What is TARP?

TARP is an anachronism for the Troubled Assets Relief Program. The TARP resulted from legislation enacted by Congress in October 2008, called the Emergency Economic Stabilization Act, or EESA. This law was enacted as an attempt to stabilize ailing financial institutions. Because of the collapse of the real estate market during that time, many banks began to fail in a spiraling economic downturn.

Prior to 2006, the real estate market was booming. So much so that homes were selling for close to double normal market values. Credit was cheap and easy to get, so home prices rose excessively high. In order to continue feeding the demand for housing and increase profits, lenders began to relax lending standards, handing out mortgages to almost anyone, regardless of their ability to pay.

Adjustable Rate Mortgages (ARMS)

tarp

Many of these mortgages were sub-prime loans, meaning their interest rates were lower than the prime rate set by the government. These Adjustable Rate Mortgages, or ARMS, looked good on the surface and were often the only way families could afford the pricey homes at that time. Low interest rates created low initial monthly payments. The problem: these payments skyrocketed three to five years after the loan was initiated. Inevitably, many families could not afford the loan once the rate adjusted. Mortgages began to fail.

At the same time, another stew was brewing in the mix. Many lenders churned out mortgages, reselling them to investors as fast as they could close them. Many perilous loans were bundled together with other healthy and low-risk loans into financial instruments called mortgage-backed securities. Investors who bought these investment vehicles hoped the loans would keep their value while the securities paid dividends based on the revenue generated by the mortgage. This way, investors could reap the benefits of a mortgage without the hassle of servicing customers. Many banks and other investment houses held large shares of these mortgage-backed securities when the dangerous loans began to turn up delinquent.

As more and more mortgages went into foreclosure, the value of these mortgage-backed securities plummeted. Because they were counted as assets on investors’ books, the drop in value meant companies had fewer assets. So much value was lost that many banks, investment houses and some insurance companies were forced into bankruptcy or were bought by other larger companies. Banks responded to their reduced cash flow by halting lending, resulting in a nationwide credit crunch. Cash flows came to a halt and many businesses were forced to lay off employees and sell off assets.

Troubled Assets

The “Troubled Assets” in TARP refers to assets tied up in mortgage-backed securities. No one could be sure what the value of those assets truly was because good and bad loans were all tied together in these securities. There was simply no way place a realistic value on the assets. The functional value was zero, since trading had halted over fears the securities were filled with toxic loans.

To help the institutions begin lending again and “unfreeze” the economy, Congress authorized the spending of $700 billion through TARP to support the lending industry. The first $250 billion was released that fall, used to prop up banks with failing balance sheets, essentially replacing the lost value from the mortgage-backed securities, or “toxic assets.” The government left few requirements for those receiving the funds, other than making the US government a stakeholder in the business.

The problem with providing the funds free of requirements became apparent when banks continued to keep tight fists. The government did place political pressure on the banks, but this was insufficient to make the necessary changes. The financial news settled for a short while in November as elections took center stage. In the end, Barack Obama was elected and the new leadership began drafting a plan to get banks lending again.

FDIC Chairwoman Sheila Blair championed the idea of providing incentives for lenders to offer loan modifications to struggling homeowners. Unfortunately, the Bush administration would not enact her plans. Homeowners had to wait until Obama took office and enacted his own plan to help homeowners. Banks were required to offer loan modifications to help homeowners honor their debts.

Toxic Assets Plan

In addition, the new treasury secretary, Timothy Geithner rolled out a Toxic Assets Plan funded by $1 billion of the TARP money. He announced plans in which the government and private businesses would work together to encourage trading of mortgage-backed securities again. The government agreed to refund investors, should their purchased turn out to be worthless.  Another fund was established to provide loans for investors wishing to invest in mortgage-backed securities.

It is too early to know if TARP was effective or not. The Obama administration has put new conditions on bailout money given to banks and some of the original TARP recipients are returning the money to go it alone. Markets did become liquid as TARP intended, but not to the extent previously experienced. Other economic factors make it difficult to secure loans, regardless of the bank’s willingness to lend. Property values have sunk so low that homes no longer have the equity needed to secure a loan in the first place. In addition, unemployment rates are high, so fewer people can qualify for loans.

All these factors make it difficult to determine the extent of the economic downturn. There are no clear indications of how long it will last or how deep it will fall. Because this economic failure has affected economies all over the world, the problem is deep and complex and is unlikely to be solved quickly or easily.