The article you are about to read has been redrafted on several occasions now, as a result of what seem to be constant changes in the actions taken by world governments to help ease the problems in both credit and share markets. The proposed solution started in the U.S. with political leaders spending the best part of three weeks negotiating and drafting the Emergency Economic Stabilization Act of 2008. At its heart was authorisation
for the U.S. Government to purchase as much as US$700b in subprime mortgages from U.S. financial institutions, in order to free
up their balance sheets and allow them to resume lending.

The key sticking point, which resulted in its rejection the first time, boiled down to legislators ensuring that the effect to the taxpayer was minimised over the long term and that those responsible for the problem were kept in check via restrictions on compensation and profit sharing when
things start to turn around. Whilst the original Bill was quite small (only three pages) the version that finally passed the House
of Representatives was over 400 pages and included large numbers of additional measures designed to secure its passage.

The major thrust of the Bill, known as the Troubled Asset Relief Program (TARP) was to allow the Federal Reserve to purchase subprime mortgages from the banks that has the effect of exchanging the bad debt on their balance sheet for cash, thus improving their liquidity. It is hoped that this will then allow them to begin lending within the market again, which should free up credit.

The key details are:

• the Treasury Department will immediately receive $250 billion to begin the program
• an additional $100 billion will be provided if the President certifies that the money is necessary
• an additional $350 billion will be provided if the President certifies that the money is necessary and if the Congress approves of funding
• establishes a program to allow the government to insure, instead of buying, some troubled assets held by banks
• establishes an oversight board to monitor the Treasury’s use of the funds.

One of the key issues that was debated at length was the responsibility of Wall Street and the investment banks for the current malaise. To address this, two measures were included:
• the Federal Reserve can establish rules limiting executive compensation, bonuses, ’golden parachutes‘ and other incentives at institutions participating in TARP
• participating institutions will also lose certain tax benefits related to compensation.

One of the more left field amendments to the Bill was an excise tax exemption for producers and importers of certain types of wooden arrows used by children, which demonstrates how desperate law makers were to get enough votes to get it passed.

However after the Bill passed, things took a turn for the worse. World markets began to tumble at an accelerated rate and credit markets basically stopped functioning all together. The financial system was nearing the point of complete collapse and no one trusted anyone. With the system crumbling around them, it was Britain that enacted measures that would eventually be adopted by other European countries and would result in the TARP Bill being further adjusted.

In an unprecedented move the British Government announced that it would adopt a three point plan to rescue the stricken financial system. The plan included:

1. A recapitalisation of banks using taxpayers’ money in return for a state share in the company (partial nationalisation).
2. Action by the Bank of England to pump more liquidity – cash – into the financial system.
3. The British Government would ’guarantee‘ loans between banks – the financial system’s life’s blood – for up to five years.


These recapitalisation measures alone will see the U.K. spend AUD$94bn, the equivalent of 2.5 percent of their national GDP, in the part purchase of Royal Bank of Scotland, HBOS and Lloyds. This plan was announced in the middle of the week that saw share markets drop by 15 percent and culminated in a meeting of the G7 and G20 leaders over that weekend. What emerged from those talks was nothing short of stunning. Adopting the British model the major countries of the EU, France, Germany, Spain, Netherlands and Austria all agreed to take stakes in tottering banks and underwrite their lending, committing initially $AUD2.6tr.

Over the same weekend the Australian Government made similar moves, guaranteeing all bank deposits held in Australian bank accounts, underwriting interbank loans and announcing a $10.4b Economic Security Strategy designed to stimulate the economy. This in turn prompted a change of policy in the U.S. which adjusted the use of funds allocated from the TARP Bill, to mirror the actions of their European counterparts.
In the U.S., from the $700bn initially allocated, $250m will be used by the government to make direct purchases in nine of the top U.S. banks.

This is designed to allow these banks to quickly shift the money directly out into the economy. A further $100bn will be used as originally intended - to purchase the subprime mortgages. In addition the U.S. has also followed its European counterparts and guaranteed interbank lending.

Only time will tell what affect all of these measures will have on both financial institutions and world markets, and ultimately, how it will be viewed when these events are looked at in the pages of history.

Daniel Minihan
Director
dminihan@moorestephens.com.au