The Fed posted an interesting article on their blog Tuesday that solidified some of our thinking about how to resolve the fire-sale problem. There is an opportunity for fire-sale risk mitigation here but it comes at a high price.
The article, “On Fire-Sale Externalities, TARP Was Close to Optimal,” by Fernando Duarte and Thomas Eisenbach, modeled out what would have been the impacts of fire-sales under various conditions, including one without any cash injection by the Federal Reserve. Unsurprisingly, the results without the Troubled Asset Relief Program (TARP) were disastrous, but TARP did what is was supposed to do in keeping systematic risk contained.
A brief history: TARP was created in the heat of the financial crisis as part of the US Emergency Economic Stabilization Act and invested US$245 billion across five bank programs. One of the provisions was an allotment of up to US$700 billion to buy mortgage-related and other underperforming assets (Secretary Paulson got US$250 billion on day one). According to the US Treasury, TARP has now recovered US$273.4 billion from its investments and has almost wound down the program entirely (see chart below).
Source: US Treasury
The lesson that TARP teaches us today is that the best fire-sale prevention program is one that does not have to sell its assets the moment that a crisis hits. As a colleague noted at the Federal Reserve’s fire-sale conference last October, 2013, there is only so much liquidity to go around in a crisis. We think that TARP worked so well, as proven out in the Fed’s article, exactly because it did not need to leverage market liquidity right at the time that said liquidity didn’t actually exist. This gave the market time to breathe, which in turn allowed a recovery. TARP made its money back after the crisis had safely passed.
This brings us to today’s program. The Fed and other regulators remain deeply concerned about fire-sale risk especially in the less liquid markets and are pushing all sorts of alternatives to get a conclusion. Among the solutions proposed is a resolution facility that would pay out the value of collateral right away, but this would require a standing fund paid into by the industry (more on that here). We think this is a non-starter even if it were financially viable. As one example, would banks today put up US$200 to US$300 billion in the value of the less liquid repo market in order to ensure that in case of a default, everyone gets paid out? We don’t think so – they would more likely leave repo first.
The next solution is that the government mandate an insurance fund or another type of TARP. We think that this is the only real solution that is going to work, and then the question is whether the government has the stomach or political will to engage in such a move. Yes, TARP worked, but it was also nicknamed the “US$700 Billion Wall Street Bailout Bill.” This probably isn’t the right time to ask for a backup TARP program.
Ultimately then we conclude that the only real solution to fire-sale risk is a standing fund that can afford to not sell until a crisis has safely passes. The tougher question is who puts up the money.