TARP Repay : what does it mean for the banks?

Tense negotiations over the value of warrants held by the Treasury Department could prevent some of the biggest U.S. banks from fully shaking off government ownership after they repay billions of dollars in bailout funds in coming days. Some big banks, including JPMorgan Chase & Co, are wrangling with officials over the warrants they want to buy back from Treasury, which the government owns in addition to the banks' preferred stock.

The banks argue they should get a discount on the warrants because they did not want the money in the first place. The issue puts Treasury in the tough position of wanting to give the banks a fair deal while not shortchanging taxpayers, who financed the industry rescue plan at a time when the sector was extremely shaky. The standoff means the warrants may remain in government hands for a while longer -- leaving the banks ensnared within a Treasury Department tentacle.

"There would be a huge political issue with pricing the warrants below what the market would pay," said Douglas Elliott, a former JPMorgan investment banker now with the Brookings Institution, a Washington think tank. Jamie Dimon, chief executive of JPMorgan -- which has taken $25 billion in federal funds and has chafed under the government's influence -- said earlier this week that the United States should cancel 50 percent of the warrants "out of fairness." Dimon has said the largest banks were strong-armed into taking bailout funds last October and should not continue to be punished.

The Federal Reserve will name next week the first batch of big banks given the green light to repay funds from the $700 billion Troubled Asset Relief Program. Repayment involves buying back the preferred stock the banks issued to the government, as well as the warrants. The warrants come with a total price tag of almost $4 billion for eight of the largest U.S. banks seen as contenders to soon repay the TARP funds, some estimates show, with JPMorgan's warrants making up $1.5 billion of that total.

Once the banks bought back their preferred stock they would be free of many of the restrictions attached to TARP money, including limits on executive pay, according to legislative language recently approved by Congress. But until the banks bought back the warrants, the government would still have an interest in them. It would be "a very realistic scenario" that some banks could repay TARP for the preferred stock while still negotiating warrant buybacks, said Scott Talbott, an executive with the Financial Services Roundtable. "Until the warrants are repurchased, the government still has an ownership stake in the banks," Talbott said, raising concerns that the rules of the rescue program could be changed again.

A FAIR DEAL

Valuing the government-held warrants is an inexact science because there is no directly comparable market price. Fed Chairman Ben Bernanke on Wednesday highlighted the challenge, telling lawmakers that banks would have the option of buying back their own warrants before Treasury could publicly auction them. That means banks could negotiate with Treasury on the price because a market price is not clear, resulting in low-ball offers from banks.

But Bernanke said the government has a responsibility to honor its obligation to taxpayers. "The point of the warrants was that as things turned around and got better, that the public would share in some of that gain, and I would say that TARP has been pretty successful in terms of stabilizing the banks," Bernanke said. Herb Allison, the nominee to head the financial bailout program, told lawmakers on Thursday that Treasury is looking at valuation and will announce its policy "before too long."

The issue of fair valuation has already resulted in one dust-up. Old National Bancorp, a small bank based in Evansville, Indiana, recently bought back its warrants for $1.2 million, when other estimates had indicated the warrants were worth as much as five times that amount. Since then, lawmakers have urged Treasury to make deals that get taxpayers maximum value for their investments.

Linus Wilson, a finance professor at the University of Louisiana at Lafayette, said the banks got a "massive subsidy" through the capital infusions, which were good deals at the time, whether they asked for the money or not. The private negotiation process tends to reward banks that low-ball the value of their warrants, Wilson said, but public scrutiny for fair prices could balance that concern. "Treasury should be taking a very hard line in these negotiations," Wilson said.

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Bernanke's big deal for India

The massive liquidity infusion by the Federal Reserve, say its critics, has left the US economy awash with cash. So much so that when economic activity revives, the Fed won’t be able to mop up the surplus liquidity quickly enough and the US will have very high inflation, which it will dutifully export to the rest of the world. How true is this view? Let’s just say the jury is still out on this one.

Research by Michael R Rosenberg, a former head of fixed-income and foreign-exchange research at Merrill Lynch and Deutsche Bank, helps to put the challenge before Federal Reserve chairman Ben Bernanke in perspective. In an analysis on financial conditions for financial-information provider Bloomberg, Rosenberg has broken down the US investment-grade credit spread — the difference in yields on Aaa-rated and Baa-rated bonds — into two parts.

