The Real Use of TARP Funds and why the Banks' Earnings are so GOOD!

The Real Trade Behind Re-Liquidating Balance Sheets (or where the TARP money is being deployed)

For the last year there have been substantial write-downs among all of the major financial institutions due to “toxic assets.” The premise behind the TARP (and various other alphabet soup programs) has been to ease the toxic assets off the books, or provide the financial institutions with the ability to remain properly capitalized and loan money to businesses. It is interesting that in today’s WSJ “TARP Cash Isn’t Moving Forward.” Where is it going?

GS, JPM, WFC et al are all reporting surprising earnings. Even in early March when the equity markets turned the CEOs of BAC, C, and JPM were promoting the story that they were making money and that times were not so dire for them. What did they know? They knew that the economy was continuing to get worse, asset values in real-estate, commodities, and other hard assets were continuing to deteriorate. They also knew that they were getting large sums of money from the government, easy access to the Fed window; trial balloons had been floated regarding “quantitative easing,” and “unconventional easing.” The Fed can only lower the interest rate so far, i.e. zero, but they can create an environment where by expanding the Fed balance sheet the effective rate drops below zero. It has been forecast that in order to make the policy appropriately easy that the “Taylor Rule” funds rate need to be at -8%, which would mean the Fed balance sheet would need to expand by as much as $10 trillion. The Fed expands their balance sheet by purchasing Treasuries of varying maturity.

This unconventional easing creates the opportunity for banks to releverage in the Treasury mark and arbitrage the spread by purchasing 5yr, 7yr, and 10yr Treasury Notes at yields ranging as high as 2.75%. As a straight cash trade this would be a good use of the TARP money; $5 Billion would earn $137.5 million over the course of a year. But this is where the creative folks of Wall Street earn their keep, they decide to purchase the 10 yr. Treasury for example on margin and finance the transaction in the over night / term repo market at 25 bps (.25%). This results in a positive carry of 2.50%. Now a large financial institution such as C, GS, MS, BAC could possibly leverage this transaction 50:1, 100:1, and 200:1. In this example let’s take the more conservative number of 50:1; this means for every $1 Billion in 10 yr. notes they buy at a yield of 2.75% they need put up (in repo terms this is called a “haircut) 2% or $20 Million. In theory every $1 Billion in TARP money that goes into this trade, the banks could purchase $50 Billion in 10 year US Treasury notes. This trade creates a positive carry of 250 bps (2.50%) (Yield-cost to carry) or $1.25 billion in income over the course of a year by leveraging just $1 Billion. Not a bad ROI. So for every $5 Billion ($250 Billion in T-Notes) of TARP money in this trade, the banks create $6.25 Billion; not a bad way to reliquidate the balance sheet.

The risk in this trade is substantial, and is similar to what creating the mess in the first place. Using margin through the Repo market means that if the Treasury Notes were to move against the trade by more than 2%, the trade would wipe out the TARP money; and moves above that threshold would eat into the banks’ capital once again. The risk is mitigated by the Feds unconventional easing through the purchase of Treasury Notes along the yield spectrum. If they sense the market is moving against the banks, they print more money and buy more bonds keeping prices at a steady level. If the Fed really wanted to create liquidity on the balance sheet of the banks they could drive the prices of the 10 yr Note up (lower yield) by 3pts; prices would go from 100 to 103 (yields would drop by approx. 30 bps to 2.45%. This would be the turbo-charged version of Fed helping the banks; the carry would result in $6.25 Billion per year, but the principal increase would result in a profit of $7.5 Billion; that’s a total profit of $13.75 Billion over a 1 year period on $5 Billion in TARP money. Perhaps it is becoming clearer why the banks are not lending, their return is far better in the Fed’s arena.

How can one know if this is really taking place? Let’s look at one of the major Wall Street bank’s recent 8 K filed this week. The average daily VaR (Value at risk jumped from 197 in the previous quarter to 240 with the increase in the interest rate sector going from 178 to 218. This means the bank believes it could lose $240 million in a day based on its risk model. This same bank showed total revenues from Trading and principal investments and Interest Income of $10 Billion, with interest expense of $2.4 Billion. This bank in particular has had the use of $10 Billion in TARP funds.

This trade and solution to build back banks’ balance sheets in very creative on the part of the Fed and the Treasury, for there is no way to fill the black hole of toxic assets by just taking them off the balance sheets, the hole can be filled by creating fresh $s to replace the losses. How long might this take? How long might this trade go on?

There is risk in the trade. Can the government through its unconventional easing support the prices in the Treasury Note market? The ultimate risks also involves the U.S. Tax payer for the positive carry that exists in the trade increase the amount of the Budget deficit over time. Effectively the leverage works in favor of the banks and Wall Street by creating a special trade where they are given money (TARP) for a trade, then allowed financing the trade with the Fed for next to nothing, and having the Fed support the prices of securities they are leveraging by expanding the Fed balance sheet. In other words, I give you a $1, you buy $50 of government debt and finance it with a positive carry of 2.50% for one year, and the government basically guarantees to buy the paper back at the price you paid or better (maybe they want to make you feel even better). At the end of one year your $1 has become $2.25 if the government just buys the debt back at what you paid. But let’s say the paper improves in price and yield drops (for everyone wants in on this trade) by 30bps; the government buys the paper you purchased at $1 ($50 total) for $1.03 ($51.50) your $1 has now become $3.75. I like this trade! So do the banks with your money! What could go wrong? The Fed may not be able to keep prices at current levels by expanding their balance sheet (ultimately our children’s debt), and at some point in time when everyone has the trade in place and it needs to be unwound there will be too many rushing for the exit. Look at what happened with the Yen carry trade and how it kept the value up as everyone looked to unwind.

Meanwhile this creative liquidity could bode well for all of the financial stocks for some period. This could super charge all of the markets.

Ben