Recapitalizing the banking system via $700bn bailout
Global Investment House – Kuwait - Recapitalizing the banking system via $700bn bailout- Owing to systemic banking crisis in US, there is a need to recapitalize the financial system to avoid an excessive and destructive credit contraction. Recapitalization via the use of public resources can be via purchase of bad loans/assets, government injection of preferred shares, government injection of common shares, government purchase of subordinated debt, government issuance of government bonds to be placed on the bank’s balance sheet, government injection of cash and government credit lines extended to banks.
The $700bn Troubled Assets Relief Program is the Treasury’s plan to solve the 2 principal problems in the banking system:
1. Capital destruction tied to declining asset quality and a lack of demand of risk assets.
2. Drying up of liquidity during the crisis, as a lack of transparency in banks exposure to risk assets and asymmetric information regarding the extent of the exposure have led to a lack of trust in the interbank lending system.
Impact of the TARP program
- The impact of the TARP program can be analyzed through two lenses; one is to deal with the general economics of the plan and the other in the actual execution of financial institutions and instruments.
The economic effects on execution of $700bn bailout plan
- Improvement of economic capital by raising the valuations of risky mortgage assets above their distressed-pricing levels.
- Transferring the multifaceted assets from private sector to public sector balance sheet.
- It should improve interbank lending by increasing balance sheet transparency and taking complex assets off the balance sheet.
Impact on the regional banks
The regional banks can be treated as solvent and insolvent banks, the insolvent banks can be taken over by the FDIC (Federal Deposit Insurance Corporation), and the FDIC will either hold onto the assets, if the deposit base is strong, it might enclose the assets with the deposit liabilities to be sold off immediately.
For the solvent regional banks, the strategy will be different the TARP will buy the whole loans outright netting off the accounting losses.
The combination of FDIC takeovers and TARP purchases address the capital and liquidity problems. We believe an immediate actual recovery of credit flows is more problematic until home prices turnaround.
Effect on Yield Curve
The execution of TARP program will increase the treasury supply, thus we anticipate a sell-off in the treasury curve. A $700bn TARP purchases and $125bn takeovers will affect the yield curve of short-term treasury instruments, but we believe the actual effect will be on the gross purchases of TARP issuances.
Sentiments towards execution of bailout plan
We expect that TARP $700bn bailout plan is necessary, since anything smaller than that will lead to extremely disappointing to the financial markets. If the size of the issue is smaller or if it is broken down in tranches it will lead to Congressional approval and delay in relief plan.
Stimulus plan
US effectively has come out with a $700bn bailout plan to buy Troubled Assets and $125bn FDIC takeovers will have some respite on any excessive destruction on credit contraction.
Zero Interest Rate Scenario
US currently has cut the interest rates to 1% from 5.75%, a reduction of 475bps in no time, the Fed has done in order to support the financial system and curb excessive credit contraction and slump in real estate. The fed can cut the interest rates to zero, it can use this tool in the future and have a zero interest rate in US as was the case in Japan, this is a clear measure to pro-long the recession.
Also over and above the current bailout plan the government is ready to pump in additional funds to stimulate the growth of the economy.
Sources to financing $700bn
US Government plans to borrow the money from world financial markets. The legislation under which the scheme was passed, gives the Treasury the authority to issue an additional $700bn worth of Treasury securities.
G-20 outcome of meeting on 15th November 2008- “Promises with meager Action”
Leaders from the biggest developed and emerging nations agreed to further steps to shore up global economy sliding into recession, and laid out regulatory proposals to prevent a recurrence of the financial crisis. The G-20 urged “broader policy response”, mentioning the potential for additional interest rate cuts and fiscal stimulus.
Key Areas of focus
- Interest rate cuts and government spending should be used to restore economic growth.
- The group recommended on strengthening accounting standards, derivatives markets and vigilance on hedge funds and debt rating companies.
- Better disclosure to market participants of the characteristics of credit default swaps and other complex derivatives.
- Improving transparency and the underlying infrastructure of the over-the-counter credit derivatives market, in order to reduce out of control risks.
- The need for enhanced supervision of the credit ratings agencies.
- Heads of state agreed to put in place registration requirements for the ratings agencies across the globe as now in US.
Other Economies follows US Economic Stimulus plan
As the US economy started facing severe defaults and credit contraction and many of the big banks and other financial institutions started reporting write-offs, it was clear that US was in recession.
China announces economic stimulus plan of $586bn
China announced a bailout package of $586bn to withstand the financial crisis, the Chinese president Mr.Hu Jintao said that this plan will help to boost the confidence at home. The largest stimulus plan in China's history calls for new housing, roads, railways and airports, plus rebuilding areas devastated by the May 12 earthquake.
The stimulus plan will help China to drive its spending in infrastructure and benefit many companies to expand their wings globally. This in turn will help in consumer spending and should sustain the growth momentum.
Concerns: There are growing concerns that China's stimulus package will primarily fuel more investment in construction and infrastructure, rather than putting money into the pockets of consumers. Chinese consumer demand could be crucial to easing the global economic slowdown, yet the plan fails to do much to boost consumption. This package is only useful to the extent that it boosts real demand, especially if it boosts household demand, but that doesn't seem to be in the cards.
