Troubled Asset Relief Program - Money Essay Example
Troubled Asset Relief Program
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The Troubled Asset Relief Program (TARP) was created as a part of the Emergency Economic Stabilization Act of 2008. The goal of this Act is to restore liquidity and stability to the United States financial system. The TARP program gives the US Secretary of the Treasury authority to buy up to 700 billion dollars worth of troubled assets, such as mortgaged-backed securities, that are weighing down financial institutions’ balance sheets. Supporters of the TARP say that this will free up the frozen credit markets and prevent bank failures. However, there are many critics who argue that it will take us far from our laissez-faire economic philosophy and bring about more economic uncertainty due to increasing government stakes in those financial institutions.
The paper aims at analyzing the global economic crisis and various causalities. It will also examine the TARP and programs similar to the TARP, such as the Reconstruction Finance Corporation from the 1930s, and the Swedish experience of the early 90s. It will also analyze the British approach in mitigating the effects of the crisis. The paper will focus on comparing such historic programs to the TARP and their results. This research may be used to analyze different possibilities and present the most probable outcome.
The global economic crisis is the biggest threat which is facing most economies today. This crisis has caused the collapse of many firms across the world and has made very many people lose their jobs. It started in the United States and has gradually spread to many countries in all continents. The major reason for the global crisis is the predatory lending practices by banks, fraud, poor accounting systems, excess lending and taking of unnecessary risks. Many mortgage firms engaged in predatory lending practices in order to make higher profits, but this instead led to their downfall. Firms such as Lehman brothers which have been operational for over a century were among the first casualties of the mortgage crisis. Other factors such as excess lending and fraud have also contributed to the financial crisis which is being experienced in the United States.
The United States government has taken various steps in efforts to mitigate the effects of the crisis. One of the major initiatives taken include the troubled Asset Relief Program, and this is a program which is aimed at injecting capital into firms which perform poorly in a bid to stimulate the flow of credit. This program will be analyzed in detail in the paper and compared to other approaches which have been used both in the present and in the past. In order to understand this issue clearly, it is important to analyze the global economic crisis and its causalities.
The mortgage crisis has adversely affected the credit market in the United States, and it began between 2005 and 2006. This crisis has led to the collapse of major mortgage lenders such as Lehman Brothers, which was the fifth largest mortgage firm in US, after operating for more than a century. The mortgage crisis has been caused by many factors, but the key factors attributed to the crisis is the predatory lending practices by mortgage firms and the use of inferior accounting systems.
Mortgage firms usually analyze the probability of borrowers to repay funds granted to them through the calculation of a credit rating. This is a scale which is constructed using the characteristics of previous borrowers and predicts the probability of customers to repay loans. Through the observation of past repayment trends, the mortgage firms can compare the characteristics of present borrowers against past borrowers and predict their probability to pay back loans. After the calculation of these scales, the banks rate the clients as low risk or high risk, according to their observations.
In this case, the mortgage firms intentionally targeted high risk customers, and these are the customers who had high probabilities of defaulting on payments. They did this in order to benefit from the collateral which they would repossess once the borrowers defaulted on payments. However, the number of borrowers who defaulted was so high that the collateral seized lost value due to its enormity. These firms should have realized that the value of the collateral and assets held was falling and made the necessary adjustments, but this was not the case due to the inferior financial system used, which will be explained below.
The financial system used by most US firms is the GAAP system of accounting. This refers to the Generally Acceptable Accounting Principles and is sets the standards which are used to present accounting information. However, this system of accounting faces certain weaknesses which contributed to the collapse of mortgage firms in the United States. This accounting system values assets according to the historical cost and ignores changes in the asset values. As a result of the use of this system, when the asset values decreased, the mortgage firms were not aware, and they did not take adequate steps to cushion themselves from the fall. By the time the mortgage firms realized that assets and collateral held was below the historical price, it was too late to make any significant changes. This led to the disposal of the assets at very low values and huge losses by the mortgage firms.
This is a part of the global financial crisis which is currently facing the United States. It has been explained that the global economic crisis was caused by the excess lending and risk taking by mortgage lenders and other financial institutions. Mortgage lenders disregarded the risk policies of banks and issued sub-prime mortgages which targeted people who had high chances of defaulting. The banks also issued very high levels of credit without having adequate security to cover the loans, since the assets held had fallen in value. These are the two major factors which have led to the credit crisis.
