A Better Use for TARP Funds?

By Jim McTague
TREASURY SECRETARY HANK PAULSON, an old Goldman Sach's investment banker, should take a good look at the yield curve, which looks something like it did back in 1992. It might then prompt him to play the old "carry trade" with some of the TARP funds instead of pumping all of it into banks to shore up their capital.
One expert claims that Paulson is leaving a minimum $200 billion-to $500 billion-a-year in profits on the table by failing to adopt the strategy.
The "carry trade" is financial jargon for borrowing money at low interest rates and then using the funds to buy securities with very high yields. The spread between the cost of funds and the interest coming in from the securities is profit. In 1992, former Fed chairman Alan Greenspan drove down short-term rates so the banks could borrow cheap from depositors and then make higher-yielding loans, which allowed them to make enough money to offset the real estate losses.
Because of the current, extraordinarily high, world-wide demand for U.S. Treasuries, Paulson easily could borrow $700 billion at say 3% and use the proceeds to buy investment-grade mortgage securities for about 65-cents on the dollar and yielding 9% to 12%, according to a back-of-the-envelop estimate by Larry Goldstone, president and chief executive of Thornburg Mortgage, a REIT traded on the New York Stock Exchange.
If Goldstone's calculations are correct, then Treasury could make 5% to 8% of carry profit every year, even if credit losses get so bad that it only recovers 90% of the face amounts of the underlying home loans. That would go a long way toward offsetting the steep cost of shoring up our financial system and save future taxpayers much grief.
"You basically could take all of these high-rated securities off the market and put them in an account somewhere," says Goldstone.
Goldstone would like Treasury to engage in the carry trade by buying some of his company's assets. It would be a demonstration program for dealing with credit-stressed nonbank financial companies, he says. Thornburg needs a buyer for the securities, so that it can raise cash to remain current on $12 billion in loans. The usual markets have collapsed because of the credit crisis.
Goldstone says Thornburg's portfolio is heavily weighted with investment-grade mortgages and mortgage securities. Thornburg qualifies for TARP funds under the language of the bill that created the original program, he says; but when Paulson abruptly decided this month to use all of the TARP funds to prop up bank capital rather than buy assets from financial companies, the Treasury Secretary left Thornburg out in the cold.
Goldstone believes making profits in the carry trade currently is pretty much a sure thing, prompting him to ask, "If Treasury can make 500 to 800 basis points in $700 billion, then why would they not invest $1.5 trillion or even three trillion? The country certainly needs the money!"
Goldstone says he understands the logic of Paulson's controversial TARP switcheroo earlier this month. Since banks can leverage their money 10 to 1, it looked as though the Treasury would get $1 trillion in buying power from the move.
After all, the banks, in theory could also engage in the carry trade in part by accepting the higher-rated mortgage securities as collateral. In reality, however, bank credit problems this go-around are so severe compared to 1992, that the sector cannot out-run its mounting losses. So instead of lending out the TARP money, banks are holding it back, Goldstone says, to make certain they don't fall below regulatory capital levels.
As a consequence, nonbank companies are having difficult time finding adequate amounts of affordable credit.
Treasury, thus far, has committed $250 billion to shoring up bank capital and its invested another $40 billion to save insurer AIG. That means there's $410 billion of the original TARP fund left.
Surely Paulson could use some of it to see if Goldstone is on to something. Taxpayers could use a bailout too, and the carry trade might just be the ticket.