up in the U.S.

4. Congress added a provision that the President submit a proposal to recoup any net-losses incurred by the TARP portfolio. Appropriately, the CBO assesses that this may impact the overall fiscal cost of the program since the actual mechanism by which net-losses will be recovered was not specified. Who will pay? All of the entities that benefitted from TARP, or just the ones that sold the assets that produced losses? Do the loss include administrative costs? Who knows. However, the CBO does not address the issue of ongoing insolvencies that will cause member institutions – even the ones who participate in TARP – to fail.

TARP transfers illiquid assets from the banking system’s balance sheet to the U.S. Treasury, but TARP can’t possibly assume the entirety of illiquid assets in the banking system. Therefore, there will be banks or firms that participate in TARP that become insolvent and fail. How will the government recoup losses from a firm that has filed for Chapter 11? This recoupment mechanism is completely flawed and not likely to ever produce results, let alone reduce losses. Recovering net-losses is unlikely.

5. “Administrative fees” are strongly subject to Congresses’ interpretation of what constitutes an administrative fee. The CBO uses the costs associated with outsourcing institutional portfolio management as a fee, implying that this will be the largest cost. This cost, however, could be substantial. Let’s say that the asset manager charges a 5 bps fee to manage the $700 billion portfolio – that’s a $3.5 billion “administrative fee.” This is not a small sum. Further, I am sure that going forward, Congress will find a way to tack on Administrative fees that have nothing to do with the portfolio itself. Administrative fees can only add to the ultimate price tag, and they are no-doubt going to be substantial.

My final thought on CBO cost estimate is about interest payments. This report includes no mention of rising interest payments that must be paid when the government assumes $? trillion in new debt. How do you think that the government will pay the interest? Yup, they will sell more debt until realized gains can finance the payments. At that point, Congress can pay down the debt, and thereby reducing interest payment, but even that is far from certain. Here starts a vicious circle. Alongside rising interest payments sits a rising current account deficit (the infamous twin deficits). The twin deficits can produce real and negative effects on the economy via currency depreciation (perhaps), reduced imports, or reduced capital flows.

Ultimately, the price tag is unknown. In the second quarter, the U.S. government deficit (net government saving) was $706.9 billion at an annual rate. Without crafty accounting procedures on the part of the Congressional Budget Office, the fiscal year 2009 would have certainly start off with an upwards-of $1 trillion annual deficit. However, the expenditures will be listed on balance net-of expected gains, resulting in a more-normal (these days) $400-$500 billion expected annual deficit.

Good luck U.S.A. – we will need it!

Rebecca Wilder

1 comment:

  1. Interesting - interest and management fees costs. Inflation will have to be factored into this equation, too, for the number of years the bailout will cover. Someone said, "under the mattress is looking a better option all the time." AND the market fell off again today AFTER the vote and Presidential signature. Thanks for the indepth analysis of this way-to-many-page bill. aj

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