The intense negotiations between the government and the two parties in the US Congress over the weekend have resulted in a broad agreement on the structure of the rescue package (Troubled Asset Relief Program, or TARP) intended to stabilise the US banking sector. This package will now have to be formally passed by Congress this week.

 

As originally proposed, the core of the plan is for a new ‘rescue company’ formed by the government to buy up the troubled, illiquid securities (mainly mortgage bonds) from financial institutions active in the USA for up to USD 700 bn, in order to take some of the pressures off the balance sheets of these institutions and to ease their acute liquidity problems (cf. our publications from 19 and 22 September).

 

The first USD 250 bn of the total USD 700 bn will be made available immediately for the purchase of the troubled mortgage bonds, with another USD 100 bn subject to approval of the President. With regard to the remaining USD 350 bn, the US Congress will have the opportunity to block approval at a later point in time.

 

Institutions which sell securities to the rescue company will have to provide share options to the government in certain cases. This is intended to allow tax payers to benefit from the anticipated long-term increase in the value of the companies receiving the support. If the financial stabilisation programme ends up with a loss in 5 years, the loss is to be recouped by drawing on additional funds from the financial industry (unspecified additional revenues for the government).

 

An oversight board is to be established for the programme, and the head of the US central bank, Ben Bernanke, will be a member of this board. The programme shall also be subject to the control of the US Congress.

 

Companies participating in the programme will be subject to conditions on the amount of remuneration of senior management (including severance pay, aka ‘golden parachutes’).

 

The Treasury is entitled to establish an insurance programme, through which the assets (including RMBS) of the troubled institutions are to be guaranteed, insofar as such assets were purchased prior to 18 March 2008 (this system will be financed from contributions of the financial industry).

 

In relation to the mortgage bonds that it holds, the government is entitled to grant more favourable conditions to the debtors of the underlying mortgage loans.

 

(One detail which is not insignificant is that shortly prior to the agreement being reached, a preferential loan package of USD 25 bn was approved for the embattled US auto industry, and the ban on new off-shore oil drilling was lifted).

 

Official approval by the House of Representatives is planned for today, on Monday. As there is no meeting scheduled for the Senate on Tuesday due to a holiday, the necessary Senate approval is likely to take place on Wednesday.

 

Actually, the most important point is still not clear: What will be the price that is paid to buy up these securities from the banks? Because this will determine how many banks make use of the programme and to what extent they profit from it. We assume that purchase of the securities will occur at conditions which render participation in the programme interesting. As a result, there is a good chance that the market for these securities will thus be able to stabilise, thereby supporting the financial system.

 

The panic which gripped the financial market in the wake of the collapse of Lehman Brothers was temporarily suspended by the US government’s announcement of a rescue programme on 18 September and hopefully today’s moves will keep the panic from spreading on the markets again for the time being. Nevertheless, the programme will neither prevent further banks and companies from going under nor avert a slowdown in economic activity at the global level. Consequently, our economic and financial market prognoses remain unchanged. Nor do we believe that it is likely that the situation on the money market will normalise before mid-2009. Nonetheless, over the medium term it does appear realistic that conditions will return to the levels seen prior to the Lehman bankruptcy and even this would be an improvement (whereas today the crunch on the interbank money market has intensified further, with OIS-Spreads reaching new highs).

 

It is possible that we will now finally see the emergence of a more sustainable recovery in equities in the financial markets. Nevertheless, one must keep in mind that some financial institutions will still be hit by instability and that the sector as a whole still has plenty of write-downs in store for the third quarter and fourth quarter of 2008. Moreover, the low point in the economic cycle is still to come. And this downturn will also affect other areas of the economy. Hence, there is obviously plenty of room for disappointments still (e.g. corporate earnings). On the other hand, the stock markets have already priced in a great deal of negative development in share prices and valuations. As a result, one can assume that any new setbacks will open up some attractive opportunities for investing in the long-term.

 

Considering that approval of the package will (hopefully) be followed by a certain amount of relief on the markets for riskier assets, it is quite possible that government bonds will come under short-term pressure again. As a result, we stick with our short-term neutral recommendation on government bonds, but would view a correction in bond prices as a good opportunity for buying. First, because we are rather sceptical with regard to the prospective sustainability of any improvement in sentiment on riskier assets, with due consideration of the deterioration in economic fundamentals (keep in mind that the last rally on the stock market lasted just two days). Secondly, the steep decline in inflation and the equally steep downward trend in the economy will also be two factors supporting government bonds in the months ahead.