What it means
TARP was created by the Emergency Economic Stabilization Act of 2008, which authorised up to $700 billion of purchases. The limit was later reduced to $475 billion by financial reform legislation in 2010, and the programme stopped making new commitments after that.
The original plan was to buy troubled assets, such as mortgage-backed securities that had lost value, from banks. The Treasury soon changed course and used most of the money to buy preferred shares and warrants in banks, so that the banks had more capital to absorb losses and keep lending.
Other parts of TARP supported insurers, car makers and their finance arms, and programmes to help homeowners avoid foreclosure. Each part had different terms, and the results varied.
Some firms repaid in full with a profit to the government, while others, including parts of the housing and auto efforts, cost taxpayers money. In the main bank programme, the Treasury bought preferred shares that paid a dividend of 5% for the first five years and 9% afterwards, which encouraged banks to repay early.
It also received warrants, which are rights to buy common shares later at a set price, so taxpayers could share in any recovery. TARP is studied today as a case of emergency policy.
Supporters credit it with preventing a deeper collapse, while critics point to moral hazard, the idea that rescuing firms encourages risk-taking, and to the perception that the rescue favoured large institutions over households. The programme also changed bank regulation.
Regulators began to run stress tests, which are exercises that check whether banks could survive a severe downturn, and required banks to hold more and better quality capital.
In practice
Real-world examples.
Example
A regional bank with $15,000,000,000 of assets sells $300,000,000 of preferred shares to the Treasury. It uses the money to protect its capital ratios and keeps lending to local businesses through the downturn.
Example
A bank's finance team calculates the cost of the programme's 5% dividend against its alternative funding costs. It decides to repay early, since the 9% step-up after five years would make the money expensive.
Example
A business school professor uses the programme in a case on moral hazard. Students debate whether the rescue prevented a worse crisis or encouraged future risk-taking by large institutions. They also compare the terms with those of a normal loan, noting that the government took shares and warrants rather than only charging interest.
Formula
Calculation
Annual preferred dividend = Investment amount x Dividend rate
Warrant value = Investment amount x 15% (the share of the investment covered by warrants in the main bank programme)
The Treasury invests $200,000,000 in a bank's preferred shares. In the first five years the dividend is 5%, so the bank pays 200,000,000 x 0.05 = $10,000,000 a year. After year five the rate rises to 9%, so the payment would be 200,000,000 x 0.09 = $18,000,000 a year.
The Treasury also receives warrants worth 15% of the investment, which is 200,000,000 x 0.15 = $30,000,000 of shares purchasable at a fixed price. Over five years the dividends alone total 10,000,000 x 5 = $50,000,000, before any gain on the warrants.Case study
Seen in the real world.
Cobalt Harbour Bank is an illustrative, fictional lender that held large mortgage-related assets as house prices fell. Its capital ratio dropped close to the regulatory minimum, and customers began to withdraw uninsured deposits.
The bank sold $500,000,000 of preferred shares to the government under a rescue programme. The 5% dividend cost $25,000,000 a year, but the capital allowed the bank to keep lending and to reassure depositors.
Four years later the bank raised new capital from private investors and repaid the government in full, which ended the dividend burden and the restrictions that came with the rescue. The illustrative lesson is that rescue capital can be costly, so the bank's board treated early repayment as a priority, and the government earned dividends and a gain on its warrants.
Watch out
Common mistakes.
- Assuming TARP was a gift to banks, when most of the bank money was an investment in preferred shares that was repaid with dividends.
- Thinking the whole $700 billion was spent, when the final commitments were far lower.
- Believing TARP only bought toxic assets, when most of it went into capital for banks and other targeted support.
Questions
People also ask.
Did TARP lose money?
Overall the programme recorded a net cost, mostly from the housing and auto efforts and support for an insurer, while most bank investments were repaid at a profit.
Who ran TARP?
It was run by the US Treasury, with a special inspector general appointed to oversee it and report regularly to lawmakers on how the money was used.
What are warrants in this context?
They are rights to buy a company's shares later at a fixed price, which gave taxpayers a share in the recovery.
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