Thursday, April 30, 2009

The real cost of paying back the TARP

Reports have indicated that at least some financial institutions would like to repay the TARP money that they have received and unwind their financial relationship with the U.S. Government so that they can run their businesses free of government intervention. Specifically, these institutions want to buy back the warrants that give the government the right to buy shares of the company, which is a way to exercise at least some form of control over it.

The government has signaled that they will only allow the buy backs by institutions that it deems healthy enough to be free of government control. Some WI bloggers (and no doubt others around the county) have been alarmed by this prospect of a government refusal to sever their relationship with the financial institutions. They see this as a means of government control over private enterprise-something that it is, and that should give one pause. Perhaps though, there is another less nefarious and more economically sensible reason for the government's reluctance.

It is likely that the price at which the warrants get bought back will not represent the true value of those warrants given the current climate of taxpayer funded intervention to prevent the collapse of financial institutions.

That is to say, the government's recent actions have made it clear that they will not let major financial institutions go under. This is the case even at a potential cost to taxpayers in the trillions. These firms may not be backed by the full faith of the government, but they are certainly backed by its full credit. There is a value to this.

Shares of a firm that has access to a line of credit secured by the government, will be worth more than shares of a firm without such access, other things being equal. So a government guarantee funded by taxpayers will drive up share price. This is the case if the guarantee is either implicit or explicit and these days they are almost all explicit. It's the same old public risk/private gain that we have seen played out many times in the recent past.

The warrants that were part of the TARP deal give the government the option to buy shares of stock in a company at a predetermined price. The government could use these warrants to capture some of this taxpayer funded value in share price by waiting until the shares are worth more than the predetermined price in the warrants, it could then buy shares at the predetermined price, and then sell those shares at the current, higher price.

I am willing to bet that there are economists out there that could at least come close to determining the effect of government guarantees on the share price of financial firms. If so, this value could be used to more closely determine the real value of the government held warrants.

If such a scheme were attempted though, I predict that many pundits and politicians especially those enthralled by Wall St. (yes, they are still out there), would call this highway robbery. I would call it giving the taxpayer his due.
Economics side note: If the government pursued this strategy would it be the opposite of regulatory capture? Would that be free market capture? Corporate capture? Is there a name for this?

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