After the credit lenders undertook these unethical practices, many people defaulted on their loans. This was due to the reason that the sub prime mortgages had targeted people who were not able to pay back. Due to the high number of defaulters, the assets fell in value. The accounting system which was being used at the time disregarded changes in the asset values and mortgage firms incurred losses on assets held. Soon after, large mortgage firms such as Lehman Brothers collapsed and this increased the uncertainty in the mortgage market.
Gradually, inter bank lending rates rose, and banks were skeptical about issuing credit amongst themselves and to customers. The banks and customers adopted an approach which involved saving money as opposed to investing or lending. This marked the beginning of the credit crisis, and this problem is currently being experienced in many economies across the world. Credit opportunities have become scarce, and the available ones have very high interest rates, a factor which limits the growth and expansion prospects of firms.
The financial crisis facing the United States is a complex issue which has been caused by a variety of factors, some of which include excessive borrowing, fraud, sub-prime loans and other factors.
Fraud and mismanagement.
There has been an increase in the number of US firms which have collapsed in the recent past as a result of fraud and mismanagement. In fact, in late 2008, Bernard Madoff implemented the largest fraud scheme ever committed by an individual in history. He managed to cause the loss of over $40 billion dollars from various firms and investors through the implementation of a ponzi scheme. A ponzi scheme is a type of scheme which ‘guarantees’ extremely high returns in a very short period of time. However, these schemes do not pay returns on investment from profits like ordinary businesses, but they pay them from deposits which are given by subsequent investors. Bernard Madoff successfully perpetuated this fraud until he was arrested in December 2008, after he was unable to honor payments to many investors who had sought to pull out from his investment schemes due to the mortgage crisis. Other firms which collapsed such as Lehman Brothers are also associated with fraud involving financial analysts and investment bankers. The investment bankers allegedly gave favors to the financial analysts to present the financial state of their firms in good light even though this was not the case. This case is currently under investigation by the FBI.
Excess lending and high risks.
When the housing bubble began in 2005, the government ensured that there were low interest rates in order to attract investments. This led to massive investment by both local and foreign investors in the US financial market, especially in the property industry. As a result, the value of the mortgage held in 2006 was $11.2 trillion. The financial lenders began engaging in high risk lending, and with time, the market reached its peak and began falling. The interest rates subsequently began increasing and many borrowers defaulted on payments which eventually led to loss of confidence in the financial market. The share prices began falling and investors panicked and started selling their shares at very low prices. As a result, the financial markets plunged very deep.
Response to the financial crisis.
Passage of the 2008 Emergency Economic Stabilization Act.
This Act was passed in October 2008 as a means of controlling the crisis facing the US financial sector. It was passed in order to empower the US Treasury to spend funds on injecting capital into banks and purchasing distressed assets. The bailout involves both domestic and foreign banks and it was meant to restore confidence in the financial markets as well as reduce uncertainty pertaining to the existing assets.
The effect of the bailout plan has been met with mixed reactions from various experts. Some argue that it will gradually help the economy, but others are of the opinion that this bailout will not give the economy the boost it needs. The international community supports the passing of the bill and see it as a means of restoring the confidence in markets. The supporters of this plan explain that by injecting capital into banks, this will provide them with funds to improve their capital base and issue new loans to the market. This will serve to restore the market confidence and will gradually revive the performance of financial markets.
As has been stated, there are some experts who are opposed to the bailout plan due to various reasons. Most critics are of the view that there are no proper plans in place to use these funds, which increases the probability of their misuse. They see this as a ‘knee jerk’ reaction to the crisis without adequate plans, which may increase the budget deficits since these are huge amounts of money involved. This view is shared by many people, and polls taken among the public have consistently showed low support for the plan. Others view the $700 billion bailout plan as too little to revive the economy which has suffered losses amounting to trillions of dollars. Finally, other critics are of the opinion that since the US financial problems were caused by excess debt and credit, injecting more debt and credit only serves to worsen the crisis. They further explain that by injecting more debt and credit into the economy without viable means of creating money, then this serves to create more debt and credit to the economy.
Troubled asset relief program (TARP).
