$700 Billion? So What?

Guaranteeing an asset is equivalent to buying the asset while giving the seller an option to repurchase at the same price. Conversely, buying an asset is equivalent to guaranteeing the asset while retaining an option to purchase at the guarantee price. (The proof is left as an exercise for the reader.)

When Secretary Paulson first proposed the TARP, it was a plan to buy $700 billion worth of assets from banks. Some valid criticisms were made – for example, that the program would do nothing to help recapitalize banks unless the Treasury deliberately overpaid for the assets. But the criticism that seemed to resonate most with the general public was that taxpayers would be “spending” $700 billion (a huge amount even compared to the already historically large budget deficit) to “bail out” the banks.

Suppose instead that Secretary Paulson had proposed guaranteeing $700 billion dollars worth of bank assets – at some appraised value – in exchange for call options on those assets. That’s equivalent to what he actually proposed, but it might have been met with considerably less hostility.

The FDIC already guarantees several trillion dollars worth of deposits (depositors’ assets), at face value, in exchange for a small insurance premium. Guaranteeing a mere $700 billion worth of assets, at a more realistic appraised value that takes into account the probability of default (analogous to the probability of bank failure in the case of deposits), in exchange for a rather valuable call option that will pay off handsomely if the default rate is less than expected (an option which could presumably be sold on the open market, though it may be more valuable to the government, with its large capacity to absorb risks, than to private owners)? That hardly seems like a big deal, and it doesn’t seem to involve any “expense” of taxpayer money – at least not in the short run.

There is, of course, a risk to the taxpayers, just as there already was for the FDIC. The theoretical worst case scenario for the TARP – a loss of $700 billion – is not nearly as bad as the theoretical worst case scenario for the FDIC – an obligatory public bailout costing several trillion dollars.

One may, of course, have valid criticisms for this “equivalent TARP” (“Troubled Assets Guarantee Sytem” maybe – “TAGS”) – the same as the valid criticisms of the actual TARP. Again, the TAGS does nothing to recapitalize banks unless the appraisals are deliberately inflated.

But if the problem – as Secretary Paulson originally seemed to maintain – was just liquidity, then the TAGS would solve it. Assets guaranteed directly by the Treasury are almost as good collateral as direct liabilities of the Treasury, so banks – even suspect banks – would be able to borrow against the guaranteed assets at reasonable interest rates whenever they needed money. They might run out of collateral, but in that case, the bank must have been undercapitalized in the first place.

There are a lot of details to be worked out. For example, what would the TAGS guarantee? Resale value? Reovery value? And how much time has to pass before the guarantee applies? And if an asset is sold, does the call option attach to the asset, or is the original bank on the hook for the option? And so on and so forth. The whole exercise is academic, since Congress has now passed a different version of the TARP. I just wanted to make the point that the TARP was not (and is not) as big a deal as the $700 billion figure makes it sound.