It sounds like a lot of money and by any measure it is a lot of money. The US Troubled Asset Relief Program (TARP) proposes to spend $700bn of US tax payers money to effectively buy asset backed securities (mortgage or otherwise) that banks can’t get off their balance sheet. Whether that is “enough” depends on what you want it to be enough for. The concern expressed by Congress, as they voted the plan down last night, is that it would amount to an expensive bailout of Wall St without any meaningful impact on the broader economy.

It’s a complicated business and one that isn’t well understood. Yet to try and understand whether the TARP will be enough we have to understand what the problem actually is. So bear with me. Very basically, the issue is the huge amount of toxic assets that banks, investment funds and the like hold on their balance sheets. These assets are typically investments in mortgage related debt and other loans that were securitised by banks (or pooled to then resell into the secondary market). Now the problem is that a lot of these products were created at a time when interest rates were historically low. So the price paid for them didn’t reflect an accurate assessment of the risks (of default) associated for these assets. As interest rates went up, people and firms began to default, and so the value of these assets plummeted, and it became very difficult to sort the wheat from the chaff, as it were. So a lot of institutions found their asset base being eroded and profits being hit. To try and stymie that process, it was necessary for these institutions to “deleverage” – or pay down debts and lift their asset base by hoarding cash. They had to do this or face a big hit to shareholder equity.

As companies tried to shore up balance sheets with cash, money became more expensive and hard to find. It was bid up in price so that today, relative to official cash rate expectations, the price of money is at a record. This is why central banks around the world have been pumping money into the system – to ensure that there is sufficient money for companies to rebuild their balance assets without halting broader bank lending activities, essential for a well functioning economy. It’s not all big business that borrows money from banks. If coffee shops can’t borrow money to buy that coffee machine, a builder, that block of land or a manufacturer for that bit of equipment, eventually economic activity freezes up.

Just how much of these assets are floating around? The US Securities Industry and Financial Markets Association estimates that there is just under $8 trillion in mortgage related debt outstanding and another $2.6 trillion in other asset backed securities. So $700bn sounds like a lot of money and by any measure it is a lot of money. But it’s not even 10% of the underlying problem. $700bn might be enough to protect the solvency of a limited number of firms, and it will hopefully prevent the lending markets shutting down completely. But it can’t stop the process of deleveraging and that’s the key.

$700bn won’t increase investor appetite for asset backed securities given the real economic recession is yet to come – the uncertainty over solvency will consequently linger. This isn’t just about mortgages but other asset backed securities. In that context $700bn can’t forestall the looming recession.

Peter Fray

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