The first component, which he calls the “liquidity-risk premium”, is the excess yield demanded by investors to hold between Aaa-rated corporate bonds rather than US treasuries. The second component, which corresponds with what Rosenberg terms as the “default-risk premium”, is the additional reward investors want in order to hold Baa-rated bonds instead of those that are adjudged to be Aaa.

The liquidity-risk premium in the US hit a low of 62 basis points in June 2007. Then, as the mortgage crisis began unfolding, the premium started to climb up, hitting a high of almost 300 basis points in mid-March this year. After the Fed began buying treasuries directly from the government — a policy known as “quantitative easing” — the liquidity risk premium fell steadily.

It stands at 200 basis points now. By historical standards, liquidity in the US bond markets is still fetching a substantial premium. But the rate at which the Aaa-treasury spread is falling does seem to indicate that return to ‘normal’ premiums for liquidity may not be far.This does bolster a case for the Fed to start drawing up an exit plan.

However, one must also consider the default-risk premium, which is where the story gets interesting because the excess yields that investors are currently demanding for holding Baa bonds — rather than Aaa bonds — is still at an elevated level and trending lower painfully slowly.Bernanke has a vexing problem. If he withdraws liquidity too soon, the default-risk premium — which is currently at 217 basis points, compared with the average of just 85 basis points between 2004 and 2007 — could once again start rising toward the post-Lehman high of 350 basis points. And that might throw the US economy into the vortex of a deep depression.

But if Bernanke prints a few more trillion dollars in crisp new dollar bills to force down the default-risk premium, then there’s a good chance that he’ll end up proving his critics right.One of the staunchest critics of Fed’s policies is investor Jim Rogers, who sounded deeply pessimistic about both US bonds and currency in an interview he gave me in Mumbai this week.

“I can’t understand why I am one of the few people who see this. Either I’m nuts, or they’re nuts,” said the chairman of Singapore-based Rogers Holdings. “You have huge amount of money being printed at a time when the supplies of everything are under duress — the inventories of food are the lowest they’ve been in decades; nobody can get to open a mine. This is the perfect scenario for higher prices and long-term inflation.”

Bernanke doesn’t buy this argument. In his testimony to the House Budget Committee this week, the Fed chairman said that he foresaw inflation to remain low. “The slack in resource utilisation remains sizeable, and notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued,” he said.

“As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008. That said, improving economic conditions and stable inflation expectations should limit further declines in inflation.”What makes this debate very relevant to us in India is that we need to import both commodities and capital from the rest of the world.

We would be hurt if oil went back up above $100 a barrel; we would suffer a great deal more from a premature withdrawal of US liquidity, especially if that were to lead to yet another spike in investors’ perception of default risk in the world’s biggest economy.It’s instructive to see how the liquidity-risk premium shot up in India following the collapse of Lehman Brothers and the attendant jump in the default risk in the United States.

The spread between Aaa-rated corporate bonds and Indian government bonds tripled to 420 basis points in just about a month. The liquidity shock has since then eased considerably: the Aaa spread is down to a little more than 200 basis points. But unlike in the US, the liquidity-risk premium in India has stopped falling. Domestic liquidity may get squeezed if finance minister Pranab Mukherjee decides to use the budget to ramp up government spending in a big way.

As Nobel-winning economist Paul Krugman has been pointing out, the risk that Obama administration’s big-spending ways will “crowd out” the private sector is minimal. Obama’s fiscal expansion is simply allowing excess household savings to get absorbed in the absence of private credit demand even at near-zero interest rates.Our situation is different.

“With every percentage-point increase in the fiscal deficit, maintaining adequate liquidity in the system becomes that much more difficult,” RBI governor Duvvuri Subbarao said at the Economic Times Financial Management Seminar last month.Bernanke’s final choice will matter tremendously for equity investors in the Indian market.

If the Fed chairman elects to ignore the inflation risk, the commodity producers that make up almost 30% of the sensex ought to continue to do well. But if Bernanke moves in quickly to withdraw liquidity, the worsening US unemployment outlook and the consequent increase in the default-risk premium may stamp out the worldwide equity rally.

