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USD: What does TARP mean for FX?

Mon, Sep 29 2008, 16:25 GMT
by Teis Knuthsen

Danske Bank A/S

In this note we consider the details of recent US initiatives to deal with the financial crisis as well as implications for financial markets, including currencies.

It now seems highly likely that the USD 700bn TARP (Troubled Asset Relief Program) will become a reality after weekend negotiations resulted in a deal between US government and Congress. Relative to the original plan, the revised plan includes restrictions on executive pay as well as increased oversight of the Treasury. It also mandates the Treasury to take an equity stake in the companies that benefit from TARP, probably in the form of equity warrants. Somewhat unclear is a plan to reduce foreclosures which was not in the original plan. We expect the overall plan to be presented for a vote in the House on Monday and in the Senate on Wednesday.

What is the impact of TARP?

We see TARP as part of a proposal for a systemic way of dealing with the financial crisis that consists of several different parts.

The first is TARP itself. The main purpose is to provide liquidity to lenders by letting the Treasury buy as much as USD 700bn in mortgage-related assets. The initial, immediate endowment is USD 250bn, which can be raised by USD 100bn following a Presidential report to Congress. The President can then ask for the final USD 350bn, unless Congress votes specifically to withhold the money. TARP will operate through reverse auctions, where a key feature will be to increase transparency on mortgage assets, presumably also allowing external parties to bid. Relative to outstanding mortgage debt, TARP should be big enough to have a meaningful impact (non-GSE mortgage debt is USD 5.6trn with delinquency rates of 5-6% so USD 700bn is indeed a considerable amount). Details on eligible securities under TARP remain patchy, and although the Treasury can probably start buying linear securities straightaway, it may take a while before structured products can be auctioned.

The second is a plan under TARP legislation to allow the Federal Reserve to pay interest on bank reserves held at the Fed immediately rather than from October 2011, which was agreed under the Financial Services Regulatory Relief Act of 2006. By paying interest on reserves, the Fed can establish a floor for interest rates (thus potentially preventing the recent collapse in T-bill rates), and if necessary initiate a quantitative easing of monetary policy to stimulate the economy.

The third is the substantial initiative to support money market mutual funds. Here there are three actions: one consists of non-recourse loans to depository institutions to buy asset-backed commercial papers from money market funds, another lets the Fed buy agency discount notes and the final is the deposit insurance D A N S K E B A N K 2 guarantee to money market funds from the Treasury by way of the Exchange Stabilisation Fund. Money market funds have assets of cUSD 3.4trn and are central to corporate financing.

The fourth is another round of liquidity from the Fed. Recently we have seen the Fed increasing the list of collateral in the primary dealer credit facility and the term security lending facility (TSLF). We have also seen an increase in size and in frequency of the TSLF. And finally, banks have been allowed to move liquidity back and forth to non-bank affiliates.

And the final one is the recent ban on short-selling by the SEC.

The purpose of TARP as well as the other parts is to separate performing from troubled assets, slow financial deleveraging and reduce the risks of not just a systemic run on banks and money market funds, but also reduce the risk of an economic hard-landing. It is not a given that the plan will work. The whole point about transparency and price discovery is a bit vague, and among other things increases the risk of exposing additional bank losses. But it is probably a safe bet that even the first USD 250bn will go a long way in increasing liquidity in mortgage-related debt products these days.

The rescue package is not a general bank bailout, so bank lending is likely to be under pressure for quite a while just as further bank failures can be expected. Neither does the plan address consumer credit or commercial real estate debt.

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Published on  Mon, Sep 29 2008, 16:32 GMT