This is a program which is undertaken by the United States government to mitigate the effects of the global financial crisis. It involves the purchase of equity and assets from financial institutions and it aims at strengthening the financial sector. This is the largest strategy which is being used by the United States government to control the effects of the mortgage crisis. TARP gives the Treasury authority to insure or purchase troubled assets to a tune of $700 billion. It is important to describe what troubled assets are in order to understand this issue clearly. Troubled assets are commercial or residential mortgages, financial obligations or securities which were issued before or on March 2008, which promote the financial stability of the United States, according to the view of the Secretary.
Troubled assets can also be defined as financial instruments which are viewed to financial market stability according to the secretary, after consulting Federal Reserve System Board of Governors. However, in the latter case, this determination has to be in writing. Troubled assets can be said to be difficult to value, non-liquid assets from financial institutions including banks. These assets include debt obligations which are collateralized, and were sold in booming markets prior to the widespread foreclosure on loans in 2007.
It is important to note that TARP does not aim to assist banks recoup already incurred losses, but it stabilizes them in order to encourage trading and increase their value. This leads to gains to both Treasury and the bank, and this mitigates the losses which were previously made by the banks.
This Act demands that financial institutions which intend to use the TARP program to sell assets to issue senior, equity debt securities, or equity warrants to the Treasury. When the financial institutions issue warrants, they are required to be non-voting shares in order to prevent Treasury from profiting at the expense of tax payers through the new ownership stake. This is necessary since if the objective of TARP is achieved and the financial institutions recover through the government assistance, the government will also recover in the process.
TARP aims at purchasing these assets to improve their liquidity and allow financial institutions to make their balance sheets more stable in order to minimize further losses. TARP also has an objective of encouraging banks to go back to lending businesses and customers at similar levels which were present before occurrence of the conflict. This can be achieved through stabilizing capital ratios in banks and stimulating them to lend cash as opposed to hoarding it. The increased lending is expected to restore confidence by customers in financial markets and institutions. When this is achieved, inter-bank interests rates will fall, leading to increased lending.
This strategy is likely to be successful since it is similar to the Reconstruction Finance Corporation strategy which was used during 1930, which proved to be successful. However, additional measures should be incorporated into this strategy, and these will be discussed at the end of the paper.
The TARP program is set to operate in a revolving manner. Treasury has an operating limit in the initial phases of the program and the amount set is $250 billion. This amount will be used to purchase assets and hold them to collect coupons or sell them. The funds which will be received from the coupons and sale will be injected back into the pool and will be used to purchase more assets for holding or sale. However, this sum can be increased to $350 billion if the president is able to convince Congress that it is necessary to increase the allocation for the objectives of the program to be achieved. The remainder of the money, which is $350 billion can be released only after Treasury writes a report to Congress and explains how it plans to spend the funds. After Congress approves the plan, the funds are released within 15 days.
Treasury approved the purchase of warrants and stocks in nine of the largest banks in America. There was a certain criteria which was set in order for the institutions to gain from the allocations and they are explained as follows; The first criteria was to ensure that compensation for senior executives did not encourage excessive and unnecessary risks which could negatively affect the value of the financial institution. The second was that there should be a claw back of any incentive compensation or bonus which is received by senior executives if it can be proved that the claim is materially inaccurate. The third was that the financial institutions are barred from making golden parachute payments on the basis of the Internal Revenue Code to senior officials. Finally, the banks were prohibited form withdrawing funds which exceed $500,000 to pay senior executives for tax purposes.
The Reconstruction Finance Corporation
This was an independent agency for the government of the United States and was created in 1932 during Herbert Hoover’s administration. It was created to tackle the Great Depression and was modeled in a similar way to the War Finance Corporation. The primary goals of this corporation was to restore confidence and provide liquidity to the banking system. This was as a result of the Great depression where banks collapsed after customers pulled out money from them due to fear that they might fail. This was a serious problem since during this time the federal deposit insurance had not yet been established and failure of banks led to loss of deposits by depositors.
The Reconstruction Finance Corporation was formed during the beginning of February 1932 after legislation was passed by Congress allowing formation of the same. Initially, the corporation was supposed to run for a ten year duration, but subsequent clauses required the approval by the president for the corporation to run beyond the current year. For the corporation to run beyond a time frame of two years from when it was approved, it needed the support of Congress. However, in the course of its life, further legislation added additional authorities and responsibilities as well as extended its life.
