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A close look at emergency economic act of 2008
By Xin Lian
Updated: 2008-10-14 11:34

Since last month, the American financial market has fallen into great turmoil. Fannie Mae and Freddie Mac were taken over by the government. Merrill Lynch was acquired by Bank of America. Lehman Brothers filed for bankruptcy. AIG was nationalized. Washington Mutual went bust. The credit market was clogged. All point to the worst financial crisis since the Great Depression.

To relieve fears and restore confidence, the Treasury released a Troubled Asset Relief Program (TARP) on September 20 to stabilize the market and unleash liquidity. Blessed by the Bush Administration, the program was forwarded to the Congress. TARP was expected to be used to purchase distressed subprime assets from financial institutions with USD 700 billion of public funds. It also gave the necessary authorization and flexibility powers to the Treasury. By preventing the crisis from spilling over, stabilizing the market, and boosting market sentiment, the plan would unclog the credit market and promote growth. It was officially titled the Emergency Economic Act of 2008 during congress debates and will be voted upon on Sept. 29th.

Knock-on mechanism of TARP TARP is based on investor confidence as the key to a functioning market where financial institutions, households and businesses have access to lifeline credit.

As an institutional innovation, TARP employs a long-term market transaction simulating model to amortize bailout cost. This helps to revamp confidence with minimal cost. The rationale of the model is that, with the drying up of short-term liquidity and widespread scares, mortgage securities and other financial instruments may be undervalued. Therefore, it’s a good deal for the government to acquire these assets at the current price. The cost will not be incorporated into the budgetary deficit. When the market rallies, the government will sell the holdings and compensate for the bailout cost with the profits taken in. This is similar to China’s special treasury bonds.

According to TARP, Congress will allow the government to borrow more. This mechanism, based on a trade-off for all stake holders, seeks to strip toxic assets from financial institutions, shore up the market, and ensure benefit to the government and the market. The federal discount facility will enable banks to turn their quality ABCP into liquidity, while distressed MBS can be sold to the government. The bifurcate approach will sort out balance sheets, improve transparency, and restore confidence, thus getting the market back on track. When the financial system resumes normal operation and households are able to repay their liabilities, the price of mortgage-related assets will rise, turning the bailout package into a profitable investment.

History shows that government bailout doesn’t necessarily lead to an enduring fiscal burden. To counter the 1991 financial crisis, Sweden set up an asset management company with an investment of SEK 65 billion, 4% of its GDP. When the crisis was over, the company sold its assets, collecting sufficient proceeds to recoup the input.

The principle of TARP is to seek a balance between the long term interest of tax payers, represented by the Treasury, and the short term quest for stronger confidence in the financial market. Its effectiveness and efficiency hinge on the following factors:

（A）Scope of applicability Most holders of distressed assets are leading investment banks or commercial banks. They are blamed for the crisis, which also takes a toll on smaller banks, pension funds and community banks. If the bailout is only applicable to the heavyweights, the political risk would be high. Therefore, the Treasury will expand the scope of applicability. However, if the relief package is made available to non-commercial enterprises or households, its effectiveness will be undermined.

（B）Asset rating and pricing This proves a technical trick for the authorities. If the government buys the distressed assets at par, it will be interpreted as a special favor for the banks. And the total cost will make the bill unaffordable. At the other extreme, if the assets are acquired at the prevailing discount, bankers may well pack up and go home, sending confidence to a new low. Therefore, a balanced price, presumably around the price at maturity, is crucial to confidence and normal operation of the financial institutions. Different banks have different troubles, including liquidity shortages and insolvency. The quality of distressed assets varies. So it’s imperative to rate and value assets before setting prices. The government may either make discretionary offers or hold reverse auctions with the price-at-maturity as a benchmark.

（C）Trading tools In assets deals, TARP needs to take care of shareholders’ interests. If the government, by holding warranties or preference shares, has too much presence, the interest of the current investors will be watered down. That outlook would force shareholders to withdraw investment, dealing more blows to the stock market. However, if the government presence is minimal, the bill can’t get clearance with the Congress. The percentage of government holding will, to a large extent, determine how the bailout program is received by the banks and by the stock market. The latest draft awards the Treasury discretion to formulate a warranty scheme.

