Saturday, November 1, 2008

Emergency Economic Stabilization act of 2008 - The US Bailout Package

The Emergency Economic Stabilization Act of 2008 commonly referred to as a bailout of the U.S. financial system, is a law authorizing the United States Secretary of the Treasury to spend up to US$700 billion to purchase distressed assets, especially mortgage-backed securities, from the nation's banks. The Act was proposed by U.S. President George W. Bush and Treasury Secretary Henry Paulson during the global financial crisis of September-October 2008.

The purpose of the plan was to purchase bad assets, reduce uncertainty regarding the worth of the remaining assets, and restore confidence in the credit markets.

When the Bill was initially introduced, it had been rejected by the US Senate on Sep 29th 2008. It was then amended and approved by the US Senate on Oct 3rd 2008. President Bush signed the bill into law within hours of its enactment, creating a $700 billion Troubled Assets Relief Program to purchase failing bank assets..

Proponents of the bailout plan argued that the market intervention called for by the plan was vital to prevent further erosion of confidence in the U.S. credit markets and that failure to act could lead to an economic depression.

Opponents objected to the massive cost of the sudden plan, pointing to polls that showed little support among the public for bailing out Wall Street investment banks, and claimed that better alternatives were not considered and that the Senate only tried to force the passage of the unpopular but sweetened version of the bailout through the opposing House and was successful in this attempt. Opponents of the rescue plan argue that since the problems of the American economy were created by excess credit and debt, a massive infusion of credit and debt into the economy only excaberates the problems with the economy. The bailout infuses credit and debt into the economy because the government is creating the money out of thin air and thus immediately creating more credit and debt.

What Happened Before this Bailout package was announced?

The US Subprime financial crisis, caused a massive void in the country's economy and the liquidity in the markets was affected badly. The US Treasury Secretary Henry Paulson, proposed that the US Treasurey acquire $ 700billion worth of Mortgage Backed Securities. The proposal called for the federal government to buy up to US$700 billion of illiquid mortgage-backed securities with the intent to increase the liquidity of the secondary mortgage markets and reduce potential losses encountered by financial institutions owning the securities.

Mortgage asset purchases

A key part of the proposal is the federal government's plan to buy up to US$700 billion of illiquid mortgage backed securities (MBS) with the intent to increase the liquidity of the secondary mortgage markets and reduce potential losses encountered by financial institutions owning the securities. The draft proposal of the plan was received favorably by investors in the stock market.

This plan can be described as a risky investment, as opposed to an expense. The MBS within the scope of the purchase program have rights to the cash flows from the underlying mortgages. As such, the initial outflow of government funds to purchase the MBS would be offset by ongoing cash inflows represented by the monthly mortgage payments. Further, the government eventually may be able to sell the assets, though whether at a gain or loss will be known only in future.

The Reasons for the Bailout Package:

1. To Stabilize the economy
2. Improve Liquidity
3. Improve Investor Confidence
4. Reduce the impact of the financial crisis on the US Economy and GDP.

Is there a Conflict of interest?

There is concern that the current plan creates a conflict of interest for Paulson. Paulson is a former CEO of Goldman Sachs and Goldman stands to benefit greatly from the bailout. Paulson has hired Goldman executives as advisors and Paulson’s former advisors have joined banks that will also benefit from the bailout. Furthermore, the original proposal exempted Paulson from judicial oversight. Thus there is concern that former illegal activity by a financial institution or its executives might be hidden.

The treasury staff member responsible for administering the bailout funds is Neel Kashkari, a former vice-president at Goldman Sachs.

Because of the above mentioned reasons, a lot of financial experts in the US are not too appreciative of the Bailout package. The public too is not too happy because, they do not want the Tax Payer's money to help out the financial guru's who screwed up the economy because of their greed.

Troubled Assets Relief Program

The program is run by the Treasury's new Office of Financial Stability. This is the name of the program that will be taking care of infusing the much needed stability & liquidity into the markets. The fund will be split into the following administrative units:

1) Mortgage-backed securities purchase program: This team is identifying which troubled assets to purchase, from whom to buy them and which purchase mechanism will best meet the bailout policy objectives.

2) Whole loan purchase program: Regional banks are particularly clogged with whole residential mortgage loans. This team is working with bank regulators to identify which types of loans to purchase first, how to value them, and which purchase mechanism will best meet the bailout policy objectives.

3) Insurance program: We are establishing a program to insure troubled assets. They have several innovative ideas on how to structure this program, including how to insure mortgage-backed securities as well as whole loans.

4) Equity purchase program: They are designing a standardized program to purchase equity in a broad array of financial institutions. As with the other programs, the equity purchase program will be voluntary and designed with attractive terms to encourage participation from healthy institutions. It will also encourage firms to raise new private capital to complement public capital.

5) Home ownership preservation: When the treasury purchases mortgages and mortgage-backed securities, they will look for every opportunity possible to help homeowners.

6) Executive compensation: The law sets out important requirements regarding executive compensation for firms that participate in the TARP. This team is working hard to define the requirements for financial institutions to participate in three possible scenarios: One, an auction purchase of troubled assets; two, a broad equity or direct purchase program; and three, a case of an intervention to prevent the impending failure of a systemically significant institution.

7) Compliance: The law establishes important oversight and compliance structures, including establishing an Oversight Board, on-site participation of the General Accounting Office and the creation of a Special Inspector General, with thorough reporting requirements. We welcome this oversight and have a team focused on making sure we get it right.

TARP participation restrictions

Companies that sell their bad assets to the government must provide warrants so that taxpayers will benefit from future growth of the companies. The President is to submit a law to cover taxpayer losses on the fund, using "a small, broad-based fee on all financial institutions." In order to participate in the bailout program, "companies will lose certain tax benefits and, in some cases, must limit executive pay. The fund has an Oversight Board so that the U.S. Treasury cannot act in an arbitrary manner. There is also an inspector general to protect against waste, fraud and abuse.

1 comment:

  1. The conflicts you mention were kind of expected. There is little expertise in the area, and what there is seems to be compromised by ties to the recipients of the bailout.

    And there is more.

    I'm not really persuaded that it's okay for banks and other powerhouses getting federal funds to spend millions on inappropriate activities because it's separate from the bailout. Tax money is freeing up their limited funds, so it still comes back on us.

    AIG really gets me mad and I'm not alone.


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