What is the TARP? And, why does it cost $700 Billion?

The TARP is the Troubled Asset Relief Program which is part of the Emergency Economic Stabilization Act of 2008 which was signed into law last week. These are genereally what people are talking about when they refer to “the bailout plan.”

I have spoken to so many people that are confused by the purpose of the program, what it means to the overall economy, and how the heck we can afford this. I am going to try to give a plain-English explanation to the plan the best I can. Here are the main pats of the plan:

1) $700 Billion Bailout – not really, though

The first thing that confuses most people is that most people are referring to it as a bailout. The term bailout conjures up visions of the Treasury opening up its piggy bank and giving $700 Billion to banks and Wall Street firms to make up for their poor business plans. This is not what is happening

The government is going to purchase assets that are already existing and currently being held by the banks. These assets, mostly mortgage-backed securities (MBS), will be purchased at greatly depressed prices. By owning these MBS, the government will be entitled to the payments being made on these mortgages. So, almost immediately, the government will realize cash inflows as the borrowers make their mortgage payments.

Also, since these assets are illiquid (there is no market to buy and sell these assets so there values have fallen) the government will be buying these assets at greatly depressed values. As the market corrects itself, these assets should increase in value. The government then can sell these assets at a profit.

The purpose of this part of the program is to get these illiquid assets off the balance sheets of the banks in order to free up capital (money) for the banks to use to increse their lending. Also, by purchasing these assets the government will be creating a market for these assets to be bought and sold. As the market is created, and there is more demand for these assets, the value of these assets will increase.

Warren Buffet, the world’s second wealthiest man and one of the most respected investors in the world made a comment that he wished he had the money to do this kind of program himself. He sees a huge potential profit for the government.

2) The government will get equity stakes in the companies that take part in this plan.

In order to further protect the taxpayer, the banks that participate in the program will be required to give the government warrants. These warrants will give the government the right to purchase shares of the company at a certain price at some time in the future. So, as these banks free up capital and are able to operate normally again their values should increase giving the government a potential to make a profit on these warrants.

3) Foreclosure avoidance and homeowner assitance

For the mortgages that are involved in the assets that are aquired by the government, the Treasury department will be required to implement as plan to increase the assistance to the homeowners and to encourage the servicers of these mortgages (the companies that actually collect the monthly payments) to take advantage of the HOPE for Homeowners Program or other programs to minimize foreclosures. Also, the Treasury can offer guarantees or other inducements for the mortgage servicers to modify the terms of the mortgages.

4) Limits on executive compensation

If the Treasury purchases any assets directly from a company, or if they take an equity stake or debt position in the company, the company is restricted from offering compensation incentives that wil encourage their executives from taking risks. The companies are also restricted from making “Golden Parachute” payments to a senior executive and, the companies are given “clawback” premission whereby they can take back any bonuses or incentive pay that has been paid to an executive if it is later found out that the reason for these payments is not true. (e.g. the income or profit of the company turns out to be less than originally thought).

5) FDIC insurance increase

The Federal Deposit Insurance Corporation will increase the amount of deposit insurance from $100,000 to $250,000 through the end of 2009.

Hopefully, this programs helps the credit crunch and mortgage crisis and gets the banks lending again. This is a very important step to helping the housing crisis and the overall health of the economy.