（D）Discretion and flexibility TARP calls for expertise in asset rating, pricing, and trading. Detailed solutions will not be finalized until the program is implemented. Therefore, it must be executed by officials with Wall Street insight. Mr. Paulson, the treasury secretary, should be given sufficient authorization and flexibility in this process, and Congress will oversee principle issues and guard against abuses. Pressure for implementers to take full responsibility will prevail..

（E）Scale of bailout The magnitude of the crisis indicates that potential loss in the MBS market may be hundreds of billions of dollars. To work out, the bailout must be of a matching scale. But it can be implemented in phases as what matters is the message it conveys.

Result of the compromise

On September 28, leading congressmen from the Republican and Democratic parties compromised within the framework of TARP and renamed it the Emergency Economic Act of 2008. The new plan aims to revitalize the economy by buoying the financial sector. The new title highlights the purpose, making it easier to create a common ground. Compared to the original plan, the new one takes a more balanced approach through the following amendments:

（1）Taxpayer protection Pressed by Democrats and liberal Republicans, the new plan provides that the Treasury, on behalf of taxpayers, have the right to hold warranties and preference shares of the bailed out companies. This ensures that taxpayers will benefit from any future growth these companies may experience. But it’s to the discretion of the Treasury whether to exercise the right and, if it does, how much stake to hold. If the beneficiaries go bankrupt, investment by the Treasury is warranted. However, such a warranty is not practical in case of bank collapse. It is just a gesture to appease taxpayers. The new plan will review its bottom line in 5 years. Any loss will be covered by the participants of the relief program. Moreover, the Treasury may introduce an insurance scheme for the distressed assets. These proposals will increase the cost of banks selling to the Treasury. But enough room is reserved to maneuver.

（2）Trading tools The bailout is now applicable to pension schemes, assets held by local government, and community banks that serve mid-income and low-income households, but remains unavailable to non-financial sectors and households. The scope of applicability is reasonable and balanced, raising the odds of a successful bailout.

（3）Authorization to suspend mark-to-market accounting Since the outbreak of the crisis last year, American regulators have insisted on fair-value accounting, leading to rising on-balance-sheet loss and draining liquidity. Although it now appears to be mistaken, it’s very difficult and morally risky to revise the accounting standard. With the Congress’ authorization, the government can breathe a sigh of relief. The suspension can reduce mark-to-market loss, thus improving the balance sheets of the financial sector. But it may give incentives for indiscreet valuing, making accounting data less reliable. A blurred picture of corporate health will only make investors less confident. It’s too early to tell the influence of the deregulatory move on liquidity and confidence.

（4）Enhanced oversight on funds and greater transparency The new plan will establish an oversight board, composed of the Fed chairman, SEC chairman, presidents of federal mortgage institutions, and the Secretary of Housing and Urban Development. The board will ensure compliance with principles and stay out of field operation.

（5）Tighter regulation and limits on executive compensation The new plan imposes limits on the remuneration of executives of the bailed out companies. It requires that unearned bonuses, a result of tampered profit or exaggerated projection, be returned. As the government turns into a potential shareholder and business model of the financial sector changes, the days of lavish windfall are gone.

（6）Phased implementation The new plan will release USD 700 billion in 3 installments. 250 billion is made available right away. Another 100 billion is to be certified by the President. And the remaining 350 billion will be subject to disapproval by the Congress.

The new plan lives up to market expectation by striking a balance between the parties concerned. It intends to mitigate scare, put an end to the self-sustaining panic selling, restore confidence, and breathe life into the financial market. Despite these short-term benefits, however, it fails to address the structural problems of American economy.

It is no more than a framework. With many trade-offs, the plan has to show more details. Uncertainties abound, including the rating and pricing of distressed assets, the option of trading tools, the speed of implementation, and the attitude of the Congress to the USD 350 billion. Every detail matters. Before all are settled, the turmoil will continue.