US Treasury Secretary Henry Paulson asserts that the full resources of the
Treasury Department are being used to ensure the success of its US$700 billion
Troubled Assets Relief Program (TARP). The "full resources of the Treasury
Department" commands the full faith and credit of the United States anchored by
Treasury's taxing authority as approved by Congress. Tax payments in the US are
made to the US Treasury via the Internal Revenue Service.
The Congress can approve taxes for and spending by the Administration, but
Congress cannot create money like the Federal Reserve can. The Treasury's money
can only come from
future taxes approved by Congress. Article I - Section 7.1 of the Constitution
stipulates that "All Bills for raising revenue shall originate in the House of
Representatives". The Federal Reserve has the authority to create money as part
of its monetary policy prerogative but the Treasury does not have any
constitutional authority to expand the money supply. The Treasury must depend
on tax revenue for funds beyond which the Treasury must sell sovereign debt to
raise funds up to the national debt ceiling approved by Congress. Section 8.2
stipulates that only Congress has the power to borrow money on the credit of
the United States. Proceeds from sovereign debt are advances on sovereign
liability and not revenue, and must be paid back from future tax revenue.
Thus far, Congress has approved $700 billion of taxpayer funds to be used by
TARP. President George W Bush also signed a $634 billion spending bill on
September 30 that includes funding for $25 billion in low-cost government loans
for the distressed auto industry. More public funds may be approved as needed.
Since the Federal government is and has been operating on a fiscal deficit,
these funds can only come out of future tax revenue and/or more fiscal
deficits.
Also, the Treasury is coming under increasing pressure to expand its financial
rescue plan beyond banks to include direct assistance to the ailing auto and
insurance sectors.
In recent days, lawmakers and interest groups have stepped up their efforts to
persuade the Bush administration to divert part of the $700 billion authorized
by Congress to additional categories of companies that were not originally
expected to be rescued.
TARP gives the Treasury broad authority to buy any assets that are important
for the stability of the US financial system. But participation in the sweeping
$250 billion recapitalization plan has so far been confined to US banks. On
October 24, the Financial Services Roundtable, an influential lobbying group in
Washington, sent a letter to Neel Kashkari, interim assistant Treasury
secretary for financial stability, a former Goldman Sachs banker brought to the
Treasury by Paulson, himself also a former Goldman Sachs banker, urging the
administration to consider taking stakes in "broker-dealers, insurance
companies [such as Ambac and MBIA], and automobile companies [such as GM and
Chrysler]" as well as "institutions controlled by a foreign bank or company"
that play a vital role in the US economy by providing liquidity to the market.
A Treasury department spokeswoman declined to comment on whether the US would
consider expanding the rescue in such a way.
Members of the Michigan congressional delegation also sent a letter to the
Treasury and the Federal Reserve asking them to take steps to "promote
liquidity" in the US auto industry. It is true that cars are not selling
because leasing credit has frozen and collateral debt obligations (CDO) backed
by auto loans. But it is well known the automakers are facing insolvency in the
long run beyond credit problems.
Separately, AIG, the insurer that was rescued last month by the government,
revealed it had already used $72 billion of an $85 billion government loan and
$18 billion of an additional $37.8 billion credit facility from the Fed.
An expansion of the recapitalization plan beyond US banks would mark a
significant new chapter in the government's response to the financial crisis.
TARP's seven policy teams
Ten days after the new $700 billion TARP was signed into law on October 3, the
Treasury announced that it had created seven policy teams to develop several
tools and other important elements that are required under the new law.
1.Mortgage-backed securities purchase program: This team
is identifying which troubled assets to purchase with taxpayer funds, from whom
to buy them and which purchase mechanism will best meet Treasury policy
objectives "to protect taxpayers by making the best use of their money". The
Treasury is designing the detailed auction protocols and will work with vendors
to implement the program.
For more than a year, the market has been unable to identify with clarity
troubled assets, their owners and how such assets can be purchased and at what
price. The uncertainty is real and it has created justified fear of yet unknown
losses in the market. It is not likely that the new team at the Treasury, no
doubt highly capable, can solve this riddle quicker than the market can without
the existence of a central clearing mechanism.
2. Whole loan purchase program: Regional banks are
particularly clogged with whole residential mortgage loans that have not been
securitized and sold to dispersed investors. This team is working with bank
regulators to identify which types of loans to purchase first, how to value
them, and which purchase mechanism will best meet policy objectives "to protect
taxpayers by making the best use of their money". This is not a simple task. It
would involve value judgments and political calculations inherent in the policy
objectives. It is not clear how this program will work more effective than
market forces without distorting market value.