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'Buy gold. It'll only rise from here'

James Turk, founder and chairman of GoldMoney, firmly believes gold will rise to over $1,000 per ounce in the next month or two, and stay above $1,000 for the rest of the year (that could mean over Rs 18,000 in India).James Turk, founder and chairman of GoldMoney, firmly believes gold will rise to over $1,000 per ounce in the next month or two.

It may stay above $1,000 forever if the Federal Reserve ends up printing dollars to fund the borrowing the US government is planning for this year, Turk, co-author of the investment bestseller The Collapse of the Dollar, told DNA. Excerpts:Investors across the world now seem to be taking refuge in US government treasuries. Is that a safe thing to do?No, for several reasons. First, interest rates on long-term paper in the US are starting to rise, so the price of government T-notes and T-bonds will likely fall from here.

More worrying though is the risk of a US default.The US government owes over $110 trillion, when aggregating all of its commitments. It is very over-indebted, and the price of default insurance is rising because the market perceives a growing risk of default.

Also, it is likely the US government will need to borrow $2.5 trillion this year because its revenues will decline as the economy weakens and it's spending rises as a result of the weakening economy, which brings up another worrying point. The Federal Reserve will need to monetise much of this debt, which will further debase the dollar and cause more inflation.

The only solution the US government seems to have for all the financial troubles is borrowing more and throwing them at the problems. It also wants its citizens to borrow more...It is not going to work. Too much debt is the problem. We had the boom, and now we are getting the inevitable bust. Because debt is the problem, it is impossible for more debt to also be the solution.

The US government is terribly misguided. Fortunately, people know better. They have therefore cut back on spending and increased savings in order to help prepare for the tough times the US - and indeed, much of the world - is facing in the months ahead.What will be the repercussions of the planned fiscal stimulus and all the dollars that are being printed?

The most important repercussion will be that the price of gold will continue to climb. That is always the result when governments create currency out of thin air in order to give to politicians the money they want to spend.The prevailing feeling among a lot of experts right now is that the US dollar and US treasuries are the biggest prevailing bubbles...Yes, the US dollar is the biggest bubble, and US government debt instruments are the second-biggest bubble.

People do things during a bubble that are not prudent. That reality unfortunately only appears after the fact - after the bubble has popped. The gold price is rising because of increased demand from people looking for a safe haven to protect themselves when these two bubbles pop, which I think may happen as soon as this year or possibly next year.

Can you visualise a catalysing event that will lead to the outright capitulation of the US dollar?It's impossible to predict. It could be another major bank failure in the US. It could be when the Federal Reserve becomes the biggest buyer of US T-bonds. It could be when China or other trade surplus countries stop accumulating dollars and start spending them instead.

The event causing the tipping point cannot be predicted, but once the tipping point is reached, history shows that the currency has less than a year before it totally collapses.How soon do you see the world moving away from the US dollar as the reserve currency?The world has been moving away from the dollar for years. In the 1960s, nearly 90% of world trade was conducted in dollars.

Today it's about 55%. People are looking for alternative currencies, and I expect gold to emerge in the future in its traditional role as international money - in other words, the money that is used for global trade.So, investing in gold is the right decision to make right now?Gold is not an investment. It is money. Gold doesn't generate a rate of return like investments do.

The price of gold is rising against all the world's currencies because currencies are losing purchasing power, while gold is preserving purchasing power. For example, one barrel of crude oil today costs about 2 goldgrams, which is the same it cost 50 years ago. So always calculate prices in terms of gold in order to see how badly currencies are being inflated by central banks.

What price do you see gold rising to over the next one year, three years and five years?I believe that gold will rise to over $1,000 per ounce sometime during the next month or two, and then stay above $1,000 for the rest of the year. It may stay above $1,000 forever if the Federal Reserve ends up printing dollars to fund the borrowing the US government is planning for this year.

Within five years, gold will go much higher. It depends on how badly the Federal Reserve and US government debase the dollar. Remember, it is not that gold is going up; rather, it is that the dollar is going down because it is purchasing less and less because of inflation and other debasement.

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