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Understanding How Bailouts Work

How Bailouts Work

A lot of acronyms such as TARP, TALF, and financial jargon such as Mortgage Backed Securities (MBS), and Collateralized Debt Obligations (CDO), have been thrown around by the experts and also the media since the financial crisis of 2008 began. Here’s helping the average Joe get a better idea to what these terms mean and how the ‘strange’ concept of bailouts work.

Mortgage Backed Securities (MBS) & Collateralized Debt Obligations (CDO)

Essentially both are similar financial products which are mortgage pools made up of large bundles of mortgage payments and house prices that are sold to investments to ease of risk and recapitalize lenders. This product offers a lot of benefits to the banks and general U.S housing market as it lets banks recapitalize on mortgages issued thus making funds available for additional loaning.

TARP – Troubled Asset Relief Program

This program was established under the Emergency Economic Stabilization Act of 2008 allowing the government purchase Mortgage-backed securities (MBSs) and Collateralized Debt Obligations (CDOs) backed by subprime mortgages. The program cost $700 billion which was to be released in two installments of $350 billion to the Federal Reserve.

To an extent TARP has helped improve liquidity amongst the banks, but the failure of the Federal Reserve to monitor how funds were used is cited by critics as a flaw which could create an avenue for future problems.

TALF – Term Asset-Backed Securities Loan Facility

The TALF is a second program allowing the Federal Reserve purchase mortgage-backed securities and debt obligations by the GSE (Fannie Mae, Freddie Mac) and Federal Home Loan Banks and at least $800 billion was made available to recipients through this program.

$600 billion would be used to purchase mortgage backed securities and debt obligations owed by the GSE and other government backed lenders. Another $200 billion would be issued on a non-recourse basis to financial institutions owning securities backed by consumer loans such as auto loans, credit cards, and student loans.

How the TARP & TALF work?

Both the TARP & TALF were designed to introduce liquidity into the banking system. By providing loans, guarantees, and investments to the parties involved, more funds for additional lending and other banking activities become available. Both programs have yet to do little to protect mortgage borrowers at risk of defaulting, thus making experts believe the bailout process may turn to a vicious if left unchecked.

Are the bailouts an investment or expenditure?

Treasury Department Secretary Henry Paulson has also claimed the bailouts are an investment rather than an expenditure in which the government loses the monies it spends.

The bailouts have largely involved the U.S government in stock warrants, preferred shares and asset guarantees. Preferred shares are basically loans earning a fixed interest rate every year. As for stocks, there’s no reason to believe the market wouldn’t bounce back in 10 or 20 years time during which the government can liquidate its equity in banks it ‘bailed out’ for a profit.

The bailouts should be seen as an investment which will provide the U.S. government with extra income from interest rate payments. And the only way things can go bad as such is if the banks declare bankruptcy – during which the U.S. Government has options to collect proceeds from the asset sales in event this happens. Otherwise, most preferred shares bought by the Treasury and Fed pay 5% annually for an initial five years and 9% thereafter.

In the beginning, experts criticized the U.S. government saying it did very little to prevent homeowners from defaulting on their payments, leading to foreclosures and the vicious cycle that led to the financial crisis but due to the drastic reduction in crude oil prices from a high point exceeding $120 in mid-2008 to less than $40 per barrel as of December 2008, gas and food prices have reduced in prices.

As a result of recent events especially low crude oil prices, a period of deflation is expected in 2009 & 2010 while consumer spending is expected to pick up during such years.

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