I recently had the pleasure of hearing Leon Royer, Vice Chair of American Bank, address the Bozeman Rotary Club on November 24, 2008. I feel that his message about the Financial Rescue Plan and TARP is as succinct and accurate as any I have heard. I hope you find this explanation helpful and informative as we search to acquire a basic understanding of the “bail-out”. What follows is an excerpt of his speech printed with his permission.

Let’s start from the beginning. The real name of the legislation is H.R.1424 but the short title is the Emergency Economic Stabilization Act of 2008. It was ultimately passed by Congress on October 3, 2008.
 
The common name for the effects of the Act is the Troubled Asset Relief Program or “TARP”.  
 
What it is not? – It is not a bailout of banks.
 
What it is: (a) an exchange of Federal funds to acquire assets or (b) receipt of a monetary premium in exchange for a Federal guarantee.
 
Initial publicity centered around the Treasury buying “troubled assets” from financial institutions (the primary focus was going to be on investment banks, not commercial banks) in order to provide liquidity to unfreeze credit markets. The most talked about assets to be acquired were mortgage-backed securities. The prevalent public assumption, which was perpetuated by the media, was that these distressed assets would be offloaded to the American taxpayer at inflated values with the investment bankers being unjustly enriched in the process. Speculation was that Wall Street executives would personally benefit from such sales and would then return to their former bad behavior having been “bailed out” in the process. This also contributed to the negative perception of the Act and was reinforced by the restrictions on executive compensation that are part of the Act.
 
The Act was purposefully drafted to allow the Secretary of the Treasury great latitude in administering funds. Three examples of this follow:
 
First: The stated purposes of the Act are: to immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States; and to ensure that such authority and such facilities are used in a manner that: protects home values, college funds, retirement accounts, and life savings preserves homeownership and promotes jobs and economic growth; maximizes overall returns to the taxpayers of the United States and provides public accountability for the exercise of such authority.
 
Second: A financial institution means: “any institution, including, but not limited to, any bank, savings association, credit union, security broker or dealer, or insurance company established and regulated under the laws of the United States.
 
Third: A troubled asset means: Residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and any other financial instrument that the Secretary … determines the purchase of which is necessary to promote financial market stability …
 
In each instance, the primary definition was almost boundlessly expanded by the vagueness of a subsequent phrase or junior section which provides the Secretary of the Treasury with great discretion to maximize the impact of funding.
 
After passage but before any troubled assets were acquired, it dawned on someone in Washington that the financial institution losses that would occur from the acquisition of these assets would likely destroy the capital structure of many institutions. The focus of TARP really changed to a mechanism that would permit Treasury investment in financial institutions in exchange for preferred stock and common warrants. Once the capital is infused, then the financial institution would be able to enter into troubled asset sales and could absorb the losses without creating an insolvency event.  
 
The primary reason for the Capital Purchase Program is to make preferred equity available to financial institutions that apply for the funds. The amount available to individual institutions is the lesser of $25 billion or 3% of risk-weighted assets.
 
What are the strings attached to these capital issuances to publicly held companies? The rate on the preferred is 5% for the first five years and 9% thereafter. The preferred can be retired without penalty at any time by the issuance of additional equity or after three years from other sources. In addition to the rate, the Treasury will receive warrants for common stock in an amount equal to 15% of the value of the preferred.
 
The terms for privately held banks are similar except that Treasury gets 5% of the amount of the preferred in warrants. Those warrants will be exercised immediately and start earning interest at 9% on day one.
 
For the Treasury to lose on its investment, all common shareholders must be completely wiped out. There is a provision of the act, Section 134, entitled “Recoupment”. This provision states:
 
“Upon the expiration of the five-year period beginning upon the date of enactment of this Act, the Director of the Office of Management and Budget … shall submit a report to Congress on the net amount within the Troubled Asset Relief Program. In any case, where there is a shortfall, the President shall submit a legislative proposal that recoups from the financial industry an amount equal to the shortfall in order to ensure that the Troubled Asset Relief Program does not add to the deficit or national debt”.
 
In other words, the President has the authority to in effect recommend the levy of a tax on the financial industry to recoup any losses. On the Capital Purchase Program, ($250 billion of the $700 billion total) I believe that an aggregate loss is unlikely for several reasons:
 
Once again, for Treasury to lose, all common equity in an entity must be lost. Although the 150% return (yield to funding cost) is pretty impressive, 5% is still a relatively low cost of capital that should enable recipients to use that money to make money.
 
At any time, the Treasury is free to sell any asset it acquires under the Act (including the preferred and the warrants). Imagine the consolidation that is likely to occur in the financial system if someone were to approach the Treasury to acquire blocks of preferred and the accompanying warrants. This could be done by an auction process that yields a very significant profit in that the strike price for the warrants is being set at a very low point in the market.
 
In summary, I believe that this legislation may have saved the American economy from an even more dire set of circumstances than we face today. So far, in my opinion, the program has been managed very well. At least for the $250 billion set aside for the Capital Purchase Program, I believe that the American taxpayer will enjoy a significant return – now if they only manage the remaining funds with equal vision.