TARP SHMARP

Having spent some time burrowing into the details of the $250 billion capital injection into the banking system, I've come to the conclusion that this is a much better alternative than buying $700 billion in crappy mortgages from institutions and either holding them until they mature at zero or selling them to PIMCO (Bill Gross seemed a bit too excited about that plan.)  So the new version of the TARP is an equity infusion rather than a huge debt puke bucket.  Assuming that the banks leverage the equity 10 to 1 (and they have been sternly instructed to deploy the capital,) this amounts to $2.5 trillion in additional liquidity that has been created out of thin air.  Sort of.  The Treasury still has to finance this venture, but given how dire the situation has grown overseas (see Iceland's 77% stock market plunge the day after trading resumed after a 3 day halt), the United States can comfortably maintain its status as a safe haven for the world, a very very screwed up world.

The capital injections will take the form of senior preferred shares that will pay a 5% dividend for the first 5 years and 9% thereafter.  The Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the senior preferred investment.  The exercise price on the warrants will be the market price of the institution's common stock at the time of issuance, calculated on a 20-trading day trailing average.  Common shareholders will experience some dilution from the warrants and earnings will be negatively affected by the new dividend obligation that will be paid out before earnings are distributed to the common.  Surprisingly, the government did not insist that banks stop paying their common dividends.  I suppose Mr. Paulson thought that investors owning bank stocks for the past two weeks had suffered enough and he'd let them keep their measly dividends.  This deal is extremely similar to the ones that Warren Buffett struck with GE and GS two weeks ago, except Mr. Buffett got much better terms.  While the government is earning 5% and getting 15% in warrants, Mr. Buffett is earning 10% and receiving 100% of his investment in warrants.  Anyone who doesn't want Mr. Buffett as the next Treasury Secretary is a fool.

To ensure that the Treasury's equity investments are protected, the FDIC will provide a three-year 100% guarantee on newly issued senior unsecured debt for banks and financial holding companies.  Firms will need to issue the new debt before June 30,2009.  Covered debt is not allowed to exceed 125% of a company's debt outstanding as of September 30 that was scheduled to mature before Jun 30th of next year.  Firms would pay an annualized fee of 75 basis point for the guarantee.  I'm certain that 75 basis points is a small price to pay when financial company debt has been trading at crazy-wide spreads to Treasuries of late (see Morgan Stanley's CDS,  which finally came in 400 bps today).  I suspect that the first money-making scheme that banks will engage in is to buy back their old debt that is trading at a discount, retire it, and reissue new debt with a guarantee.  They can book a nice profit in the meantime assuming that the arb hasn't disappeared yet.  They can also pay themselves investment banking fees.  So the cycle resumes. 

The FDIC is extending deposit insurance on non-interest bearing transaction deposit accounts to alleviate panicked depositors.  Furthermore, the Fed is expanding its commercial-paper funding program which is set to begin on October 27th.  Both of these actions should help restore confidence and liquidity to the market.

All in all, I believe that these bold plans will unglue the credit markets and borrowing and lending should return to a more reasonable pace.  Unfortunately this plan will not stop further pain in the residential and commercial real estate markets as real estate values are certain to continue to decline.  The residential market suffers from too much inventory, while the commercial real estate market faces increasing defaults as more short-term loans that were originally underwritten with lax standards come due and banks begin to demand more equity capital from developers.  I don't even want to get into what a debacle the US auto and airline industries are in, only to say that if you are patriotic in the least and still have a job, go buy a car and take a trip.  We are most certainly already in a recession.  But I think I can finally say with relative assurance that the worst really is over.