The objectives of the RFC were divided into time frames, and the first thirteen months were dedicated to provision of loans to financial institutions. However, the objectives and scope of this corporation was expanded during the second world war. The corporation funded or purchased eight corporations which greatly contributed to economic stability during the war.
This agency used $2 billion to help local and state governments as well as various businesses which included railroads, banks and others. Initially, the objective of the corporation was to assist banks but railroads were also included since most of them were owned by banks, and also because most of them had declined in value. This was also attributed to the reasoning that recovery of the railroads would lead to the increase in value of bonds. This was in turn expected to improve financial position of the banks which held the bonds.
It was an effective way of mitigating the effects of the Great Depression and nearly all loans which were taken were repaid. This agency dispersed $1.5 billion, $1.8 billion and $1.8 billion in 1932, 1933 and 1934 respectively. After 1934, the amount disbursed was reduced to about $350 million annually. Between 1932 and 1941 the total amount disbursed was $9.465 billion. After the war, the Reconstruction Finance Corporation was curtailed its activities to provision of loans to businesses. In 1953, the lending practices ceased and the assets which were being held at this time were transferred to other agencies of the government.
This is a similar approach to the one which is being currently used in the United States through the Reconstruction Finance Corporation program. Both approaches required consent from Congress and involved the provision of funds to financial institutions in order to improve their balance sheets and increase the credit flow. Since it was highly successful, it is likely that the current economic bailout plan will also work since the causes of the two problems are similar.
The Swedish experience.
Sweden faced severe financial crisis in between the 1980s and 1990s. The banking industry faced a crisis which threatened it and necessitated the intervention by the Swedish central bank to prevent its collapse. Although the crisis which faced it is different to the one facing US, it presents useful insights which can be applied to the United States economy to mitigate adverse effects which are attributed to the global economic crisis.
The major problem which faced the Swedish banking system was attributed to the effects of liberalizing the banking system. Initially, the insurance companies and banks had limitations in lending. These financial institutions faced certain requirements such as investing in bonds issued by mortgage institutions and the government. The strict controls made the financial institutions face weaknesses in managing risk on their own, without supervision. When the sector was deregulated, the inexperience in handling risk was a major contributor to the decline in the banking industry. After a boom in the 1990s, the real estate expanded. However, after reaching the peak, commercial occupancy rates began falling and stock prices in the construction and real estate sectors began falling. Gradually, the effect of the reduction of stock prices affected financial firms and they began collapsing.
The Swedish strategy involved the separation of good assets from the bad ones. The good assets were handed to banks to oversee, while the bad ones were managed by a separate agency. Each bank which faced financial difficulties was divided into two entities; one with its bad assets and the other with its good assets. The bad assets were managed by assets management companies which, although owned by the government, had financial and political independence. The non performing loans were assessed and rescued whenever possible. These asset managers restored values of troubled firms through injection of equity. They took over the troubled firms and run them until when it was possible to liquidate them. They were then sold through thee major ways which included corporate transactions, individual property transactions and public offerings.
These interventions ensured that the Swedish economy rebounded at a very low cost. There are four major lessons which can be learnt form the Swedish experience and the first is that the process must be transparent. The second lesson is that the agency which is resolving the financial problems should be financially and politically independent. The third lesson is that in order to successfully reverse negative effects on the financial system, there should be discipline at all levels. Finally, the fourth lesson is that a plan should be developed to stimulate flow of credit to the economy.
Britain is also facing the global economic crisis which has spread to most countries of the world. It is facing a similar challenges to the United States’ and is adopting similar measures. However, the magnitude of the problem in Britain has not reached the United States’ levels. British banks have not collapsed yet, but they face lending drought and a reduction in the amount of credit available. If left unchecked, the situation may get out of hand and result in the same consequences which are facing the US economy.
Britain has similarly offered a bailout plan which is worth GBP50 billion in order to stimulate the flow of credit. This involves partial nationalization of banks, and it was revealed after the decline in share prices of some of the largest British banks. Britain plans to offer short term liquidity in order to stimulate the flow of credit by banks. These funds are meant to help banks sustain their medium term plans. However, this strategy is viewed by many people as bound to fail since it is insufficient to solve the financial problems if used on its own. They advocate for cuts in interest rates which will encourage borrowing and stimulate flow of credit to the business.
