The world according to Tarp

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Back in November last year, Risk ran a comment piece on the Master Liquidity Enhancement Conduit (MLEC) proposed by Bank of America, Citigroup and JP Morgan. The purpose of the vehicle was to buy up highly rated assets from structured investment vehicles (SIVs) struggling to refinance in the asset-backed commercial paper market, avoiding the need for SIVs to sell assets at fire-sale prices.

The idea, in principal, was a good one. It would potentially have improved liquidity and avoided the vicious circle of troubled SIVs being forced to sell assets at knock-down prices, compelling other vehicles to re-mark their books at lower levels. Where the plan fell down was a disagreement over how the assets would be valued. In the end, the scheme fell by the wayside amid a lack of support from banks.

Twelve months later, the same questions are being asked, but this time in relation to the so-called Troubled Asset Relief Programme (Tarp), a $700 billion fund proposed by the US Treasury that will buy mortgage assets from the balance sheets of stricken financial institutions.

The concept is similar to MLEC - although taxpayers' money will be used to buy the assets, rather than cash pooled together by participating banks. Nonetheless, the idea is still good. As a vehicle backed by the US government, Tarp would potentially help restore confidence in the battered mortgage-linked securities market. It has also been hinted the vehicle will buy assets based more on their hold-to-maturity value, rather than on current market prices. Banks would then be able to re-mark their books to higher, observed market prices, creating a virtuous circle.

Politicians have baulked at the suggestion Tarp will pay above the odds for distressed assets. Proponents counter that current market prices reflect investor fear and a lack of liquidity in the sector, rather than the fundamental value of these assets. In theory, they argue, Tarp could buy these assets at above the market price, yet still make a handsome profit for the taxpayer if they are held to maturity - assuming the securities aren't wiped out completely by high defaults.

However, we come back to the questions that plagued and eventually sank MLEC. How will the assets be valued? Who will take responsibility for valuation? What assets will qualify for the vehicle? And, crucially, will $700 billion be enough to sort out the problem once and for all?

The voting down of the initial proposal by the US Congress on September 29 will presumably prompt renewed horse trading as a revised plan is put together. Despite the political grandstanding, those involved mustn't lose sight of the fact this proposal will bring some desperately needed stability to the financial system after three weeks of chaos. They must also bear in mind that while debate has so far focused on the rights or wrongs of the rescue, slammed by some as a blank cheque to bail out Wall Street's excesses, details of how exactly the fund will work have been more or less overlooked.

Nick Sawyer, Editor.

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