3.Insurance program: The Treasury said it is establishing
a program to insure troubled assets. It has several innovative ideas on how to
structure this program, including how to insure mortgage-backed securities as
well as whole loans. At the same time, it recognizes that there are likely
other good ideas out there that it could benefit from. Accordingly, on Monday,
October 10, the Treasury submitted to the Federal Register a public Request for
Comment to solicit the best ideas on structuring options. The Treasury was
requiring responses within 14 days so it could consider them quickly, and begin
designing the program.
With many insurance companies on the verge of insolvency from rising claims on
counter-party defaults, the Treasury's insurance program on troubled assets
looks like an attempt to insure losses that have already occurred, in violation
of the basic principle of insurance.
4.Equity purchase program: The Treasury is designing a
standardized program to purchase equity in a broad array of financial
institutions. As with the other programs, the equity purchase program will be
voluntary and designed with attractive terms to encourage participation from
healthy institutions. It will also encourage firms to raise new private capital
to complement public capital.
On a voluntary basis, it is a puzzle why healthy institutions would need or
want to sell equity to the Treasury. On Tuesday, October 14, an hour before the
market opened in New York at 9:30 am, Treasury Secretary Paulson, Federal
Reserve chairman Ben Bernanke and Federal Deposit Insurance Corporation (FDIC)
chairwoman Sheila Bair, announced that the government would invest up to $250
billion in preferred stocks, half of it at large banks. They were supported in
the announcement by Securities and Exchange Commission (SEC) chairman
Christopher Cox, Commodity Futures Trading Commission chairman Walter Luken,
Office of controller of Currency Controller John Dugan and Office of Thrift
Supervision chairman John Reich.
The lists of banks participating includes Goldman Sachs Group Inc ($10
billion), Morgan Stanley ($10 billion), JP Morgan Chase ($25 billion), Bank of
America Corp - including the soon to be acquired Merrill Lynch ($25 billion),
Citigroup ($25 billion), Well Fargo ($25 billion), Bank of New York ($3
billion), Mellon ($3 billion) and State Street Corp ($2 billion). These moves
are designed to keep money flowing through the frozen banking system to keep
the economy going.
The government will purchase preferred stocks, an equity investment designed to
avoid hurting existing shareholders and deterring new ones. The preferred
stocks do not have voting rights, and carry a 5% annual dividend that rises to
9% after five years. The government's plan will be structured to encourage
firms to bring in private capital. Firms returning capital to the government by
2009 may get better terms for the government's stake. Financial institutions
will have until mid-November to decide whether they want to participate in the
government recapitalization scheme. The minimum capital injection will be 2% of
risk-weighted assets and the maximum will be 3% of risk-weighted assets, with
an overall cap at $25 billion. Critics are asking why the government is only
getting 5% when Warren Buffet was getting 10% guaranteed dividend in his recent
investment in Goldman Sachs.
The senior preferred shares will qualify as Tier 1 capital and will rank senior
to common stock and pari passu, which is at an equal level in the capital
structure, with existing preferred shares, other than preferred shares which by
their terms rank junior to any other existing preferred shares.
The senior preferred shares will pay a cumulative dividend rate of 5% per annum
for the first five years and will reset to a rate of 9% per annum after year
five. The senior preferred shares will be non-voting, other than class voting
rights on matters that could adversely affect the shares. The senior preferred
shares will be callable at par after three years. Prior to the end of three
years, the senior preferred may be redeemed with the proceeds from a qualifying
equity offering of any Tier 1 perpetual preferred or common stock. The Treasury
may also transfer the senior preferred shares to a third party at any time.
In conjunction with the purchase of senior preferred shares, the Treasury will
receive warrants to purchase common stock with an aggregate market price equal
to 15% of the senior preferred investment. The exercise price on the warrants
will be the market price of the participating institution's common stock at the
time of issuance, calculated on a 20-trading day trailing average.
Executive compensation, including golden parachutes, will be limited at banks
that accept government investments. The Fed will guarantee all senior debt
issued by banks over the next three years.
The FDIC, invoking a "systemic risk" clause in Federal banking law, will
provide unlimited insurance to all non-interest-bearing accounts primarily used
by businesses. The cost of this insurance will come from user fees paid by
banks outside of the $700 billion TARP. It appears that the US has joined the
global race to guarantee bank deposits to prevent US bank deposits from fleeing
to countries with safer guarantee levels. This is billed as a global
coordination of all central banks while in reality is a sign of rising
financial nationalism.
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