Page 2 of 3 China needs a vigorous income policy
By Henry C K Liu
This is the first part of a series.
In the case of warrants, the Treasury will only receive warrants for non-voting shares, or will agree not to vote the stock. This measure is designed to protect taxpayers by giving the Treasury the possibility of profiting through its new ownership stakes in these institutions. Ideally, if the financial institutions benefit from government assistance and recover their normal financial strength, the government will also be able to profit from their financial recovery.
Another important goal of TARP is to encourage banks to resume lending again at levels seen before the 2008 crisis, both to each
other and to consumers and businesses. If TARP can stabilize bank capital ratios, it should theoretically allow them to increase lending instead of hoarding cash to cushion against future unforeseen losses from troubled assets.
Increased lending equates to "loosening" of credit, which the government hopes will restore order to the financial markets and improve investor confidence in financial institutions and the markets. As banks gain increased lending confidence, the interbank lending interest rates (the rates at which the banks lend to each other on a short term basis) should decrease, further facilitating lending.
TARP was to operate as a "revolving purchase facility". The Treasury will have a set spending limit, $250 billion at the start of the program, with which it will purchase the assets and then either sell them or hold the assets and collect the coupons. The money received from sales and coupons will go back into the pool, facilitating the purchase of more assets. The initial $250 billion can be increased to $350 billion upon the president's certification to congress that such an increase is necessary. The remaining $350 billion may be released to the Treasury upon a written report to Congress from the Treasury with details of its plan for the money. Congress then has 15 days to vote to disapprove the increase before the money will be automatically released.
The first $350 billion was released on October 3, 2008, and congress voted to approve the release of the second $350 billion on January 15, 2009.
One way that TARP money is being spent is to support the "Making Homes Affordable" plan, which was implemented on March 4, 2009, using TARP money by the Department of Treasury. Because "at risk" mortgages are defined as "troubled assets" under TARP, the Treasury has the power to implement the plan. Generally, it provides refinancing for mortgages held by mortgage guarantors Fannie Mae or Freddie Mac. Privately held mortgages will be eligible for other incentives, including a favorable loan modification for five years.
The authority of the US Department of the Treasury to establish and manage TARP under a newly created Office of Financial Stability became law on October 3, 2008, the result of an initial proposal that ultimately was passed by Congress as H.R. 1424, enacting the Emergency Economic Stabilization Act of 2008 and several other acts.
The Fed announced in 2008 that under TALF, the Federal Reserve Bank of New York (NY Fed) would lent up to $1 trillion (originally planned to be $200 billion) on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. As TALF money did not originate from the Treasury, the program did not require congressional approval to disburse funds, but a new act of Congress forced the Fed to reveal how it actually spent the money.
The Fed explained the reasoning behind the TALF as follows:
New issuance of ABS declined precipitously in September and came to a halt in October. At the same time, interest rate spreads on AAA-rated tranches of ABS soared to levels well outside the range of historical experience, reflecting unusually high risk premiums. The ABS markets historically have funded a substantial share of consumer credit and SBA-guaranteed small business loans. Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of US economic activity. The TALF is designed to increase credit availability and support economic activity by facilitating renewed issuance of consumer and small business ABS at more normal interest rate spreads.
According to the plan, the NY Fed would spend up to $200 billion in loans to spur the market in securities backed by payments from loans to small business and consumers. Yet, the program closed after only funding the purchase of $43 billion in distress loans.
Under TALF, the Fed lent $1 trillion to banks and hedge funds at nearly interest-free rates. Because the money came from the Fed and not the Treasury, there was no congressional oversight of how the funds were disbursed, until an act of congress forced the Fed to open its books. Congressional staffers then examined more than 21,000 transactions. One study estimated that the subsidy rate on the TALF's $12.1 billion of loans to buy Commercial Mortgage-Backed Securities (CMBS) was 34%.
Collateral assets accepted by TARP include dollar-denominated cash ABS with a long-term credit rating in the highest investment-grade rating category from two or more major "nationally recognized statistical rating organizations (NRSROs)" and do not have a long-term credit rating below the highest investment-grade rating category from a major NRSRO. Synthetic ABS (credit-default swaps on ABS) do not qualify as eligible collateral. The program was launched on March 3, 2009.