This strategy cannot be effective in the US since the problems which are being faced are slightly different. The financial woes facing the United States are at advanced stages, unlike in Britain where the symptoms of financial meltdown are beginning to appear. Many banks in US have already collapsed, which makes it ineffective to give them short term liquidity to stimulate credit flow.
Conclusion and recommendations.
According to the models which have been analyzed, the current strategy which is being used by the United States is likely to achieve the desired results if implemented efficiently. This is because a similar strategy which was used during the 1930s worked very well in stimulating the economy. However, for the system to work efficiently, some aspects should be borrowed from the Swedish strategy. The government or asset managers should concentrate on the non-performing loans, while leaving the good assets to the bank to operate. The problematic assets should be the ones managed by the asset managers, and this should be done through injecting capital which will help improve their performance. Once they can be liquidated, they should be sold and the funds realized used to improve the performance of more firms.
This approach should be carried out by an institution and individuals who are financially and politically independent. The current bailout plan in the US is facing criticism due to the perception that the people who are implementing the plan are not neutral. Most of them have been managers of the firms which have previously collapsed and they are viewed not only to be ineffective, but they are also likely to conceal any mistakes which led to the collapse of these firms.
The US firms are currently shifting to the IFRS accounting system which uses the most accurate and valid information in determining assets prices. They should move with speed to embrace this accounting system due to the benefits it possesses. This accounting system classifies information on asset prices according to its importance and ranks information from the financial markets as the most important. Information from sources which cannot be confirmed is ranked is ranked as the least important. When firms use this system, they will be able to tell when asset prices rise or fall, and will make adjustments to reflect the same. This will prevent a repeat of the mortgage crisis which saw the collapse of many mortgage firms.
The financial regulators also have a crucial role to play as far as controlling the effects of the global crisis and preventing the situation from occurring in future. These regulators should discourage predatory lending practices and should intervene when the rate of borrowing is so high that it threatens economic stability of the United States. This can be achieved through the use of monetary policies by the central bank to discourage lending practices. They also have a duty to investigate financial firms operating in the market with a view to detecting any firms which are involved in fraud or any other unethical practices. This will prevent the loss of investments by different stakeholders, as was witnessed in the Bernie Madoff Ponzi scheme.
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 Butkiewicz, James L. “Reconstruction Finance Corporation,” EH.Net Encyclopedia edited by Robert Whaples, July 20, 2002. Available: <http://eh.net/encyclopedia/article/butkiewicz.finance.corp.reconstruction>.
 Calomiris, Charles & Joseph R. Mason. How to Restructure Failed Banking Systems: Lessons from the U.S. in the 1930’s and Japan in the 1990’s, National Bureau of Economic Research, 2003, p 43-47.
 Butkiewicz, James L., “The Reconstruction Finance Corporation, the Gold Standard, and the Banking Panic of 1933,” Southern Economic Journal, June 1999, 66, 271-93.
 Mason, Joseph R., “Do Lender of Last Resort Policies Matter? The Effects of Reconstruction Finance Corporation Assistance to Banks During the Great Depression,” Journal of Financial Services Research, 2001, 20, 77-95
 The National Archives. “Records of the Reconstruction Finance Corporation.”
“Section by Section Analysis of Legislation,” House Financial Services Committee, February 8, 2009 Available: <http://financialservices.house.gov/EESABill_section-by-section.pdf>.
 Holmlund, Bertil & Storrie, Donald, “Temporary Work in Turbulent Times: The Swedish Experience.” Economic Journal, 2002, 112, F245-69.
 Englund, Peter. “The Swedish Banking Crisis: Roots and Consequences.” Oxford Review of Economic Policy, 1999, 15, 80-97.
 Ergungor, O. E., “On the Resolution of Financial Crises: The Swedish Experience.” Federal Reserve Bank of Clevland, June 2007, Available: <http://www.clevelandfed.org/research/POLICYDIS/pdp21.pdf>.
 Fox News, “Raw Data: List of Banks Receiving Funds From $700B TARP,” February 5, 2009.
 “Emergency Economic Stabilization Act of 2008,” Encyclopedia Britannica,
http://search.eb.com/eb/article-9471256, February 9, 2009
 Lohr, Steve, “Intervention Is Bold, but Has a Basis in History.” The New York Times October 14, 2008, Available: <http://www.nytimes.com/2008/10/14/business/economy/14nationalize.html>.