Special Purpose Vehicle - financial neutron bomb
TALF money was designed not to go directly to targeted small businesses and consumers, but to the institutional issuers of asset-backed securities (ABS). The NY Fed would take the securities as collateral for more loans to the issuers of ABS. To manage the TALF loans, the NY Fed created a Special Purpose Vehicle (SPV) that would buy the assets securing the TALF loans. The function of a SPV is to isolate risk from the creator, in this case the NY Fed, as a device to hide debt from the balance sheet of the creator. In the case of TALF, the SPV creator is ultimately the NY Fed's parent, the Federal Reserve, the nation's lender of last resort to banks.
SPVs are financial neutron bombs, the equivalent of real bombs made for use in war to kill an enemy population without causing damage to physical assets, thus saving reconstruction time and cost in captured enemy territories. A neutron bomb is a fission-fusion thermonuclear weapon (hydrogen bomb) in which the burst of neutrons generated by a fusion reaction is intentionally allowed to escape from the weapon, rather than being absorbed by its containing components. The weapon's X-ray mirrors and radiation case, normally made of uranium or lead in a standard bomb, are instead made of chromium or nickel so that the neutrons can escape to kill enemy troops and civilians, leaving empty undamaged cities for occupation by the winner in a battle.
The Fed's plan for eventual wind-down of its financial bailout and economic stimulus measures by selling in the open market some of its vast holdings of mortgage backed securities and Treasuries when the economy recovers faces the possibility of massive losses which could force the central bank to suspend annual payments of its profit to the Treasury for the first time since the 1930s.
The Fed is holding some $3 trillion in Treasuries as of February 2013, and is adding about $85 billion a month to keep interested rates low and to provide liquidity to the market in an effort to keep unemployment from rising. In 2012, the Fed contributed $89 billion to the Treasury to reduce a significant portion of the government's borrowing and interest costs. But as the Fed sells its holdings on economic recovery, the Fed must also raise interest rates to combat inflation, which is pushing down the market value of the low-rate securities in its holding, causing significant financial loss.
A Fed analysis published in January 2013 which projects interest rates at 3.8% later in the decade, shows the Fed incurring a record loss of $40 billion which would force it to suspend payment of the Treasury for four years beginning 2017. If interest rate rises another percentage point, the resultant loss would triple. This would put political pressure on the independence of the Fed to set interest rates. Worse yet, if the Fed fails to pull its own weight and becomes an added burden to the public debt, political momentum to abolish the Fed will gain strength.
Central bank uses SPV to hide balance sheet expansion
The Treasury's Troubled Assets Relief Program of the Emergency Economic Stabilization Act of 2008 would finance the first $20 billion of troubled assets purchases by buying distressed debt in the NY Fed's SPV. If more than $20 billion in assets are bought by the SPV through TALF, the NY Fed will lend the additional money to the SPV. Since a loan is treated in accounting as an asset, the NY Fed, by providing the funds to buy distress debt, actually expands it balance sheet positively while its SPV assumes more liability.
SPV used to skirt Basel II capital requirements
In a May 2002, Asia Times Online article, I warned about Special Purpose Vehicles (SPV) five years before the credit crisis broke out in July 2007:
While Third World banks that do not meet BIS capital requirements are frozen from the global interbank funds, BIS rules have been eroded by so-called large, complex banking organizations (LCBOs) in advanced economies through capital arbitrage, which refers to strategies that reduce a bank's regulatory capital requirements without a commensurate reduction in the bank's risk exposures. One example of such arbitrage is the sale, or other shift-off, from the balance sheet, of assets with economic capital allocations below regulatory capital requirements, and the retention of those for which regulatory requirements are less than the economic capital burden.
Aggregate regulatory capital thus ends up being lower than the economic risks require; and although regulatory capital ratios rise, they are in effect merely meaningless statistical artifacts. Risks never disappear; they are always passed on. LCBOs in effect pass their unaccounted-for risks on to the global financial system. Thus the fierce opponents of socialism have become the deft operators in the socialization of risk while retaining profits from such risk socialization in private hands.
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